A number of industry insiders were quoted using this datum as validation of their business model.  The best was from Ira Hammerman, general counsel for the Securities Industry and Financial Markets Association, the lobbying group for the brokerage industry, “If you’re only going to trade five or seven times a year, it’s probably more economical for you to pay a commission as opposed to paying someone one percent of your assets as a management fee.”

Investment News should have asked the industry spokespeople about the 33% of investors surveyed who said they didn’t know how they pay for the investment advice they receive, and the 31% said they thought their advisor or broker provided investment advice for free.

Really? 1 of 3 investors has no idea how they pay for their investment advice.  Even if they didn’t ask why, didn’t their advisor disclose this information up front?  Then there is another third who think they are getting their advice for free. Same question: Why was there no disclosure?

About 64% of those surveyed said they believe their financial advisor is held to a fiduciary standard of care, and 63% of clients of the largest broker-dealers said they thought that as well. Brokers currently are only required to meet a standard to offer “suitable investments,” whereas registered investment advisors have a fiduciary obligation to put clients’ best interest first.

Cerruli Associates survey shows that 2/3 of the customers of the brokerage industry are unclear as to how they pay for the industry’s services. It also shows that 2/3 of the customers of the brokerage industry want the oversight of a fiduciary; think they have it and are wrong.

“Our clients have consistently indicated that they want choice in how they purchase and pay for wealth management services,” said Christine Pollack, a spokeswoman for Morgan Stanley Smith Barney, the world’s largest brokerage.

Framing this as an issue of consumer preference misses the larger issue of fiduciary duty when giving investment advice. It is only about consumer preference in the sense that so many would prefer to work with a financial advisor who puts the client’s best interest first.

But the brokerage industry resists because they are manufacturers and distributors of financial products. Typically, their network of advisors are rewarded more generously when they “advise” their clients to purchase the products produced by the firm as compared to other choices. The “suitability” standard allows this. It is very profitable and the brokerage industry would like it to remain that way.

Wall Street is fundamentally the same as Detroit. Detroit manufactures and distributes automobiles. Wall Street manufactures and distributes financial products. The difference is you don’t expect to be talking to someone who is looking out for your best interest when you are in a dealer show room.

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Judging from the questions I receive from prospective clients, it is clear that many investors do not understand their brokerage statements and confirmations.  During the bull market of the late 1990’s may people didn’t care what their trading costs were.  But in a flat or declining market both visible and hidden costs can make a difference; so it is important to pay attention.  Here are some things to consider when reviewing brokerage confirmations and statements for clients.  Further, if they have been told they are not paying any commissions for their stock trades read this article carefully.

There are two kinds of brokerage transactions; agency transactions and principal transactions.  An agency transaction occurs when the firm acts as a broker or agent.  It results in the commission you see on a confirmation.

In a principal transaction the brokerage firm acts as a dealer, meaning that it sells out of, or buys into its own inventory of stock.  The firm will earn a markup, a markdown, or the spread on the difference between what the stock cost the brokerage firm and what the client paid; but the amount of the markup or markdown is usually not disclosed.  It can be identified by a notation on the confirmation such as “X firm makes a market in ABC stock.”  So even though they are not charging a commission, they are still making money on the trade.

Many firms claim they only charge an annual “wrap fee,” and that the client does not pay any commission or other costs.  But they may fail to disclose the costs their clients actually incur when trades take place.  TV and print ads try to get people to focus only on the commissions they charge (or do not charge).  In reality, the commission may be the smallest cost of a transaction.  Whether it is a discount or on-line broker, a major brokerage firm, or an independent firm there is no such thing as a cost-free transaction.  There are costs involved in every stock or bond trade.

While this cost can be passed on in the form of a visible ticket charge or commission, it can also be built into the trade, without disclosure to the investor.  For example, if you assume a typical $25 cost per trade, an account with 15 trades in four companies will generate $375 in costs to the investor.  If the same number of shares were purchased in four trades (one per company), the cost would have been only $100.  Careful attention needs to be paid to the number of transactions and the number of different issues.

The same applies to mutual funds.  You can usually move from one fund to another within a share class at a fund family without any commissions or transaction charges.  You are therefore usually better off with one class of shares using one, or perhaps two mutual fund families at the most.  A brokerage statement that shows a smorgasbord of different fund families and share classes could be a red flag that too much is being paid and that the investor is not receiving reduced “breakpoint” commissions available to investors in a single fund family.

Pay attention to the “solicited” and “unsolicited” disclosure on trade confirmations, too.  This is a required disclosure for every trade.  It tells the broker’s compliance department whether the broker or the client initiated the trade.  This is important because if the broker recommends the trade (purchase or sale) the broker has to make sure it is a suitable trade for the client.  As a result, they have much higher liability than if the investor chose it themselves.  Think of this from the broker’s perspective.  If the broker recommended the trade it was solicited.  If the investor asked the broker to buy or sell the stock, bond or fund it was unsolicited.  Hence, if confirmations repeatedly show the unsolicited disclosure but the client didn’t request the trade it can be another red flag.

For the most part there are many good, reputable, honest people working in the financial service profession.  And there is a lot of work that goes on behind the scene.  Financial service professionals and their firms deserve to be fairly compensated for their time and service.  The issue is not which brokerage firm or method of compensation is better.  The issue is, are investors paying a fair amount for the services they receive, and do they really understand what their total costs are?

No one can make an informed decision without full disclosure, and without a full understanding of brokerage confirmations and statements.  Practitioners who have clients with questions or who discover areas of concern should consult with a reputable Registered Investment Advisor who can help them understand brokerage confirmations and statements.

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I suppose I should have known better. Expertise in one area does not always translate into competence in another. There were some important things he did not know about his retirement investments. The primary issues had to do with diversification and the value received for fees paid.

Diversification

Diversification is such an accepted principle of investing that it is easy to forget there was a time when such wasn’t the case. Until Harry Markowitz published his seminal study on portfolio allocation in 1952, the beginning of what we now call Modern Portfolio Theory, the prevailing approach to investing was to pick individual high-yielding stocks without regard to their effects on a portfolio as a whole.

But, just because we accept the concept of diversification as a way to mange a portfolio’s risk (variance) does not mean it is always applied effectively.

A common approach to achieve diversification is to use mutual funds. Mutual funds, due to economies of scale and professional management, are helpful as diversifiers. But, there is more to diversification than simply owning several mutual funds.

My practitioner colleague held ten different mutual funds with ten supposedly different investment objectives (real estate, health, tech, etc.) Yet five of these ten funds featured a position in the same company. Which company is not particularly important (it was Microsoft), what is important is that my friend thought he was diversifying when, in reality, he was duplicating.

The thing he needed to know but didn’t was the actual investments owned by his mutual funds.

Sector funds

Another enemy of diversification is the “sector” mutual fund. These are funds that concentrate on a particular industry or life-style interest. Common examples include funds focused on technology, health care, precious metals, or leisure pursuits.

Such funds, by definition, limit their investment focus to a narrow slice of economic activity. Investing in them is akin to placing a bet on a particular sector of the economic pie. Five of my friend’s funds were sector funds.

The thing he needed to know but didn’t was that that sector funds limit, rather than enhance, diversification.

US versus foreign

Another common diversification oversight is to be too concentrated in U.S. companies. There is a natural comfort that comes from investing in familiar, well-known companies. However, this is not always an advantage when diversification is the goal.

International companies make up nearly 70% of the market value of all global stock values. And, while it seems as if the global economy is blending together, the reality is that U.S. stocks and international stocks tend to rise and fall at different times.

Further, global diversification also means currency diversification. If, for example, you own European companies in your portfolio, not only do you profit from their business growth, you also gain the added benefit of transacting that business in Euros.

What my friend needed to know but didn’t is that his mutual funds were only 19.4% invested in international stocks.

Big vs. small

Another great way to diversify is to own small companies along with big companies. Small company stocks, due to their added risk, generate greater returns than the shares of large companies.

What makes them an excellent tool of diversification is that small company stocks tend to rise and fall at different times than their large company cousins.

Only 6.3% of my friend’s portfolio was invested in small company shares and all of that was in the United States.

What he needed to know but didn’t was that adding small company investments, both international and U.S., is an effective way to add return and offset the volatility of his large company investments.

What my friend didn’t know was where he had actually invested his money and how to effectively diversify. He, like most, thought he was diversified because he owned several mutual funds. Others think they are diversified because they work with more than one broker.

The key to effective diversification lies in the “asset classes” actually owned. The key is to own stocks in asset classes that have deliberately different price movement behavior. Owning large and small company stocks in the US and abroad is a good start.

Value stocks

A further dimension of diversification is to add “value” stocks into the mix. Value companies (companies whose accounting or “book” value is high relative to its market value) reward their shareholders with greater returns than so-called Growth companies.

Value and Growth stocks demonstrate dissimilar price movement behavior much like large and small company stocks.

The best way to define an effective plan of diversification is to own mutual funds that own stocks in the following asset classes:

I add Short-term Fixed Income as an additional way to moderate portfolio volatility. Not everyone is suited to own an all-stock portfolio. Depending on personal goals and objectives and individual risk tolerance the addition of short-term fixed income is a great way to customize a portfolio.

Costs and Fees

Fees and costs present an even greater challenge for most investors because they don’t know what to look for or where. A good place to start is whether or not a mutual fund imposes an up-front fee on each new investment, a front-end load or commission.

There is no good reason to pay front-end loads in this day and age. My friend got this one right. He knew he needed to eliminate this cost by only investing in “no-load” mutual funds, funds that do not impose an upfront fee for investing.

But, front-end loads are only the beginning. Every mutual fund is run by an investment manager who charges a fee to the fund for the advisory and management services they provide.

This fee is called the “expense ratio” because the fee is expressed as an annualized percentage of the total assets in the mutual fund. Expense ratios are not standardized and can range from 10 basis points (1/10 of one percent), like for Vanguard’s S&P 500 Index fund, to nearly 2.0% per year for some actively managed international small company funds.

My friend’s mutual funds were “actively” managed. In other words, the fund managers were actively seeking, through their research, to identify the best stocks to own and the best time to own them.

Their research activities were reflected in the expense ratios of my friend’s funds, which ranged from 1.03% to a high of 1.66%.

While how much you pay for fund management is an issue, what you get for what you pay is even more important. The question is, “Does the fund manager add sufficient value for the fee they charge?”

The answer to this question is found in a calculation known as R² (R squared). R² is a statistical measure that represents the percentage of a fund or security’s movements that are explained by movements in the market. In other words, R² determines how much of the returns generated by a mutual fund are due to the market as a whole (the asset class) versus the value added by the fund’s management. The calculation is expressed as a percentage and ranges from zero to 100.

A high R² means that the market has had more to do with a fund’s performance than the manager’s stock picks. My friend’s mutual funds had R² calculations that ranged from 94 to 98.

What my friend didn’t know but should have was that he was paying a premium to his fund managers to get what the markets were essentially offering for free. He would have been better off investing in a passively managed asset class (“index,” for lack of a better term) funds with substantially lower expense ratios.

Quality no-load asset class mutual funds have expense ratios of 0.60% and lower.

My friend also didn’t know that he was paying a 0.25% annual 12b-1 fee on each of his funds. 12b-1 fees can be imposed on mutual funds over and above the cost of management’s investment advisory activities to defray marketing and service related expenses. They are usually paid to the brokerage firm who originally sold the fund to the investor.

The irony of the fee in this case was that my friend did not use the services of a broker or a brokerage firm. He purchased his funds directly from the mutual fund company. He needed to know but didn’t that he was paying an additional 0.25% per year for services that weren’t needed or even being provided.

All of this information is publicly available through morningstar.com, finance.yahoo.com and schwab.com.

Conclusion

Effective diversification and diligent cost management can enhance returns and significantly lower risk over time. A knowledgeable, professional investment advisor can help clients gain an understanding of what they don’t know but need to know in order to reach their important long-term financial goals.

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When you consider the thousands of people who fell prey to Bernard Madoff’s $65 billion fraud you have to wonder whether your assets could fall prey to a similar disaster.

While the losses from Madoff’s Ponzi scheme are tragic for his victims the real tragedy is that had those investors followed some basic rules of prudent investing, they never would have invested with Madoff in the first place.  Madoff’s scheme succeeded because of its lack of transparency, its foundation of trust based on social connections, and the belief that market beating returns come with no risk.

What follows are basic steps to ensure that client investments are in the hands of people you trust, including ensuring ethical broker/advisor behavior, following a specific investment plan and securing an independent custodian and auditor.

Warning Signs

Madoff convinced his marks that they were investing in a hedge fund.  Hedge funds are typically open to a select group of investors, are run by an investment manager who increases rather than decreases risk and are not closely regulated by the government.  The exclusive nature of hedge fund membership creates an aura that attracts investors who feel they deserve exclusive treatment.  In addition to their sex appeal, hedge funds lure investors with the ever elusive hope of market beating returns with low risk.  Nearly every element of the Madoff affair mirrors the earmarks of classic Ponzi scams:

• Trust in the promoter due to some social affiliation
• Lack of complete transparency of the investment strategy
• Returns on investment that seemed too good to be true
• Investments that the investors did not understand
• The entire scam unraveling rapidly

Investors should have been warned by the very consistent returns touted by Madoff that something was amiss.  Results that are too steady over the long term are a warning sign of possible fraud.  While the stock market has rewarded investors for taking risks, those rewards do not show up every year.  Some years bring losses – sometimes significant ones.

Prudent Investment Principles

When evaluating an investment advisor, you follow common-sense principles.  Avoid managers who are unknown, don’t come with good referrals or haven’t been in business for very long.  However, this is only a start because, this alone, would not have saved you from Madoff.  He had friends at the highest levels who gave glowing referrals, he was the former chairman of the NASDAQ and had been in business since 1960.

At the core of every investment engagement should be a written “investment policy statement.”  This document details an agreed upon strategy between client and advisor that the advisor will follow and be held accountable for.  The IPS is a document that clients should clearly understand, and the advisor should not deviate from without client consent.  A trustworthy advisor requires an IPS because they want a clear roadmap to follow.  If an advisor isn’t willing to abide by an IPS, get another advisor.

There is only one thing an advisor can control – Risk.  This is accomplished by designing portfolios that have the greatest opportunity to meet client goals with no more risk than the client has the ability, willingness or need to take.  This is spelled out clearly in the IPS.

Academic research indicates that the prudent strategy is to capture the returns that the markets provide.  This understanding means giving up on the idea of “beating the market” – but it also means avoiding the risk of underperforming the market.  Madoff’s victims fell for the too-good-to-be-true trap – beating the market with no risk.

Accountants and Independent Custodians

Find out who audits your custodian of your assets.  Independent auditors are crucial because they verify the existence of the assets in the accounts managed by the advisor.  Madoff had audited financial statements, but they were prepared by a three person firm.  A no-name, three person shop auditing a $65 billion hedge fund.

Finally, make certain there is an independent third party custodian.  When handing money over to a financial advisor, the check should be made out to an independent custodian institution, typically a brokerage firm.  If an advisor managing investments and the funds are held at, say, Charles Schwab or Fidelity, it’s next to impossible for that advisor to run a Ponzi scheme.

Madoff was able to perpetrate his fraud because he operated in the shadows.  By contrast, publicly traded mutual funds operate with a high level of transparency.  Some of the advantages of investing in publicly traded investments are:

• Publicly held mutual funds are a highly regulated industry governed by the Securities and Exchange Commission.  Hedge funds are essentially unregulated.
• Mutual funds must have audited financial statements.
• Mutual funds do not perform the fund’s accounting themselves.

The saddest part of the Madoff fraud is that if investors had followed the basic rules of prudent investing, the tragedy could have been avoided.

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As a financial and investment advisor nearly every time I meet someone new and they learn what I do I am asked, “So, what do you think about the Market?”  Implied in that question is the belief that, because I am an investment advisor, I have some special foreknowledge of future price movements of the stock markets.

This illustrates two critical misperceptions of the nature of investment advice and investing. The misconception being that investing is about Performance and Prognostication.

In fact, the real value of financial and investment advice lies in a focus on behavior.  Clearly, in my twenty plus years of practice I have seen far more portfolios with investor problems than investors with portfolio problems.

The simplest, clearest and most compelling argument for the importance of behavior to successful investing is the annually updated comparison (by Lipper and DALBAR, Inc.) of the 20-year average annual compound rate of return of the average large company stocks (as measured by the S&P 500) in the U.S. and the average return realized by the average stock mutual fund investor.  For the 20 years through 2010, these were:

This study is the only one I know that focuses in on Investor Performance rather than Investment Performance.  And, while these numbers rise and fall from year to year, the relationship between them remains remarkably constant: over 20 year periods, the average mutual fund investor consistently manages to capture less than half of the return of the average fund.

How is it that, in a society obsessed with “performance,” the average investor not only underperforms the markets but also underperforms, by a whopping margin, his own investments?

What would the average investor have had to do over the past 20 years to have earned that 9.14% compounded average rate of return?  Correct: they would have had to identify the most mundane, middle of the pack, so-so, large company stock fund, invested in it and chosen the dividend reinvestment option.  And (here’s the key) left it alone for 20 years.

Of course, most people don’t do that.  They do something else.  Something else that had some combination of three important characteristics: (1) it was the wrong thing to do, (2) at the wrong time and (3) for the wrong reasons.

The reason average investors blew – and consistently blow – more than half of the return of the average fund over any 20-year period is that they behave inappropriately.  Here is an incomplete list of the types of things the average investor did over the last 20 years to insure they didn’t get the returns the markets would have otherwise given them:

• He bought only funds with the hottest recent “performance.”
• When those previously hot funds inevitably lagged, he switched into the next crop of recent hot performers.  (Use, rinse, repeat.)
• In October 1987, and/or October 1990, and/or August 1998, and/or October 2002, and/or February 2009 – that is, at any or all of the major market bottoms in the past 20 years, when stocks were the cheapest, he went to cash in a panic.  In between, around 1999, he loaded up on tech, telecom, dot.com and other icons of a “new era.”
• He probably also did some online day trading for good measure.

The irony, of course, is that this behavior is “normal.”  It is the behavior of the majority of investors being what defines normal.  Clearly, this normal behavior is the enemy of every investor’s financial wellbeing.  All of which begs the greater question: What are the behaviors and, even more important, the beliefs of successful investors?  What does one need to believe and do in order to produce superior, long-term, real life returns from their investing efforts?

The answer will be in my next post.

Behavior: The Key to Investing Success – Part Two

There are three principle beliefs and three principle practices that characterize those who achieve a successful investment experience.  This post will cover the beliefs.

The first and foremost principle is Faith In The Future.  I believe that, ultimately, investing is an internal battle between faith in the future and fear of the future.  And, over the course of a 40 years of accumulating assets during a working career followed by another 30 years of living off of those assets during retirement an investor’s lifetime return will largely be determined by which of these two impulses wins.

I’m not suggesting a Pollyannaish blind optimism or a mindlessly positive world-view in the absence of facts.  What I’m saying is that faith in the future is the investor’s only point of view supported by the facts of the historical record.  While it may be fashionable, pessimism is not only wrong but counterintuitive.  No one examining the historical record over the past seven decades would arrive at the fundamental conclusion that the world is in decline.

There are many examples, but I’ll mention only two.  The commoditization of miracles – that is, the almost instant progress of anything from breakthrough to commonplace – blinds us to the fact that human progress is not linear, but exponential.  The common, everyday minivan you see all around you today contains more computing power than existed in the world in 1951 (when I was born).  Further, in the next 25 years there will be another billion-fold increase in computing power per dollar thus solving ever more complex problems, further enhancing human productivity and quality of life.

In short, the successful investor says, “I may not know precisely how things will turn out all right; I just know things will turn out all right.”

The second principle of successful investing is Patience.  We live in a time of instant distribution of data (masquerading as information).  Instead of hearing enduring investment principles we are awash in a tsunami of late-breaking news.

All of this persuades us, even pressures us, into thinking that we must certainly have to do something – to react to the news of the moment – rather than to act on the goals of a lifetime.  Yet the more often one changes one’s portfolio – there is, in fact, evidence that the more often one even looks at their portfolio – the lower their real-life return will be.

The decision to change a portfolio – even when long-term goals have not changed – is nearly always wrong and dampens returns. The decision to get out of the market with the intention of getting back in at a “better time” means the investor has to be right twice.  Rarely is anyone so lucky.  According to Warren Buffet, “The stock market is a highly efficient mechanism for transferring wealth from the impatient to the patient.”

Patience, then, is the decision not to do something wrong with a long-term, goal-focused portfolio and can be summarized this way.  “I cannot know when things are going to turn out all right.  I just know things will turn out all right.”

The third principle of successful investing is Discipline.  Where patience is the decision not to do something wrong, patience is the decision to keep doing the right things.

It is all too common to see an investor stop a disciplined plan of regular contributions to their portfolio in the face of a declining market that feels like it is going to go one forever.  When, in fact, an aversion to falling prices is the exact opposite of common sense.  Someone who is regularly investing for their future should regard falling prices as a gift.  The lower prices lower their average cost – allowing them to buy more and more shares with their same regular contribution – thus almost certainly enhancing their prospective real-life return.

Simply put, the disciplined investor says, “I do not care what’s working now.  I care about what has always worked…and I am going to keep on doing what has always worked.”

The undisciplined investor reacts to every wind that blows.  The disciplined investor continues to act no matter the terrors or the enthusiasms of the current moment.

Next time we will examine the practices.

Behavior: The Key to Investing Success – Part Three

The first practice of successful investing is Asset Allocation.  The long-term mix of stock, bonds and cash is the primary determinant of the actual returns generated by a portfolio.  This flies in the face of our culture, which maintains that what you own (selection) and when you bought it (timing) determines your portfolio return.

In the long run selection and timing have little to do with portfolio returns.  Asset allocation, the mix, is of far greater importance.  There are a number of studies on this, the best known is the 1986 paper “Determinants of Portfolio Performance” by Brinson, Hood and Beebower (Financial Analysts Journal, July/August 1986).  They asserted that a portfolio’s static target asset allocation accounts for 93% of its variation in returns and volatility.  The other 7% is from timing and selection.

You do not need to know the details to embrace the concept: over the course of a lifetime the big variations in returns come from what percentage of your holdings are in stocks.  It is simple logic.  Because stocks are more volatile than bonds they generate great long-term returns.  The capital markets can, and often will, be crazy in the short run.  But, they cannot be anything but logical in the long run.  The greater return earned by stock over bonds and cash is the market’s way of compensating us for owning them.

The second practice is Diversification.  Asset allocation speaks to the broad mix of stocks, bonds and cash.  Diversification speaks to the mix within these macro asset classes.

Diversification of stocks says: I can not know which sectors – small or large companies, growth or value, domestic or international – are going to do well, or which will not, in the near term.  So I am going to own a broad number of each of these opposing types, in some roughly equal mix.  Because they are all stocks I will earn the premium granted to stocks.  But, because they tend not to do well all at the same time I will be somewhat insulated from the full volatility of market cycles at any given time.

In other words, “I will never own enough of any one thing to make a killing in it.”  And, “I will never own enough of one thing to be killed by it.”

The final practice is Rebalancing.  This is returning a portfolio to its target allocation on a regular, disciplined schedule.  This practice will virtually always cause the sale of high priced/low vale “hot” market sectors, and the purchase of low priced/high value sectors that are momentarily out of favor.  It is a discipline that causes investor to do what they always should do, buy low and sell high.

The adoption of these principles and the implementation of these practices show why those who believe and do these simple six things effortlessly achieve long-term investment results superior to those who do not.  And, once more, it’s all about behavior.

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The argument is made that gold is an inflation hedge.  In a world where governments are countering massive deficits by pumping more and more money into the system – simply printing money basically – then the less valuable those currencies become.  Gold, so the argument goes, becomes more valuable as paper money becomes less.

The proof according to gold’s fans is in the price.  In 1970 an ounce of gold could be had for $37 (USD).  As of 3/28/2011 that same ounce was valued at $1,420, a 3,738% nominal increase.  However, nominal returns don’t tell the whole story.  In real terms, the actual value of gold is still below the 1980 peak of $599 (equivalent to roughly $1,500 today).  In other words, even with all of its price appreciation, the underlying value of gold hasn’t changed much over the past 40 years.  Further, the metal has yet to pay a dividend and never will.

Warren Buffet’s well known antipathy to gold as an investment was recently on display in the Wall Street Journal. (http://on.wsj.com/dSzW0g, 3/28/11)  Mr. Buffet said that gold, oil and art are investments that don’t produce any income or product.  So, investors who buy these things are counting on them to become more attractive to other people in the future.  “That’s a whole different game” compared to investing, said Mr. Buffet.

He continued that if all the gold in the world were condensed in one place it would form a cube 67 feet on all sides.  But, what could do with this cube?  “You can fondle it,” said Mr. Buffet, or stare at it, but it will not be producing any returns.  “You’re betting on the price of the asset not on the productivity of the asset.”  These are kind ways to describe what is known as “the greater fool theory.”

If you remain unconvinced, here are two primary ways to own gold:

1.    Bullion and Coins
Buying the metal itself can be done, but there are challenges.  The price you pay will be marked up over the spot price.  The challenge is in not paying too large a premium.  Additionally, there are storage and security costs.  There is less of a premium to buy bullion than for coins.  Those of the survivalist mind-set who want to buy a loaf of bread with gold will need the smaller gold coins, like one tenth of an ounce, and will have to pay a higher acquisition premium.  Just don’t leave them on the dresser.

2.    Exchange-Traded Products (ETPs) and Mutual Funds
Gold exchange-traded products are traded like shares on major stock exchanges.  Gold ETPs are an easy way to gain exposure to the price of gold, but without the inconvenience of storage and security.

Typically a small commission is charged for trading in gold ETPs and a small annual storage fee is charged.  The annual expenses of the fund such as storage, insurance and management fees are charged by selling a small amount of gold represented by each certificate, so the amount of gold in each certificate will gradually decline over time.

Gold mutual funds typically invest in the shares of mining companies.  These do not represent gold directly.  If the price of gold rises, the profits of a gold mining company could be expected to rise and, presumably, the price of their shares.  However, there are many factors to take into account and it is not always the case that a share price will increase when the gold price increases. Mines are commercial enterprises, have significant capital costs and subject to problems such as flooding, geological events, structural failures, as well as mismanagement, theft and corruption. Such factors can lower the share prices of mining companies.

So, what is a better way to fight inflation?  According to Warren Buffet, “Inflation is a very cruel tax,” because it lowers the worth of your paper money.  He said one of the best ways to keep the value of your money growing is to invest in good businesses and companies which keep growing. That helps investors “maintain purchasing power no matter what happens to the currency,” said Mr. Buffett.

That advice is as good as, well, gold.

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