Why is "Investor Education" important?
With investing, ignorance is not bliss. When it comes to hiring a computer expert, I don’t have to know why they are performing a procedure in a certain manner. My main focus is making sure my computer works when they are done.
The same rule doesn’t necessarily apply with investing. The reason is that even a well designed portfolio will go through times of negative returns. In other words, it will appear to be broken. There are also times that a well diversified and prudently designed portfolio will have returns that are below the areas of the market that we hear about on the TV and radio – namely the DOW and S&P 500. It is during these times that investors will question their investment strategy and be tempted to change course. The media will be full of stories about what areas of the market performed the best in the past several months. You may recall how investors were driven to plow large amounts of money into technology stocks at their zenith. The euphoria over technology stock’s rapid climb caused investors to lose discipline and make bad, emotion or instinct-driven decisions.
An investor with a solid foundation on why their portfolios are designed the way they are will have greater peace of mind than an investor who is exercising blind faith in their advisor.
What do you need to ask before investing in mutual funds?
• What share/class is the advisor recommending?
• Why are you recommending this fund?
• How often and how do you rebalance the portfolio?
• How do you intend to tax manage this portfolio and minimize taxes on current gains?

Question #1: What share/class is the advisor recommending?

I like to use the analogy of walking into a house when explaining share classes to investors. Each "house" varies in how you pay for the visit. (Note: None of these fees include hidden trading costs which are rampant in the investment industry.) The typical share classes are as follows:

With "A" shares, an investor pays an upfront fee to "walk in the front door". That fee generally averages around 4.5% of the amount invested. If you invest $10,000, the fee is $450 to enter. As the amount invested increases, there are generally break-points at which the fee decreases. Management fees are charged on the assets managed and average around 1.4% of assets. That is the fee you pay each year to stay in the "house". There is no reduction in management fees regardless of the size of the account.

"B" shares are often wrongly touted by brokers as "no-load funds". The reason is that they don't have a front-end fee deducted from the account when the money is deposited (or no fee to walk in the house). In exchange for this, the fund charges a higher management fee. This fee is usually around .7% higher than the equivalent "A" share (ex. 1.4% + .7 = 2.1%) In addition, the fund also charges a back-end fee (or a fee to walk out the back door of the house) if the investor leaves before a set period of time (usually 7 years or so). The higher management fee and back-end fees are used to compensate the broker selling the fund.

The third type of share class most often used is called a "C" share. Like the "B" share, this class allows 100% of the investor's money to go to work right away. However, if the investor decides to leave, the back-end fee is generally much less (often 1%). The ongoing management fee is often comparable to the "B" share.

True no-load funds are the fourth most common alternative. With this alternative, the advisor does not get paid by the fund company. Rather, the advisor charges a fee directly to the investor. I prefer this arrangement, because it is the most transparent alternative. Nothing is hidden. In my opinion, commissions and hidden expenses can be a problem for several reasons:

• There is often an incentive to do something when nothing is the right thing to do
• There is an incentive to offer products that pay higher fees to the advisor (unbeknownst to the investor)
• There is the incentive to recommend what the investor will buy, rather than what they need. (This is why so many advisors use short-term track record to get investors to sign on the dotted line.)
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Question #2: Why are you recommending this fund?

This is a trick question. If the answer is: "It's got a great performance history" or "They have great managers", there is only one thing to do. RUN!!! Some of the funds you own should actually have fairly mundane track records. This is because all asset categories can't be hot all of the time. Most of the money being invested during 1999 was going to tech. funds and large US growth funds. The reason? Great short term performance. This is why many investors lost 50 to 80% of their stock portfolio's value during the market downturn. What goes up will come down.
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Question #3: How often and how do you rebalance the portfolio?

Even though this is a basic tenet of asset management, I almost never see it carried out. This can add tremendous additional returns over time and be very helpful in controlling the risk of the portfolio. The advisor should rebalance based on deviations from a target that is predetermined. For example, if the large US stock portion of the portfolio is supposed to be 10% and it deviates to 15% because of market conditions, then it is the advisor's job to bring the mix back to 10% with as little cost as possible.
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Question #4: (If the portfolio is taxable) How do you intend to tax manage this portfolio and minimize taxes on current gains?

If the look you get appears to be a blank stare… RUN!!!! Taxes can be a tremendous expense to investors. Many investors have had the grueling experience of paying taxes on portfolios that declined in value. The other problem is that mutual funds can be horribly tax inefficient. Many times investors are forced to pay taxes at short-term capital gains rates due to actions taken not by themselves, but by the fund manager. Over the long-run, failure to tax manage an investment portfolio can cost the investor dearly and create a drag on returns.
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