What is a mutual fund?

Great question. Click below to see a video of Dave personally explaining what a mutual fund is and how they work.
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What funds does Dave recommend?

Dave doesn't recommend specific funds, just types of funds. For instance, Dave suggest you look for funds that have at least a 5 year track record (Dave likes 25 years) and a high return rate. There are thousands of mutual funds from which you can choose. Morningstar.com offers a mutual fund screener to help you in your decision; Yahoo! offers a free version. Of course, you can always use one of Dave's investing ELPs too!
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What is an index fund?

An index fund invests in securities to mirror a market index, such as the S&P 500. An index fund buys and sells securities in a manner that mirrors the composition of the selected index. The funds performance tracks the underlying index’s performance. In other words, if you invest in an S&P 500 index fund, your fund’s returns should very closely follow the rise and fall of the S&P 500.
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What is Dave’s opinion of index funds?

Among investors, index funds can be a heated debate. Index funds are neither evil nor the answer to all your investment needs. Many times, index funds are no-load funds. This may mean you are choosing them without the help of a professional planner, though some do use no-load and index funds. (See Q&A on loads.) An index fund can be a part of a well-diversified portfolio. As an investor, you should understand that index funds are not typically actively managed. If the index your fund mirrors plunges, so will your fund. Don’t rule out a good fund because it is an index fund. At the same time, don’t forsake Dave’s common sense advice on diversification and the four types of funds he recommends with strong, long track records of success.
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Is there a time when index funds are preferred?

Yes. Because index funds mirror an index, turnover (how often the stocks inside the fund are sold) is usually minimized. This lowers an investor’s tax exposure. This type of index fund is often referred to as a low turnover mutual fund.
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What are loads?

Loads are one of the costs associated with mutual funds. All sales commissions and expenses are paid from the sales charges collected. Usually there is also an ongoing, sometimes paid annually, asset-based fee. The three most common ways these are paid are:

1. Class A Shares: A front-end load or fee you pay as an investor as your dollars are invested into the mutual fund. Class A shares will carry a lower asset-based fee than the other two options. While sometimes emotionally difficult to pay this fee up front (your $100,000 may turn into $95,000 on day one), this is usually the least expense choice over a long period of time.
2. Class B Shares: No-load up front, a higher ongoing asset based fee; but with a back-end load, if the investment dollars are removed within an agreed upon period of time. This load is typically a declining percentage that is reduced annually. For instance, 8 percent the first year, 7 percent the second, etc. and is usually structured so that it drops to zero after an extended period of time.
3. Class C Shares: These shares have a level load, so an investor pays a significantly higher asset-based fee monthly, quarterly or annually. Depending on your time horizon, your Endorsed Local Provider will help you determine which of these choices are best for you.

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Why would I pay a load if there are funds without loads?

Good question. This is a very debatable subject with good arguments from both sides; but here are some basics:

1. The first is that a load is just one of the factors to consider when purchasing shares of a mutual fund. Don't pass up a great fund that has a load to get in a bad fund without one. The managed loaded fund may far surpass the investment returns of a no-load fund. Also, all costs must be weighed to compare loaded funds versus no-load funds. No-load funds can actually be more expensive when this is done.
2. Secondly, most financial planners sell only loaded funds. This means that, in most cases, if you're going to go the no-load route, you'll be picking these funds on your own. This is not so different from saving the costs of a good attorney in court. If you can represent yourself, go for it. If not, pay the pro.
3. Here's another good reason to use a financial planner and look past the loads to the bigger picture. If you purchase shares of a no-load mutual fund from the mutual fund's Web site, you may never speak with a person. A good financial planner is going to do more than pick your funds. They are going to fit your investments into your life. They are going to consider tax implications, changes in legislation, educate you so that you'll understand what your investing in and why, etc. If you're having a bad day and decide to pull all of your investment out of your no-load fund, no one will challenge you. It takes seconds to get it out and derail your long-term plans. Since buying high and selling low is a bad plan, financial planner also serves as an accountability partner when things get difficult. They will remind you why you're investing and encourage you to stick with your long-term goals. Statistics support this, showing that investors jump out of no-load funds up to 80 percent more often than investors with financial planners.

All that being said, no-load funds are not evil. There are some very good no-load mutual funds out there. Some financial planners do sell them and charge different types of fees. Many investors do very well with no load funds and understand them well enough to pick good funds for the long haul. Dave Ramsey does not dwell on this one factor of mutual funds nearly as much as he does picking good funds with long histories of success and leaving the money alone.
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My investments are losing money, yet I keep hearing Dave talk about 12 percent returns?

Great question and one we get often. The answer is that Dave is referring to the average annual return of the stock market since 1926, which is very near 12 percent annually when adjusted for inflation. Even the past few years of negative returns in your funds do very little to lower the average of the last 78 years. Remember, Dave considers investing to be a minimum of 5 years. Less than that is simply saving and should not be done with mutual funds. This is a good place to disclaim that the past is not an indicator of the future; but we do highly suggest factoring in long track records of success into your plans for the future.
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UTMAs, UGMAs, ESAs and 529s? Help!

UTMA: Uniform Transfer to Minors Act
UGMA: Uniform Gift to Minors Act
ESA: Education Savings Account (aka Coverdell Savings Account, Education IRA)
529: State plans for college saving.
UGMAs and UTMAs are very similar. They are both refer to legislation that permit a gift of money or securities to be given to a minor and held in a custodial account that an adult manages for the minor’s benefit until the minor reaches a certain age. (For UGMAs, this age is 18. For UTMAs, it is 21.) At this age, the money belongs to the beneficiary. Dave recommended these for college savings for quite some time, with the understanding you must teach the minor how to handle the money before they reach age 18 or 21.
Today, Dave encourages people to instead use the ESA - Educational Savings Account, also known as Coverdell Savings accounts and Education IRAs. ESAs allow up to $2,000 per year in after tax contributions for children under age 18. Distributions are tax-free as long as they are used for higher education expenses. ESAs are similar to IRAs in that they are very portable. This means the savings can easily be moved from one investment to another. ESAs are simple. Dave encourages listeners to consider them if:

1. $2,000 per year invested into good mutual funds will meet the need. If your child is three years old and going to a state school, this should suffice.
2. If going to a private school or your child is in his or her teens, you may need to save more aggressively in a 529 plan after taking advantage of the ESA. 529 plans are newer and allow an investor to contribute a much higher dollar amount. 529 plans are state plans, meaning each state sponsors a different 529 plan and often gives tax incentives for residents to use that state’s plan. However, investors may choose any state’s plan. Dave divides 529s into two groups, based on asset allocation. Most plans require an asset allocation based on the child’s age. This means that when your child is six months old, nearly all of the dollars will be invested in an overly aggressive portfolio of mutual funds. As your child ages, the portfolio becomes more conservative. This means that by the time your child is 15 years old, nearly all of the dollars will be in bond funds or money market mutual funds. The problem with this is that neither extreme is a good idea. The early years and the last few years will not perform as well as a balanced approach of good mutual funds long term. The other type of 529 that Dave likes is one that lets you choose an asset allocation and stay with it. This means you can choose good mutual funds for your two-year-old and leave it in place until your child is closer to the age you’ll need the money, maximizing returns.

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What does Dave have against investing in single stocks?

Looking back at the last 78 years, the performance of the stock market as a whole has averaged near 12 percent annually; yet studies show the average single stock investor's annual returns are much lower due to single stocks volatiliy. Mutual funds typically hold 50 to 250 stocks in their portfolio. They hire mathematical geniuses to determine exactly how long to hold them and when to sell them to maximize returns. The average investor is simply not going to compete with the brains of most mutual funds, long term. Also, if you place much of your nest egg with one or two single stocks, your risk skyrockets. Thirdly, your sleep will be much less restful when your nest egg stock doesn’t meet earnings, sees it’s CEO locked up for fraud, or takes a 35 percent plunge because the analysts decided your stock is a hold instead of a strong buy. If you must satisfy your need to test your brother in law’s hot stock tip, Dave strongly suggests limiting this to no more than 10 percent of your portfolio. NOTE: By the time you get the hot tip, it’s old news to our friends inside the mutual funds.
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What does Dave have against investing in bonds?

Bonds are often stereotyped as safe investments with returns slightly lower than equities (stocks). This simply is not the case. Bonds, just like equities, are traded on the secondary market. This means the value of bonds goes up and down each day just like equities. The risk involved with bonds is not significantly lower than equities. In some cases, it is much higher. Bonds are debt instruments, used by companies to raise capital. The bond payments themselves are made by the companies and are dependent on the financial strength of the individual companies. Good companies can miss bond payments. Got any Service Merchandise bonds? Enron bonds? Secondly, the returns associated with bonds are not attractive compared to equities. If you must use them, Dave recommends using balanced mutual funds. Balanced mutual funds mix stocks and bonds inside of a mutual fund. You can study the track record of balanced mutual funds just like any other fund.
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What does Dave have against investing in CDs?

For saving (emergency funds, saving for purchases, etc.) CDs are great. As investments, they are bad. CDs guarantee you a small return, which increases the longer you commit to leave it. There is usually a penalty for taking the money out earlier than agreed. CDs typically pay 1 or 2 percent per year. Inflation increases 3 to 4 percent per year. (The cost of bread goes up each year by 3 to 4 percent.) If you invest in a CD and receive 2 percent, you’ll pay taxes on this gain if not in a retirement account like an IRA. You’re looking at an after-tax return of 1.5 percent, when the cost of living increased more than twice this amount. The only guarantee you receive is that your money will lose value over time compared to the cost of bread, gas, electricity, etc. Long term, you need to earn a minimum 6 percent annual return to pay taxes and be left with enough to account for inflation so that your dollars do not lose value. In order to grow your investment, you must outpace inflation. Mutual funds are the vehicle Dave recommends for long term investing, which means money that will be left alone for at least five years.
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My advisor recommends using cash value life insurance as an investment. What does Dave say?

No way! Dave says always keep your investments and your insurance separate. Buy term life insurance and invest the difference into good growth stock mutual funds.
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What are spiders?

Spiders are Exchange Traded Funds, ETFs.

• The first ETF was traded in 1993, following the S&P 500 index.
• They are a basket of stocks but not a mutual fund.
• Because they are not mutual funds, you are actually purchasing the stocks involved with ETFs, just in a bundle.
• They usually track an index, like the S&P 500.
• They can be bought or sold throughout the day, because they are a group of actively traded stocks.
• They share the flexibility of stocks, meaning they can be sold short or bought on margin.
• Expense ratios are usually lower than many mutual funds because they are not actively managed.
• Trading these gets very expensive, just like trading stocks. They incur new commission charges each trade.
• Today, there are approx 80 different ETFs. Some follow indexes, some follow countries, and others follow sectors.
• Most popular ETFs include:
  • QUBEs (QQQs): ETF that follows the NASDAQ 100, the 100 largest and most actively traded non-financial stocks. Very subject to earnings reports. Traded on American Stock Exchange (AMEX.)
  • SPDRs (Spiders; S&P Depository Receipts): Trades on AMEX. Follows the S&P 500. Some ETFs invest only into sectors of the S&P 500. Structured as a unit investment trust, meaning investors purchase units of the trust as opposed to actually purchasing the stocks. Because of this, an advantage is that they are not required to distribute capital gains each year to the investors, a tax advantage. SPDRs require higher contributions than index funds.
  • IShares: Brand name of Barclay’s ETF that follows Goldman Sach’s Tech Indexes. Some iShares do follow the S&P 500. Traded on AMEX.
  • Diamonds: Track the DJIA. Trades on AMEX.
  • VIPERs: Vanguard ETFs versions of Vanguard index mutual funds.
  • StreetTracks: State Street Global Advisors brand ETF.
  • HOLDRs: Merrill Lynch brand ETF, usually industry specific.

Bottom line:
ETFs are not evil, but they are not a good idea for our listeners generally speaking. We recommend holding mutual funds for more than five years, not trading them like stocks. More significant, the commissions make ETFs lose when compared to the indexes they mirror.
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My factory just closed. I am being asked to choose between a lump sum settlement and a lifetime pension. Help!

The short answer is that the lump sum usually makes more sense. The more thorough answer is that the stream of pension payments must be weighed against the value of the lump sum invested in good mutual funds over time. Typically, the stream of pension payments equates to somewhere around a 7 percent annual return. If you take the lump sum, it can be invested into good mutual funds that have a history of earning closer to 12 percent annually. It’s important that you sit down with a professional to weigh the options, using your numbers. Dave’s ELPs are specialists in this area: Find an Investing ELP Agent
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What are low turnover mutual funds?

Great question. If you are not familiar with mutual funds, invest five minutes with Dave by video under the question, "What Is A Mutual Fund?" first. A mutual fund buys and sells stocks inside the fund. Hopefully, it buys them low and sells them high, which creates a return for you as the investor. How often the fund buys and sells all of the stocks in the fund is called turnover. Aggressive funds may turn over their portfolio of stocks one or two times per year while other funds may sell only a few stocks per year, holding the rest long term. At the end of each year, the mutual fund reports how much money you realized (tax term) from the sale of stocks inside the fund. You pay ordinary income tax on these gains if not inside a retirement account. Low turnover mutual funds earn your return on investment by holding stocks long term instead of selling the stocks inside the fund. This results in less gain from the sale of the stocks in the fund, resulting in less tax paid on this sort of gain. Each mutual fund reports its turnover as a percentage. High turnover funds may have a 100 percent (sells 100 percent of the stocks inside the fund annually) or more turnover ratio, meaning you’ll pay income tax on the entire gain realized that year. Low turnover funds may have a 4 percent (sells only 4 percent of the stocks inside the fund annually) turnover ratio, meaning you pay very little tax on the gains. Dave’s ELPs are specialists in this area: Find an Investing ELP Agent
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What are annuities?

Annuities are a savings or investment account with a life insurance company. Dave's ELPs are specialists in this area: Find an Investing ELP Agent
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How do annuities work?

When you invest money in an annuity with a life insurance company, your investment grows tax deferred. Tax deferral means that each year that your investment grows, you do not have to pay taxes on the growth. Instead, you defer paying taxes until you take the money out. (If you invested the money into mutual funds outside a tax deferred account, you would pay taxes on the growth each year.) Dave’s ELPs are specialists in this area: Find an Investing ELP Agent
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What’s the difference between fixed and variable annuities?

Fixed annuities carry a fixed rate of savings with the insurance company. The rate is usually very low and the expenses are usually very high. Fixed annuities require you to leave the money alone for usually 5 to 10 years, with a declining penalty for taking the money out early. If the money is taken out prior to age 59 and a half, you will also be hit with a 10 percent penalty from the IRS for early withdrawal. Dave doesn’t recommend these.
Variable annuities invest your money into various types of securities, usually mutual funds. Benefits include the tax deferral of the growth mentioned above and usually allow you to invest in different fund families within the variable annuity. The key to successfully investing in variable annuities is priority and understanding what you are agreeing to and paying for. Variable annuities are often utilized too early or unnecessarily. Remember, the primary benefit of variable annuities is the tax deferred growth. But if you have available a 401K, 403b, or other retirement plan at work, you already have access to a low-cost tax deferred account. Take advantage of these first. Also, utilize ROTH IRAs that provide tax free growth or TRADITIONAL IRAs that provide tax deferred growth. These plans give you the benefit of tax deferred growth without the additional costs that the annuity will charge you. Use the variable annuity after you have taken advantage of these other options. Understanding what you are agreeing to and paying for: The benefit of tax deferred growth is significant, but it does not come without costs. First, you will pay a fee to the annuity. Second, you will pay fees to the mutual fund companies inside the annuity. Third, you pay with a commitment to leave the money alone. This means: a) you are agreeing to leave the money alone until age 59 and a half. If you take the money out early, the IRS will hit you with a 10 percent penalty plus the taxes on the growth taken out of the annuity, and b) you are committing to the insurance company that you will leave the money alone according to the schedule outlined in the annuity contract. The penalty for taking it out early is typically a declining penalty. It may be on a 7-year schedule, charging you a 7 percent penalty if you withdraw money in year one, 6 percent in year two, etc. Dave’s ELPs are specialists in this area: Find an Investing ELP Agent
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Annuities sound complicated. Does Dave recommend them?

Annuities do require a little more education than some other investments, and done without understanding the rules or at the wrong time, annuities can be a train wreck. But if done after other pre-tax investments and with money that is going to be left alone for plenty of time, they can be a great tool for getting tax deferred growth. Tax deferred growth is a big deal over time and worth learning about annuities to attain. Flags to watch for when dealing with an advisor concerning annuities are: a) an advisor that won't discuss other options besides an annuity or won't discuss more than one specific annuity, and b) an advisor recommending you move money that already has tax deferred status, such as a 401K rollover, into a variable annuity. 401K dollars already have the benefit of tax deferral and should be moved into an IRA, not an annuity. (Paying annuity fees to move tax deferred money into an annuity for tax deferral is redundant.) One last thing to pay attention to are the bells and whistles that are often sold inside variable annuities. Life insurance, guaranteed returns, long term care benefits, etc. may be appealing to you and even attract you to the variable annuity, but know that they are not free. Understand them and their costs. Happy investing, and don't hesitate to ask for clarification on anything about annuities. For alternatives to annuities, see Low Turnover Mutual Funds. Dave's ELPs are specialists in this area: Find an Investing ELP Agent
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Values-based investing: How does Dave feel about investing in mutual funds that contain the stocks of companies that are not aligned with my faith or values, such as tobacco, gambling, alcohol and pornography?

This is a tough one and one that you will ultimately have to be the decision maker on, but here are Dave’s thoughts on the subject: Dave chooses not to do what’s commonly called values-based investing. Values-based investing, not to be confused with value funds (funds which contain stocks that are believed to be under priced), is the idea that you should invest your money only in companies that align with your values. There have been many books written on the subject and there are companies that specialize in helping you accomplish this. The primary reasons that Dave does not choose values-based investing are:

• The concept is very new, which means very few of the values-based mutual funds are more than five years old. Dave recommends funds that are at least five years old or preferably much older.
• Few of these funds have track records of making money. Many have never made money.
• Traditional mutual funds buy and sell stocks inside the funds on a daily basis. It is not practical to keep up with each of these companies.
• Keep in mind that when you buy the stock of a particular company, the company itself does not make money from you. You are purchasing a small piece of ownership in that company, but you’re not funding their growth. This is similar to the situation where you purchase a used Ford car from me. Ford does not get any of that money.
• Many companies that you do not associate as sin stocks are actually owned by or own these types of companies. For example, KRAFT Foods and Phillip Morris are both owned by the same parent company, Altria Group, Inc. So in order to avoid supporting the financial success of Phillip Morris, you've got to stop buying macaroni and cheese, and then you've got to research all of the other companies from which you buy products. Your bank probably donates to United Way, which helps people in need but also gives millions of dollars annually to Planned Parenthood, which supports abortion.
• If you are going to stop buying products from companies that do not align with your values, you'll also have to consider whether to continue buying groceries from a grocer that may sell alcohol, tobacco, pornography, etc. Then you'll have to find a way to buy gas without financially supporting gas stations that sell these items. As you can see, it's not an easily defined issue. Companies are so interwoven today that avoiding doing business with companies that don’t align with your values is very difficult at best. Dave concludes that he is going to continue investing in mutual funds, shopping at the local grocery and buying gas at the local market. But it is a personal decision, and we hope this helps you with this popular question. Dave's ELPs are specialists in this area: Find an Investing ELP Agent

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