Register now for the Dentist Money Summit: Join the team behind the Dentist Money Show for a weekend of financial education.
June 20-22, 2024 in Park City, UT

>>Register today!

Six Keys to Powerful Investment Portfolios – Episode 55

How Do I Get a Podcast?

A Podcast is a like a radio/TV show but can be accessed via the internet any time you want. There are two ways to can get the Dentist Money Show.

  1. Watch/listen to it on our website via a web browser (Safari or Chrome) on your mobile device by visiting our podcast page.
  2. Download it automatically to your phone or tablet each week using one of the following apps.
    • For iPhones or iPads, use the Apple Podcasts app. You can get this app via the App Store (it comes pre-installed on newer devices). Once installed just search for "Dentist Money" and then click the "subscribe" button.
    • For Android phones and tablets, we suggest using the Stitcher app. You can get this app by visiting the Google Play Store. Once installed, search for "Dentist Money" and then click the plus icon (+) to add it to your favorites list.

If you need any help, feel free to contact us for support.

Have you ever looked at your investment statements and wondered if your returns are as good as they could be? You’ve been told cheap index funds are the most responsible way to invest, but is it really that simple? What other funds can you buy? In this episode of Dentist Money™, Reese & Ryan list six factors to consider when building your investment portfolio. They discuss tradeoffs between active and passive investing, why some index funds underperform, and how to build a portfolio with the right mix of assets.

Podcast Transcript:

Reese Harper: Welcome to the Dentist Money Show where we help dentists make smart financial decisions. And I am back in the studio as promised with my trusty co host, Sir Ryan Isaac.

Ryan Isaac: Good morning, Reese. It’s good to be back; today Reese, we are going to talk about the exciting world of building a portfolio.

Reese Harper: So you’re going to teach me how to make some money?

Ryan Isaac: I’m going to teach you how to trade. So today’s agenda is how to day trade your stocks—in between patients. Today we want to talk about the boring old steps to building a long-lasting boring portfolio that will help you retire. We talk to a lot of people who are doing things on their own. They set up their own accounts; they manage their own money; they pick their own investments. To each his own; I wish everybody good luck because it’s a rough battle. Some of the comments that come back from people concern me a little bit when I hear them because I wonder if it’s a little bit more complex than people think it is. We talked once about how to build a pencil—simple doesn’t mean easy. A pencil is a pretty simple tool, but building it is not an easy task, and I sure couldn’t build a pencil. So this is what spurs the conversations for me, Reese; some of the comments that come back are: I’m good, I’ve opened up an account with some cheap funds, and I have some cheap index funds so I’m good. So the assumption that all a portfolio has to do is it just have to be cheap, and it just has to be in an index fund of some kind. There’s a few index funds around the world.

Reese Harper: So you’re saying this is from sales calls, from presentations?

Ryan Isaac: Yeah, meeting new dentists across the country and just having conversations with people about the way they have done things with their accounts in portfolios so far.

Reese Harper: And there’s an assumption that: I’ve done it the right way because I’ve already picked inexpensive funds in my portfolio—I’m good. That’s an assumption that once that step is done, I’m good?

Ryan Isaac: It’s cheap and it’s an index fund meaning it’s not an actively managed stock picking kind of prediction-based fund that I bought. It’s cheap; it’s an index fund; it mimics a certain market around the world; and so that’s good. Now the disclaimer is: those are important, right? It’s about time people are paying attention to costs in funds and that it’s information that a lot of people know. Cheap funds existed a long time ago, but not everyone had access to them or knew about them. So that’s great, and that’s really good to hear that people are conscious of the costs in their investment portfolios now. It’s great that people are starting to understand the difference between and make the distinction between a fund or an investment style or philosophy that’s really active and trying to guess and predict what’s coming next and a philosophy or a style that just says—look I’m going to own the market as it exists; I’m going to take the returns that it gives me. If it goes down I’ll go down, and I’ll go up when it goes up; I’ll accept the returns this gives me. And that’s what people refer to when they say, “I buy an index fund.” I think it’s good that people are conscious of these things; I’m glad they are. Today we are just going to talk about why those aren’t the only two steps to building a good, successful portfolio that will end up doing what you want it to do.

Reese Harper: It’s not so linear—cheap, mutual funds do not equal a good portfolio. That’s what you’re saying. I think that’s what people want to believe, just like: if you eat well, you’ll be healthy. Well, that would be nice if that was the only expectation that you had to have for yourself or the only implementation step that was required, but there’s sleep requirements, exercise, stress levels, scheduling—all those things contribute to your overall physical health. The point you’re trying to make that I just want to reemphasize is: inexpensive mutual funds that index the market do not necessarily equal good returns. And we’ve seen just as many poorly performing index portfolios as we have actively managed portfolios. Now the fund performance of indexes might be a little more consistent because they are based on tracking error; they’re trying to track an index. The way those funds work is they don’t have as much variance to them; they don’t move up and down as much in the groups that they are in. But the portfolio is not just about making it be cheap. Let’s start with that premise and maybe let you take it from there.

Ryan Isaac: Yeah great, so I think moving forward we are just going to say: we are going to outline six difference pieces to building a solid portfolio, and number one is a question I’ll pose to you Reese Harper: what is your philosophy? Before we even begin this whole thing; before you pick funds; before you pick costs, advisors, fund families: what is your investment philosophy? And let’s narrow it down to two—you can be a really active philosophy or you could be what people call “passive.” Let’s start with those two: what are they, how do you pick them, and how do you decide which investor you are?

Reese Harper: In an active philosophy you’re trying to do something that is going to give you exceptional returns or lower risk than what the overall group of stocks in a market will give you. So by picking fewer or certain types of securities instead of owning all of them, you’re going to have your portfolio perform differently than the overall market. So if I’m an active investor I could be someone who believes in fundamental analysis which is, I’m going to try to find which companies have really good financial statement clarity that allows me to decide whether they are under priced or over priced, and I’ll pick stocks that I’ve prepared financials for that I think are better or worse than what they are currently saying, and that means that their price is wrong. The way that the stock is priced in the market is either too cheap or too expensive. You also have people that are more technical in how they look at the market—they look at cycles that we are in. Are we in a recovery cycle or in a growth phase? Which types of stocks perform well in different cycles of the market and which sectors should I be in in order to grow or in some cases short the market during time periods in certain economic cycles? There’s probably ten different categories in the way people trade, but the point is an active trader or an active investor is trying to do something unusual that the overall market would not do if you just owned the thing, and at best this philosophy can result in better returns than the average person at best. On the poor side of this equation is obviously if you pay attention to investment theory, John Bogle is the Vanguard founder and he wrote several books and his main overriding principle is that if you’re an active investor that just as many people who are beating the market have to underperform the market. All these stocks—if you put them into a big recipe and mix them all together, they all get an average return, and some people are going to get above that average and some people are going to get an average return that’s below that average. Some people have to win, some people have to lose in order for the market to return an average in the middle—someone’s got to get 15% and someone’s got to get 5% in order for the market to have a 10% average. So if you’re going to take that risk of being the person that gets a potentially higher return, then you can run the risk of underperforming the average by quite a bit. And statistically the odds are really not in your favor. The statistical truth about it is there are a lot of jokes and a lot of comedy centered around how really, really smart people cannot get the average return—monkeys will beat the average return.

Ryan Isaac: To be fair, the segment of the entire market that adopts this philosophy is quite large. It’s not a minority of people who believe this way, and some of the brightest minds in the entire planet believe this way around money and finance. This is the way they like to do things.

Reese Harper: Ryan and I, we’re not drawing a line in the sand saying, “One way is the only way.” We have taken a stance in our own investments and in our own lives that we feel like is slightly more conservative, and it also results in a lot more predictability. We have a lot of control over the outcome. In our own lives and our own philosophy, we just don’t feel like the cost and the fees associated with market timing and active management is the right decision for most people.

Ryan Isaac: Okay so the other side of this coin then is the approach that some people will call “passive” or “indexing.” Let’s address the connotation—that sounds like the boring lazy way that dumb people use.

Reese Harper: Yeah, this is another thing—this is not something that people who don’t know what they’re doing use and active strategy is the one where the smart people go. Some of the brightest minds in the investment industry have built massive companies around this concept and they attract very smart people. It’s an attractive methodology for a lot of reasons. The general premise is that overall the market has all these people in it—the U.S. has 300 something million people, and it has just under 4,000 stocks. So of all these stocks that are in the market, that’s the entire U.S. stock market; I don’t know if people realize that. When you say the entire U.S. stock market is under 4,000 public securities, it’s surprising to most people. It seems small. Globally there’s north of 10,000 securities, but there’s south of 15,000 more globally. So across the whole world you’ve got quite a few, but it’s not quite as many companies as you might think that are in the public domain. Private companies there’s obviously much more than that. Ryan has like ten. You’ve got your weed wacking business, your Popsicle sales, the lemonade stand.

Ryan Isaac: The baldness cure pill that I just launched.

Reese Harper: The baldness cure pill—that is not an MLM guys. What’s the more appropriate phrase?

Ryan Isaac: It’s just networking marketing. You just invite people into your living room and tell them about my baldness pill. And if they sign up two friends and they sign up two friends—you’re done.

Reese Harper: The general thought about indexing is that if so many people around the world are active managers, and if all this information is out there. The majority of people in the world still are active managers—so greed drives people more than risk aversion right now in the investment world. More people want to make extra money than they do sit back and just take what the market can offer. So if there’s all of these prices and all this news and all this information that gets released every day about companies—and again you’re required to release any financial information about yourself publically, and you can’t trade based on that prior to releasing that information. So every public company has to tell the public everything about their financials. They have to release their financials; they have to make estimates on what they feel like their earnings might be going forward. From that moment when a company gets on the conference call and they let everyone know what’s going on, that’s when you see the stock prices change. And you’ll see those stock prices change within thirty minutes or five or ten minutes. Before the trading day is over, the market has adjusted its price so quickly to that information that a lot of smart people just say, “Hey markets are very efficient, and they’re becoming more efficient as time passes.” As more people have access to the Internet and more people have access to data, there isn’t price advantages that you can gain over other people. So you just see a lot of people try to trade information differently, and that’s always going to be there. You will always have attention between the greed that drives capitalism and then maybe the academics or the data that people are observing. It’s not actually that successful for most people, especially retail investors, especially dentists in between patients. Not even listening to earnings calls and trying to make some quick decision about forecasted earnings, but just maybe read an article that was four weeks old from some newsletter that already got posted. The market’s priced in all that information already and you are thinking that you’re the only one that has that newsletter from Tom out of New Jersey.

Ryan Isaac: Or maybe you were golfing with a friend though that had a really compelling story.

Reese Harper: Yeah, that happens often too.

Ryan Isaac: So to recap number one: pick which person you are. Are you the investor that feels like you’re going to have an advantage to manipulate information and get a rate of return that’s higher than the market is even offering to the general average public?

Reese Harper: Me myself?

Ryan Isaac: Yeah, you have to figure that out.

Reese Harper: Oh I thought you were asking me a question. You’re saying generally the dentist needs to figure that out.

Ryan Isaac: Yes. Step one: are you that person or are you the investor that says, “I’m going to accept what the market can give me because over a long period of time that’s enough for me to retire if I save enough money into it, so I’m not going to spend the time and money trying to actively manipulate data and pricing. I’ll take the return.” So how do you figure that out then?

Reese Harper: If you’re sitting around and you haven’t ever really opened an investment account, and you have a bunch of money in your practice checking account, and you’ve got a little too much cash and you’re wondering what you should do with this, you’re probably not an active investor. An active investor by nature, that is their hobby—they live and breathe it; they would rather do that and look at markets and review data. It’s like Ryan’s bald pill company. Ryan spends every aching hour of his life trying to distribute those pills in his neighborhood. If you don’t find yourself caring that much, you’re probably not an active investor because you don’t have the patience to learn what it’s going to take. I have active tendencies, and I’m still not an active investor. I love data; I love markets; I love picking an occasional stock and losing money on it. That is a fun thing for me. But I don’t do that; it’s relegated to about 2% of my investable assets because I just don’t want to expose myself to the risk that comes with getting it wrong. I like to think I do a lot of research, and I’m pretty educated, but I’ve got friends that are active managers for a living and even they will acknowledge how difficult it is for them to be able to successfully out perform the averages, and it’s really difficult. So for the average dentist who is trying to predictably retire, I just think it adds way too much risk to his future, and I would limit it in a significant way. And you’re probably not an active investor if you have a bunch of money in cash right now.

Ryan Isaac: All right, so let’s move on to the next steps with the understanding that we’re going to be talking to this passive investor now moving forward. Because a lot of what spurred this conversation between us today is that we hear a lot that just because someone picks the passive route and buys an index fund—which I don’t know what it means when people say that, “I buy index.” I don’t know what that really means.

Reese Harper: It can be a lot of different things, but they say it like it only means one thing.

Ryan Isaac: Like it’s the main thing. But let’s kind of walk through the steps—those are important, but there’s some other things that matter when you build a portfolio. I would say number two here after number one of picking a philosophy, number two is understand the risk that you need to take and can take based on the goals that you have. Do you need a down payment for a building or a house coming up soon? Are you trying to buy a practice? Did you just start up a practice and you need cash to live on for a while? Are all those things taken care of and you don’t need money out of your retirement accounts for the next 25-30 years? Step two would be: asses your risk and how much risk you need to take and start building your accounts from there. Any comments on that?

Reese Harper: I think you’re saying: before you start building a portfolio, determine what the purpose of each dollar is or each account. And I think that’s a huge deal because a lot of people just don’t take the time to determine whether the money they’re investing is going to be used for a certain thing. People say: I’m investing and I just want it to grow. The problem is each dollar you invest needs to have a very specific timeline associated with it. Not just retirement, but which age in retirement are you going to be pulling from this specific account? Age seventy? Sixty-five? Fifty-five? It’s not just an account. Each investment you make needs to have a specific date that you’re trying to approximate what this money is going to be used for. Otherwise, you’re not going to be maximizing the return you could get for that particular tranche of your investments. The longer the time frame before you touch the money, the higher return you can get. But you’ll also be experiencing more up and down movement—more risk and volatility by picking something that gets a higher return. Statistically, the highest returning asset is really small companies that are almost going to go out of business. So if you bought all of those companies—like Blockbuster video before it was going to go out of business. Those kind of companies that have what’s called a high book-to-market ratio meaning their value—the market value they have—is not a lot more than the physical assets they own, so like their buildings, computers and equipment. It would be like selling a dental practice for like 20% of collections. So the higher the book-to-market ratio it means the cheaper the company is. But if you buy a bunch of companies that have high book-to-market ratios and they are really small—the size we measure is revenue or sales, just like collections. So a dental practice doing $50 million in collections would not be considered a small practice. One doing $200,000 would be considered a small practice, right? So if I bought a bunch of $200,000 collections practices for 20% of collections or $40,000, if I could spend $40,000 to buy a $200,000 collections practice, that’s where the highest returns would come from.

Ryan Isaac: Because of so much potential.

Reese Harper: There’s so much potential there and I have basically just bought the equipment. Everyone listening to this would be like yeah, duh. If I could do that, I would be rich. The scary part about that is if you take all of those situations that are like that; if there are a lot of dental practices like that across the country, there’s a reason they are all that small, and they are only worth that. And it might be a horrible location or a really bad declining patient base or job declines or the economy in the area. There’s a lot of risk associated with that size because you don’t know why it’s that cheap, so if you buy a bunch of those, that’s the highest possible return. So if you’re going to build a portfolio for your age seventy goals, like Ryan was talking about: I’m going to touch this money when I’m seventy. Then I might have more of those types of investments in my index. The index I buy might have more of those types of investments than big companies like Apple. Because big companies like Apple won’t return quite as much as the small companies will, so if I know I’m going to have a portfolio that I’m going to be able to not touch for 20+ years, then I might pick those smaller ones. But I’m going to see those go up and down like 40-50% per year in movement to get an average return that’s maybe 2-3% higher than what I could get from big companies.

Ryan Isaac: So the lesson there is: understand the risk you need to take when you start building your account, and that’s something you need to learn a ton about or consult with someone who knows about this stuff. Number three: after you’ve determined your philosophy, your risk, then you have to know what type of account is the most appropriate to set up at the time. We talked a little bit about this on our last podcast on how to choose the most appropriate retirement account or the best pretax retirement account: IRAs, 401Ks, profit sharing. You need to know according to the goals you’re trying to reach—things like, what’s my tax rate? What’s my income? What are collections? When do I need this money? What’s my staff census like? How many people do I employ? You have to determine what type of accounts to put together, and I don’t know if it’s just not common knowledge, but people usually associate an IRA or 401K with the only place you can put money, and you’ll get that comment: well I put money in my 401K so I’m good. But a lot of dentists have more money than can fit inside of a 401K in a single year, and there’s other places and other types of accounts your money can go that can still grow and still serve specific goals and purposes. You have to know what type of account suits the situation most appropriately.

Reese Harper: And we talked about that in detail two podcasts ago. And even Matt Bradley’s last week was pretty in depth on that. Let’s hit another concept that’s kind of crazy—are you going to talk about allocation today?

Ryan Isaac: It’s almost like we have pre planned this a little bit, because that’s what is up next. I’m just going to let you loose on allocation. Allocation is the next thing—allocation is the thing that says: where do I put the money? Now we’re starting to get into: what do I buy in this account? I know what my risk is. I know what the purpose of this account is; I know what type of account is. Now what do I put inside of it? This is usually the first place people start, but here we are step number four.

Reese Harper: Well what do you say about that? When people say, “how do I do my mix of investments in my account?” What do you talk to people about?

Ryan Isaac: Well, it’s interesting. This goes back to the comment I was making about when I hear people say, “I buy index funds.” I wonder at that point: which ones? There’s a lot of indexes, and let’s back up a little bit. When people refer to an index fund, what they are talking about is—an index is something that tracks a particular piece of the world or a certain market, right? You can have an index fund that tracks the biggest companies in the United States. Or you can have an index that tracks the tiniest, almost-going-out-of-business companies in third world countries, and everything in between. And if you’re saying, “I’m the investor who is going to buy the market.” If that’s what you say your goal is. “I’m going to own the market, and I’m going to receive the return that the market is going to give me.” Then you better own the market. Right? It’s fascinating actually—there’s a lot of studies that study something called “home country bias.” Australians do it; people in the Unites States do it; Canadians and Germans do it. People tend to place a really high percentage of their money into funds in their own country. So here in the United States, when we meet people and they say, “take a look at my portfolio,” it’s really common that people have 70-90% of their funds sitting in the United States. Now over the next 30-40 years, is that going to be a better play than buying something outside of the United States? I don’t know. No one is sitting here saying that we’re going to predict that and it’s better or worse.

Reese Harper: Well statistically, if it’s that long of a time period they should be all very similar. Equity returns across the world get a similar return forty years out. Ten-year returns are going to be quite a bit different. You’ll see the United States move from 2000 to 2010 the United States was basically flat. I mean the SMP 500 was flat. So you got basically no return from the tech crash through the Great Recession— you got nothing. There was a bunch of articles that came out in that point in time saying, “this is a lost decade.” So you had ten years of nothing from the U.S. During that same period of time though, if you were looking at Brazil, Russia, India, China, Europe, and the Far East—basically the rest of the world that wasn’t a 0 return. Most of them achieved their historical average of pushing a double-digit equity return. Emerging markets were even higher than that. So a diversified portfolio like Ryan’s saying—when you say, “I own the market,” the question is: what do you define as the market? What’s your definition of the market? Do you have the SMP 500, which is only the 500 largest stocks in the U.S.? And is that what you’re defining as the market? Or do you define the market more broadly? And it’s okay if you don’t want to define the market as the whole world, but the true market is 13,000 stocks globally. And there is competition and there are reasons why theoretically that is a better market than just picking one country. I shouldn’t say “better return,” but it’s more representative of the world’s stock market than just a country.

Ryan Isaac: Well like you said, they do different things at different times. That’s the benefit of owning more.

Reese Harper: Well it’s December right now, and year-to-date you have very different returns right now for the United States and Europe and emerging countries. And that’s kind of how most of the world breaks up the stock market—the U.S. and Europe, Japan, Canada, Australia—we call it the EFA index, and then you have the merging countries, the smaller countries. I don’t know what it is right now Ryan, but it’s probably 50% of the world’s stock is in the U.S.? So of the 40 something trillion dollars, half of it’s in the U.S. and then you probably have 30-35% in Europe and Asia and about 15% in emerging right now, and that’s the market and then what we see is most people have index portfolios that vary widely from that market. Those percentages are not what are reflected in their portfolios.

Ryan Isaac: And that’s the point of allocation. That goes back to the comment of just owning an index fund. That sentence doesn’t really mean anything because there’s so many of them. Understand what the market is and what you own, but that’s the basic premise there.

Reese Harper: Just know that your allocation dictates your return more than almost anything else. It’s more of an indication than passive vs. active. If you’re a fundamental stock picker and you have a global portfolio that’s representative of every market, that’s still going to be a more similar return to an index investor. Say an index investor has a global portfolio, and an active trader fundamental analysis guy that’s got a global portfolio—they’re going to return more closely; those patterns are going to return more similar than one that’s got all his money in the U.S. and one’s got all his money in Europe. The allocation decision drives returns more than that active/passive debate.

Ryan Isaac: So let’s hit two things really fast. You’ve already talked about one of these before in a little bit more depth, but number five would be: there’s diversification in the types of stocks that you buy. You were talking about this earlier: you can buy big companies; you can buy small ones; you can buy companies that cost a lot of money compared to their value. You can buy companies that are technically cheap because they go out of business or about to change ownership or have a lot of potential—there’s a lot of diversification in stocks and diversification in bonds. You talked about it a little bit, but do you want to hit anything there? The diversification in those areas too—they matter. Like you said, over long periods of time, certain size companies out perform others and value stocks vs. growth stocks—they have different return patterns over long periods of time.

Reese Harper: The basic differences are: scaling stocks or sorting stocks in a couple of different ways. One of them is by size, so you can take the value of the company and say companies that have more than ten billion dollars of value or companies that have more than a hundred billion dollars in value—that would be one group and companies less than five billion are in a group. You can scale by size, and every company has what’s called a market value or a market capitalization and that’s just its value over all. And I think that’s one of the very very important ways to scale. Small companies tend to perform better than large ones over long periods of time. So something you’ll see in investing called the small cap effect—small cap or small capitalization stocks tend to out perform large ones. They’re also more volatile—they go up and down more, and you need a longer time frame in order for that premium we call it to show up. So certain stocks have premiums over other stocks, or higher returns than average. You need longer periods of time for those to show up in returns. Small cap stocks don’t return more every year—they didn’t last year or in 2015, but in 2016 they will. Over a five-year period, you’ll most likely see that small caps out perform, and over a ten-year period it’s even more likely. Over a fifteen-year period the profitability is almost certain, but there may be a fifteen-year period where you don’t even see that. So for you to take advantage of that momentum that comes from investing smaller companies you need a longer time frame. All we’re saying is the larger the companies, usually the less volatile they are. The smaller they are, they more volatile they are. And that makes a huge difference. If you’re in an index portfolio, you need to know what’s the market capitalization of the stocks in my index, and what kind of volatility can I expect to that relative to picking another type of index? The other thing you mentioned is the prices of companies—that’s what we call price-scaled ratios. So you can have book-to-market ratios; you can have market-to-price; you can have sales-to-price; there’s all kinds of price ratios that you can have that scale a stock and tell you how cheap it is relative to other companies. I gave this example earlier about the dental practice: $200,000 dental practice that you buy $40,000 or 20% of collections—that would be what we call a very high book-to-market value. That type of stock you would have a lot of confidence that you’re buying something that’s cheap. The opposite example of that would be what’s called a very low book-to-market stock where you might buy a dental practice that’s collecting a million dollars, and you might pay $4 million or $5 million for that. Or you might pay $10 million for a practice collecting a million. That’s kind of like buying Facebook right now. Some of these public stocks trade for large multiples of their earnings, or what they do in collections in a year for dentists that listen to this. If you’re not dentists and you’re listening to this, I’m sorry because we translate everything into dental speak. If you’re buying a practice for 10X of collections, you know your probably in trouble—you would never do that. But right now when Facebook’s IPO came out you were paying way more than 10X of collections—I mean it was about 100 times collections. So imagine buying a dental practice for 100 times collections a year, that’s what Facebook was pricing. All of you guys that wanted me to let me buy an IPO, that’s the reason it’s a hard thing for me to let you do!

Ryan Isaac: You’re pounding the table again.

Reese Harper: I can’t let you pay 100 times collections for something and feel good about it! I wouldn’t do that in any other galaxy, okay? Anyway, that’s the price kind of thing. You can buy an index and it will have a size component to it, and it will have a pricing component. And you can have indexes that target only specific prices of collections ratios, and you can buy funds that only target specific sizes of practices or businesses. Those are the ways you can buy an index, and those can be done in Europe, Asia, or any country. Every country has got those same price effects, and so traditionally, the highest returning things are the smallest things, and they are also the ones that are the cheapest. I told you earlier that dental practice that’s $200,000 in collections that you buy for $40,000—if you could buy a lot of those, those would be the highest returning prices that you could buy, but not the hundred X. Most people listening to this probably wouldn’t recognize that; they would think if I said, “what’s a better return—Blockbuster video or Facebook,” everyone would probably say Facebook. Yes, well, if you buy all the Facebook’s in the world and you bought all the Blockbuster videos, the Blockbusters would actually outperform the Facebooks. It doesn’t mean you’re not going to own the Facebook, but if you were going to emphasize the highest returning items in an index then you would go towards the ones that were higher—they were not valued at big multiples of their earnings or of their collections. Anyway, I think that’s a good summary of those two areas.

Ryan Isaac: Okay let’s end this discussion where we began, which is cost. That’s where most people start, and I can respect that. I respect the cost battle.

Reese Harper: You tell us then—what is an expense ratio? What does that even mean?

Ryan Isaac: Well let’s talk about the different kinds of costs. When you open an investment account, you pay different people or organizations to do different things. One of the fundamental things you will pay for if we are listing some of the things you have when you open an investment account—you pay a bank to hold the money. Often times they are called “custodians” and there’s a lot of places you can go for there, and you’ll pay those people in fees; you’ll pay them in annual account fees or trading fees.

Reese Harper: You’ll see $40 or $50 bucks a year for an account, or $10 or $7 a trade.

Ryan Isaac: Sometimes with different institutions, financial advisors that have a lot more money with one custodian, one bank—a lot of times those custodian bank fees are waved. You don’t have costs to trade; you don’t have annual fees, but that’s one person that’s involved or one thing that’s involved when you open an investment account. The second thing is that the account type—we talked a lot about the account types in our last podcast, whether it’s the brokerage account, an IRA, 401K or profit sharing. Depending on the account type, there could be extra fees associated with the account. Normally there’s more fees associated when it’s a type of account that’s connected to the business or the practice. Then what goes inside of these accounts held at the bank are the investments—those are your stocks, your bonds, mutual funds, ETFs. Maybe you’ve got a little gold; I don’t know what you’ve got. But those things carry costs as well, so we will just focus on when you buy a mutual fund for example, there is something called an expense ratio. That’s how those companies get paid; those are companies just like any other business. They have costs, staff, expenses, and they have to pay their people and their overhead and keep the lights on and the research going. You pay them in an expense ratio, and the expense ratio is often referred to in our industry as the scam of the industry. You’ll see on your statement if you pay your bank any fees any trading costs or annual fees. It will show up on a statement, so will your advisor or broker costs. But your expense ratio will not show up on a statement. You have to know that it exists, and where to go look for it in a hundred-page document. So you want to elaborate a little bit on expense ratios? I will just say that they range widely. They range from less than a tenth of a percent to over two percent. The thing that’s frustrating for me in our industry is seeing how few people even understand that these expenses exist and how much they range and how often people are paying a higher side for the funds that they own.

Reese Harper: Yeah, I think you summarized it great. I would just say that you need to know that there’s a difference between—the bank that’s holding the money is not the person that’s getting paid to buy the index or the stocks in the index. So that expense ratio in the mutual fund is like Ryan said—less than .1 up to north of 2% for certain funds. I’ve seen high twos. It just depends on what the active strategy is that you might be pursuing. A really heavy momentum strategy and small markets with very little data could cost a lot of money because you need to put boots in the ground, and you’ve got to run people around these countries to find interviews with the CEOs of these obscure companies. It can get expensive, and usually know what your expense ratios are. But the $9 a trade or $7 a trade or $20 a trade you have to pay for certain funds—those trading costs go to the custodian that holds the money, but the custodian or the bank that holds the money doesn’t get the expense ratios unless there is something really weird going on. In some cases they do, and you just have someone pick apart your account to know what your fees are. It’s complicated to know. Expense ratios are hard to find, but if you go Google them—Google has a finance page and you can just type in the ticker symbol of the fund you own, and there will be a thing called “expense ratio.” You will see it. Just know it’s a percentage, and then you can kind of compare that to other funds that have similar attributes and decide if the fund you’re paying is worth the fees that it’s charging.

Ryan Isaac: Okay, well that’s a good summation of everything.

Reese Harper: You’re a good man Sir Ryan Isaac for putting up with this long conversation, and all of our listeners, we know this is an intense one. But you are much better off, and you know probably 90% more than the average person does about investments, and I think it’s a really important discussion. If you don’t know this stuff, it’s going to bite you at some point in your career.

Ryan Isaac: There you go. That’s the message: it’s going to bite you.

Reese Harper: It will, it will nip you in the bud; it will drill you in the tooth.

Ryan Isaac: The overall theme here today was: costs don’t drive everything. There’s a lot more under the hood then you probably think there is, so take some time to learn this stuff; call people, listen to the podcast. Thanks Reese for your time. It’s been fun to be back as promised. Buy my bald pills.

Reese Harper: Well, the studio is alive and well here today. Thanks Ryan Isaac. Carry on.


Get Our Latest Content

Sign-up to receive email notifications when we publish new articles, podcasts, courses, eGuides, and videos in our education library.

Subscribe Now
Related Resources