0 8 investor biases to avoid – don’t be your own worst enemy!

• Investing
• by William F. Davis, CFP®
• 02/19/2025

While we’d all like to think that we are capable of handling the stock market on our own, investor biases play a big part in interfering with our ability to do so. Don’t let them! This article covers the eight major psychological investing biases that get in our way, and what to do about each one. What is an investor bias? A bias is defined as a strong preconceived notion. It can be in favor of or against a particular person, place, or thing. An investor bias is defined as an inclination about a particular aspect of investing (a security such as a stock or bond, the market, a particular type of investment style, etc.). Often these biases are the root cause of behaviors that investors have, and actions they may take. Humans are living, feeling beings and under stress we can be subject to our emotions, making decisions that are counter to our logic, that we would not have made in a more composed state of mind. As markets and life events can never be predicted, it is a matter of time until we are faced with situations that tempt us to conform to our inner psychological flaws. Why behavioral biases are so damaging to investors It may not seem like a “thing”; but it is. Investor bias is harmful because of its impact on investment performance. According to a Dalbar report, the average stock investor underperformed the index by 5.35% in 2019 (Dalbar, 2020). If you’re reading this and doubting that the figure is accurate – well, then that’s just another example of how we can lack objectivity when faced with the cold, hard facts. So before you devote any more time to debating… Investing is emotional, and emotions vary like the wind. They are hard to quantify. I’m sure there are just as many studies proving the opposite, and there may be validity to dissent about this statistic – but that’s not really the point of this article. No matter what the investing population does, your only concern is you. And that’s where we can provide insights that may help you overcome investor biases that you may be having. Let’s talk about those instead, shall we? Alphabetically-arranged list of investor biases and how to overcome them The list of investor biases is long. We’ve organized them in alphabetical order, because we like to keep things tidy on our blog. Action bias When faced with a shocking market event, there is a penchant to take action, and it doesn’t always work in the investor’s favor. This is called action bias. Did you know that, according to Dalbar, about 70% of investor underperformance has happened over ten periods, and each of those periods was a time when the market was a major decline? (Dalbar, 2020) Go ahead and roll your eyes – oh no, now they’re citing that Dalbar report again! It may be or may be completely accurate in your case, but you’ve got to admit, there is a sneaking tendency to want to cash out instead of watching your hard-earned money sink in to the red tick marks zone. How to overcome it: There are mantras and emotional training tools you could use to keep your emotions in check. However, we do believe the best remedy is to work with a financial advisor who can behaviorally coach you through these times. Also try pausing and asking yourself, “Do I really need to sell at this precise moment, or is there any possibility that I am able to hold out and wait for the market to come back?” Anchoring bias Imagine this scenario. You love baking strawberry shortcake in the summer, and to do that you need to buy strawberries. Now, the price of this food follows a very distinct seasonal pattern. In the summer, there is a higher quantity of strawberries produced, causing there to be a lower scarcity for the product available – prices fall. However in the late fall/early winter, prices rise sharply due to scarcity. Let’s say you don’t know all this. Although you usually make strawberry shortcake in the summer, you get inspired in the midst of shopping for your New Years Party. “What? Three dollars for a pound of strawberries – I’m never buying these again!” you say. It’s anchoring bias. You’re used to paying $1.37 for the same food. You swear off of strawberries without looking at what the price is at the time when you usually consume it. It’s a classic case of shortsightedness; you’re only analyzing the most recent information presented to you instead of looking at the overall picture. This type of investor bias happens in the market all the time when investors create their expectations for what they think returns in their portfolio should be. Let’s say you are in a secular bull market. Every year your portfolio returns 10%. Then the Fed hikes interest rate and the economy falls into a recession. Now you’re in negative territory for the year thinking it’s a crisis. You’re anchored to the most recent negative return and comparing it to the high returns of years past, failing to recognize that in the long term, this average return of the market is neither negative nor 10% but somewhere in between. How to overcome it: Ask yourself, “Am I being too short-sighted? What long term information am I overlooking that could possibly change my perspective?” Confirmation bias It’s a human trait to gravitate towards things that make us feel good, and avoid things that don’t. When investing, it’s easy to selectively weed out data that does not concur with beliefs we may have. This is the essence of confirmation bias. Let’s say you are a big fan of cryptocurrency. You open your browser and the first three articles you see published on the internet are about the risks of investing in crypto, and how volatile it can be. Despite these signs of caution, you move ahead with your bullish stance. Sadly, most of the great crashes in the stock market history would have been predicted if participants had just paid attention to the obvious signs. But they didn’t see it coming (as they should have) because of their blind spot. Confirmation bias is to blame. How to overcome it: As with many other investor biases, the best remedy is to work with an objective third party, such as a financial advisor. One of the benefits is that in scenarios like this, a financial advisor will bring to your attention the information you are overlooking; and sometimes just that nudge is enough to help you from veering off course. Disposition bias Picture this. You hold a diversified portfolio which contains two stocks of note. Stock A has a 25% loss, and the prospects for future performance are not good. The management team is stagnant and the product they sell is obsolete. Stock B has a 25% gain, and it has a bright future. The CEO was just replaced with a more suitable one, the company restructured and profit margins are rising, and the industry is expected to grow rapidly in the next 5-10 years. You sit down for your quarterly review, and upon a quick glance you decide to sell the one with the gain. It’ll be great to pocket the gain to offset other losses in my portfolio, you say. On the other hand, you are too skittish about recognizing a loss to sell the stock that is in the red. The pain of seeing the loss of dollars locked in prompts you to hope and pray that somehow the stock turns around and sees better days. Disposition effect is a real investor bias, folks. How to overcome it: Making intelligent decisions about when to sell a stock is something that most investors don’t pay enough attention to. As we’ve mentioned before, one of the advantages of working with a financial advisor is that an unemotional third party can advise on the proper sell methodology. If you opt to go your own route, have a discipline that applies to your sell decisions. What criteria do you look for in deciding to keep or sell a position? Write it down and revisit it on a regular basis, and certainly as you review your portfolios. Familiarity bias With a broad universe of securities to invest in, and a long list of Wall Street shiny objects constantly touted by the media it’s easy for investors to feel overwhelmed. One natural reaction is to stick to what is familiar and exclude the full set of investment options. This type of investor bias plays out in various ways, from the style in which we manage our portfolio, the stock or bonds we buy, and even the investment decisions we make. Investment decisions should come from a sound, repeatable process incorporating elements such as risk assessments, research, valuations, and economic or market forecasting; not just a feeling. Take a hypothetical example. Let’s say you are a gastroenterologist and through your work you become familiar with the ins and outs of various gastrointestinal remedies. You invest heavily in pharmaceutical stocks that could benefit from these trends, incurring a concentration in one or two stocks. Now suppose regulators put up resistance to drug development, and your portfolio takes a hit – which it may or may not recover from. You thought you felt safe by sticking to what you knew – but the reality was you were exposing yourself to massive risk. Seeing the big picture is important for all investors. Familiarity bias is harmful because it can lead to improper portfolio diversification and failure to protect from various risks (geopolitical risk, economic recession, inflation). How to overcome it: Form a thorough investment process and write it down. Follow it every time. If you are unable to do this on your own, consider hiring a financial advisor. Loss Aversion Loss aversion is the psychological incongruity between the experience of loss and that of gain. The lows of feeling a loss are stronger than the highs of experiencing a gain, even if the two amounts are completely equivalent. Loss aversion plays out in investing in a few different ways. This investor bias may cause you to hold on to a stock longer than you should, just to avoid recognizing the loss. It may lead you to sell down to cash if you fear the market is going to take a dive. There are some pretty significant consequences when it comes to investment performance. According to the Quantitative Analysis of Investor Behavior 2019 study by Dalbar, the average investor in 2018 lost twice as much as the market (as cited in Charles Schwab, 2021). As there were a couple drawdowns over the course of that year, it’s presumable that investors did as described above – they either held on to positions they should not have, or sold when they shouldn’t have. How to overcome it: As loss version has deep emotional underpinnings, we believe the best remedy (as is for many other investor biases) is to work with a trusted financial advisor who can help you stay objective and exercise smart judgement during times of stress. Self-attribution bias Imagine the following scenario. You undertake your quarterly rebalancing process, and having read an article about the value style, you decide to make some changes in your portfolio that involve a tilt towards certain value stocks based upon some research you did. The next week, you see that those stocks experienced a 20% gain. Patting yourself on the back for your hard work, you brag to your friends at the cocktail party about your investing skills. Or was it luck? Self-attribution is an investor bias that speaks to our ego. We’re way more likely to attribute positive outcomes to our hard work and skill rather than random chance or other factors that we are not responsible for. When things go wrong, we point the finger to others instead of ourselves. It’s dangerous because it may lead us to wrongly perceive our true aptitudes and attempt tasks that we really shouldn’t be. All of this gets in the way of rational thinking. How to overcome it: As the Greek philosophers say, “Know thyself.” It’s hard to remove your own pride from investing, but it’s important to see the truth. Careful analysis of the facts can often make this hard to ignore. Trend-chasing bias As Boys 2 Men once sang, “It’s so hard to say goodbye to yesterday.” You can read every single disclaimer in the world, but human beings are naturally going to want to take an investment’s past performance into account when contemplating its future potential. And the financial media screaming about the latest “hot stocks” or “big movers” doesn’t help one iota. This is the origin of trend-chasing bias. How to overcome it: Process comes into play if you want to manage this investor bias. A thorough research process should entail an analysis of: Volatility Fundamental factors Correlations with other investments you may hold How this affects the overall risk level in your portfolio A buy and sell discipline What the risks specific to the investment are, and how to manage them What the costs of the investment are If you’re not up for all the work involved with following a proper due diligence process for every investment you hold, consider working with a financial advisor. How are YOU going to overcome investor biases? Thanks for reading our blog about investor bias and how to overcome it. We’ve written other blogs about how to find a financial advisor, what financial advice costs, and the perks of working with a financial advisor. We hope you’ll enjoy reading them, should you so desire. Need some help curtailing your investor bias when it comes to your portfolio? We are a fiduciary financial advisor in the Philadelphia area, but we work with clients across the country. We provide fee-only, objective advice to our clients on taxes, wealth management, and financial planning. If you would like to discuss a possible relationship, contact us. Sources Charles Schwab. November 3, 2021. Fundamentals of behavioral finance: Loss aversion bias. Retrieved from here. Dalbar, Inc. 2020 QAIB Report for the period ending December 31, 2019. Retrieved from here.

0 What is confirmation bias in investing (and what should I do about it?)

• Investing
• by William F. Davis, CFP®
• 02/12/2025

Confirmation bias affects many investors, and it often goes overlooked. In this blog we are going to talk about the definition of confirmation bias, and an example of how it may affect an investor. Lastly, we’ll discuss how to manage it and the role a financial advisor plays in helping clients manage confirmation bias. What is confirmation bias? Confirmation bias is defined as the propensity to select information that aligns with our beliefs, while rejecting information that does not support them. Investors often apply lower standards to confirming information and higher standards to data that does not concur with their views. As a result, they are more likely to accept what they agree with and less likely to accept what they do not agree with. Confirmation bias – example of how it affects investors Let’s talk about how confirmation bias may potentially impact investors. Here’s a hypothetical example of confirmation bias. Keisha is a doctor and knows a great deal about the pharmaceutical industry. She believes there is tremendous growth potential for telemedicine, given her anecdotal experience as a physician. Keisha reads a Wall Street Journal article touting telemedicine start ups’ growth potential and decides to allocate a portion of her portfolio to several of the stocks mentioned. Keisha reads a Barron’s article about how telemedicine startups are likely to face heightened competition and reach a plateau of growth due to regulatory pressures. She dismisses this opinion as invalid. In the example above, is Keisha making a truly unbiased decision? No. She is pursing the path of least resistance instead of asking the hard questions about the opinions against her hypothesis. Instead, she should have asked herself questions such as: Is there true validity to what the Barron’s article is saying? Is this a viable source? Do other reputable sources confer with this not-so-rosy picture of telemedicine startups? Am I missing something? Of course, this is just a theoretical example that may not be construed as a real scenario. The purpose of our example is to conceptualize the way that confirmation bias leads investors to seek information that supports their beliefs, often leading them to make decisions based on incomplete information. It’s natural to do this; it feels good to think you’re right, and it feels bad to think you are wrong. It’s human nature. But whatever the cause and reasons for it, confirmation bias is a danger to investors. It causes them to compromise objectivity and operate in a biased fashion, overlooking key data that should be employed in a proper research process. So what can you do about it? Can investing biases be overcome? In other blogs, we’ve discussed how to overcome investor behavioral bias. Please refer to our discussion of action bias and its consequences for the detailed analysis. In short, there are several ways to overcome confirmation bias in investing, ranging from behavioral controls training to mindfulness practice. But these biases are inextricably linked to our inner psyche as humans – and hard to get past on our own without another person to keep you centered. We feel the best way that an investor may overcome confirmation bias, and the many other biases that investors face (projection bias, overconfidence bias, herd bias, etc.), is to work with a financial advisor who can coach you through it. Even the strongest of investors are subject to human flaw; having an independent third party who can advise you unemotionally is one of the best benefits of working with a wealth manager.   The role a financial advisor plays in correcting investor bias The ironic thing about confirmation bias is this. The contradictory information that an investor rejects is precisely the type of input that they should paying more attention to. But unfortunately, when you’re making decisions from left (or right) of center, you won’t see that. And that is where the danger comes in: when it gets to the point that you are making an off-balance investment decision. Educated, informed people can sometimes be their own worst enemy when it comes to investing – because they believe so strongly in their convictions that in a sense they create “blind spots.” All investment decisions should be made with objectivity. There is zero room for emotion of any sort in the investment process, whether it be in selecting investments to buy, knowing when to buy, knowing when to sell, taking capital gains, managing the overall risk level of a portfolio, picking the right level of stocks vs. bonds, or any of the other crucial tasks that go into the process of managing wealth properly. The financial advisor plays a key role in helping clients overcome confirmation bias, as well as any other investing biases that they may be subject to. In some cases, it useful for the investor to have a gentle reminder or nudge that they are overlooking facts that they shouldn’t. In other (more extreme) cases, the financial advisor will need to make a full-on case for why the opposing view is valid and should be considered. The extent to which a wealth manager must get involved to correct clients’ behavioral financial blunders will vary from one case to the next. For investors who are serious about building long term wealth, a financial advisor really shouldn’t be a “nice to have.” Most people will eventually make a mistake at some point, and it can be very damaging if it is a major mistake in the latter stages of the wealth cycle. Working with a financial advisor – finding the right one A skilled financial advisor is trained in the biases that investors are subject to, and knows how to coach a client through it. The process should be collaborative and won’t make you feel like you’re being restricted but rather nurtured to a higher level of investing skill. As financial advisors in Philadelphia working with clients across the country, behavioral coaching is our core value adds to the client. We provide fee-only, objective advice to our clients on taxes, wealth management, and financial planning. If you would like to discuss a possible relationship, contact us.  

0 Interval Funds: what to know before you invest

• Investing
• by William F. Davis, CFP®
• 01/27/2025

One of the newest investment vehicles on the scene is interval funds. We’ve found other discussions of interval funds to be quite uninformative. In this blog we’ll discuss what they are, what their inner workings typically look like, and when it does and does not make sense for an investor. Before we get started, you may want to take a moment to read our other blogs on mutual fund investing. 12b-1 fee Mutual fund fees A share mutual funds – run away! First - understand open vs. closed end funds Here’s where we feel others mess up the definition of interval fund: You have to understand the difference between an open and closed end mutual fund before you can grasp what an interval fund is. There are two major types of pooled investment vehicles that are gaining some visibility with investors. An open-end mutual fund: Does not trade on an exchange. Has an unlimited number of shares. When you buy into an open-end mutual fund, new shares are created using the funds you deposited. On the converse, when you redeem, the fund buys your shares back using cash from the fund, or it may have to sell some of its holdings to create liquidity. You can effectuate a transaction any time you wish, but it is only executed at the closing day price and the shares don’t move until after the fund closes for the day. Is regulated under the Investment Company Act of 1940 and must file reports with the Securities and Exchange Commission Are bought and sold at the Net Asset Value, or NAV A closed-end mutual fund: Usually trades on an exchange. Has a limited number of shares. When you buy into a closed-end fund, no new shares are created. You are simply picking up shares that another investor is offering to sell. You can trade intraday. Is regulated under the Investment Company Act of 1940 and must file reports with the Securities and Exchange Commission Is bought and sold by the price determined by supply and demand for the fund These definitions are important to know if you are considering investing in any type of mutual fund. Don’t just trust whatever your broker or advisor says. Do your own research and know what you are owning, just to be safe. What is an interval fund? An interval fund is defined as a closed end fund that does not trade on an exchange that offers periodic liquidity. Wow! That was a mouthful. Here’s how interval funds are different from the typical closed-end fund (U.S Securities and Exchange Commission, ND). Unlike most closed-end funds, they do not trade on an exchange The fund itself will buy or sell shares directly from or to the consumer instead of these transactions happening through the exchange. You may be able to purchase shares at any point. You are only able to sell shares back to the fund at a specific time, which the fund specifies in its prospectus. Bought and sold at a priced based on the NAV, that is not known at the time the repurchase offer is made. You aren’t able to redeem your entire investment amount at once. There may be a 2% redemption fee. There may be higher management fees. Interval fund vs. mutual fund Aside from the differences mentioned above, interval funds often pursue a different investment strategy that most mutual funds. They can use leverage, and many times they run what many investors consider alternative asset strategies such as real estate debt, credit, or direct lending. These strategies tend to offer higher yield but offer less liquidity. History of interval funds Interval funds have an interesting history (Interval Funds, ND). They have been around since the 1990s, but with the recent popularity of exchange traded funds, they became less notable. After the 2008 recession, closed end funds started to become more popular and interest in interval funds rose along with them. Decreased regulation made it easier for fund vehicles to invest in alternative asset classes such as private equity. Who it makes sense for The investment objective of every fund is different, and a person’s strategy is dependent upon a number of different factors. On balance, interval funds are usually chosen by people who: Is looking to invest in less liquid instruments Desires yield Wants a return that is non-correlated with the market Don’t have high liquidity needs, as many interval funds have gated redemptions, prohibiting the investor from having free access to the money held in the fund. Do not require the ability to liquidate their investments immediately; has additional funds saved for a crisis Has done enough financial planning to feel confident in their gauge of future expenses and cash flows Is not highly fee conscious Who it doesn’t make sense for Intervals funds are not a wise choice for someone who: Requires immediate or short-term liquidity Does not have funds saved to support living expenses outside of the money invested in the fund Doesn’t have a financial plan or a clear concept of future cash flows Is highly fee conscious Need certainty about short term access to their funds What to ask yourself before buying an interval fund If you are thinking of investing in an interval fund, here are some questions to ask yourself before you do so. Could I survive without this money, if I had a sudden need for cash? If so, for how long? One of the benefits of working with a financial advisor is the ability to gain clarity about cash flows. Many financial advisors will help clients by creating a financial plan that maps out their expenses and the cash flows projected to cover them. This may give you a sense of how much excess cash is given at any one point, and how much you can invest in the market. Along with an overall assessment of your risks and life goals, an understanding of your liquidity needs may be reached. All of this should be outlined in the Investment Policy Statement that an advisor puts together for you in the beginning of a relationship, and revisits through the duration. What are the fees? The fees for any mutual fund are disclosed in the fund’s prospectus that is required to be delivered at the time of purchase by the 1933 Act. It is imperative that you understand any and all interval fund fees before putting your money into these vehicles. Take, for example, the Goldman Sachs Real Estate Diversified Income Fund (GSREX) prospectus (Goldman Sachs Asset Management, 2022). It is useful to search on the term “Fee Table” within the prospectus. Most have a section called “fund fees and expenses” or the like which outlines all the fees you could potentially pay by investing in the fund. Know what each type of fee is. In the above fee schedule, here’s how these fees would be defined. Sales Load – a commission paid to the broker who sold you the fund. Redemption fee – if you redeem the shares within a certain period, you are due to pay a fee. Management fees – fees paid to the portfolio manager for managing the fund Interest payments on borrowed funds – if the fund is using leverage, you’ll likely be paying interest on the line of credit they took out to borrow the funds Operating expenses – legal, accounting, custodial expenses Distribution fee – fee you pay to compensate the fund for marketing itself As you can see, there are quite a few fees to be aware of. It’s imperative that investors can gain an understanding of the fees; do not invest without doing the research. What are the liquidity constraints I would be facing if I were to put my money into this fund? Repurchase terms vary by fund. To quote the Goldman Sachs fund prospectus mentioned above: The Fund operates as an “interval fund” (defined below) pursuant to which it will, subject to applicable law, conduct quarterly repurchase offers for between 5% and 25% of the Fund’s outstanding Shares at net asset value (“NAV”). And in another place: An investment in the Fund is not suitable for investors who need certainty about their ability to access all of the money they invest in the short term. Even though the Fund will make quarterly repurchase offers for its outstanding Shares (expected to be 5% per quarter), investors should consider Shares of the Fund to be an illiquid investment. In addition, there is no active secondary market for Shares. There is no guarantee that investors will be able to sell their Shares at any given time or in the quantity that they desire Every interval fund has different terms; this is merely an example. However, we do take the view that given the uncertainty of redemption, you should consider any investment in an interval fund to be an illiquid investment. Even though they are somewhat illiquid, there is more liquidity compared to private funds or alternative assets. Final thoughts on interval funds Investing in an interval fund isn’t something to be taken lightly. There are liquidity constraints and the fees can be burdensome. Before doing so, we recommend that you conduct thorough diligence and proceed with caution. It’s important to find the right interval fund for you, if you chose to go this way. Many times, a financial advisors can be of assistance in determining your liquidity needs, the suitability of such investments, and your overall cash flow budget. We are a fiduciary financial advisor in the Philadelphia area, but we work with clients across the country. We provide fee-only, objective advice to our clients. If you would like to discuss a possible relationship, contact us. Sources Goldman Sachs Asset Management. Goldman Sachs Real Estate Diversified Income Fund. Retrieved from here. Goldman Sachs Asset Management. Goldman Sachs Real Estate Diversified Income Fund.(28 January, 2022). Prospectus. Retrieved from here. Interval Funds. (Sept 09, 10:53). The History of Interval Funds – and Where They’re Heading. Retrieved from here. Investor.gov. ND. U.S Securities and Exchange Commission. Interval Fund.  Retrieved from here. U.S Securities and Exchange Commission. (2020, Sept 25th).  Investor Alerts and Bulletins. Investor Bulletin: Interval Funds. Retrieved from here.

0 Say “no” to A share mutual funds!

• Investing
• by William F. Davis, CFP®
• 01/13/2025

Despite the availability of lower cost options, investors continue to buy A share mutual funds. They shouldn’t. In this blog we’ll talk about why we think investors should run away as fast as they can from A share mutual funds, and we’ll refute the fake logic of the hollow sales pitches that people are often given to urge them to invest in these vehicles. Get ready for an eye-opening analysis! But first, we are low fee financial advisors in Philadelphia, PA. We feel passionate about low-cost investing, and wrote these blogs you may want to check out: Mutual fund fees can be sky high 12b-1 fees take a big bite out of your portfolio Financial advisor fees – are you overpaying? Low-cost ETFs How investors lose money Before we get started on our crusade against A share mutual funds, let’s take a moment to discuss how investors lose money. So, you have a portfolio. Sometimes it goes up, and sometimes it goes down. It’s all the market’s fault, right? Well, not exactly. There are two very large factors that play a part in your portfolio performance. #1 Cost of investment erodes returns Your portfolio may be riddled with higher fees than necessary. True, if you need a financial advisor, that costs money. Buying pooled vehicles such as ETFs or mutual funds costs money. But with so many options available, there’s no reason you should be getting price gauged, which is unfortunately the case when people buy A share mutual funds. You may not even consciously be aware of it, but your portfolio, over time, may be suffering from the effects of a mutual fund management fee that is taking more than it should out of your portfolio. Compounded over time, this can have a big effect. Look at what the impact of mutual fund fees can be on your wealth - this graph from Investor.gov just says it all: There’s nothing wrong with using mutual funds, ETFs, or with hiring a financial advisor. But if you choose to go that route, you should always make sure that the fee you’re paying comes with commensurate value to the benefit provided. It’s not always easy – sometimes the terms aren’t clear – and we’ll get to that in a little bit. #2 Biases derail investor performance Most investors, if left to their own devices, will wind up not beating the market, or in many cases, not even performing in line with it, as confirmed by numerous Dalbar studies. Our blog about investor bias covers the eight psychological traps that investors tend to fall into. In alphabetical order, they are: Action bias Anchoring bias Confirmation bias Disposition bias Familiarity bias Loss Aversion Self-aversion bias Trend-chasing bias These psychological biases are deeply engrained in each investor’s mind, and one of the best ways to overcome it is to work with a financial advisor who can provide behavioral coaching to help you stay grounded and avoid the pitfalls. There are many subtopics within both categories, but for now let’s just focus on one of them: A share mutual funds and how they are a rotten option for investors who want to accumulate long term wealth. What is an A share mutual fund? An A share mutual fund is defined as a mutual fund that charges a sales load for you to invest in it. In addition, the mutual fund has an ongoing expense ratio that is paid out of the invested amount, which may include a 12b-1 fee. Whoa whoa, we threw some terms at you. Let’s slow down and define them. A sales load is a commission paid to the broker who sold you the fund. In an A shares mutual fund, the sales load can be as high as 5.75%. So, if you were to invest $100,000 in the fund, the broker who sold you the fund would pocket $5,750. Quite a big bite, no? With so many low-cost ETFs and no-load mutual funds available (both of which charge zero sales load whatsoever), we feel there is no need for anyone to pay a sales load anymore. What is a mutual fund expense ratio? The expense ratio is paid directly to the mutual fund company. It compensates the fund management company for administering, marketing, and managing the assets in the fund. The average equity mutual fund expense ratio is 0.50% (Investment Company Institute, 2021) and just to reiterate, this is paid out of the portfolio in addition to any sales loads What is a 12b-1 fee? A 12b-1 fee is paid to the mutual fund company. It is included in the overall expense ratio. Essentially, it pays the fund for the sales and marketing related expenses incurred for selling the fund to you. By law it can’t be greater than 1%. Enough fees for ya? By the way, some mutual funds offer breakpoints, a scenario in which you receive a discount off the sales load for purchasing a certain amount of the fund. Mutual fund breakpoints are disclosed in the fund’s prospectus. Breakpoint discounts may be recognized for a lump sum investment, or a series of investments over time. However, in the latter case, you must sign a letter of intent stating the dollar amount that you are committing to invest in the fund. Confused yet? If you’re like most people, you are! It’s important to understand how mutual fund fees work though, before you invest. What is a mutual fund share class, and why do they exist? You can just imagine how in days of yore, with all these different fee structures abounding, things became a bit overwhelming for investors. To clarify matters, the SEC came up with what are called mutual fund share classes. There are four: A, B, C, and D. Here is a great explanation of each of the mutual fund share classes. This was done under Rule 18F-3, passed in 1995. As Class A shares is the subject of our article, we’ll just focus on that for now. Class A mutual funds: Have a front-end sales load which is debited out when you buy it Have a lower 12b-1 fee than the other classes Are usually sold directly to investors by brokers Debit out ongoing expenses for the administration and operations of the fund, and this is reflected in their expense ratio. For an example, please refer to the prospectus for the AMCAP Fund. You should always refer to a fund’s prospectus before purchasing shares of it. You can see, for example, the 5.75% maximum sales charge for class A share is clearly stated. There is also a chart breaking out the fund operating expenses. Importantly, the prospectus also illustrates what the cost of the fund would be over time given various assumptions. How do you know if you are buying an A share mutual fund? That’s all well and good, you may say, but how do I know if I own an A share mutual fund? Even better: how do I know what share class of a fund I own, in general? First, you should know what share classes of the mutual fund are in fact offered, so that you can evaluate which share class meets your needs. Do your research before you buy it. This is all disclosed in the mutual fund’s prospectus. A copy is available online, or you can contact the company to have a copy mailed to you. Second, determine how you want to buy the fund. You can buy it directly from the mutual fund company or using your brokerage account. The fees may vary depending on how you go. When you enact a purchase transaction, you will be asked to specify which share class you want. After the trade is executed, you will receive a confirmation stating the ticker, amount, commission paid (if applicable), and share class. Remember to save this in your records in case you forget. Another way for an investor to check is to go to the mutual fund website and check the Fact Sheet. It will list the various shares classes. Also, in many cases, you can tell by the ticker symbol. For example. PIMCO total return fund is PTTAX for the A share and PTTCX for the C share Why A share mutual funds are not beneficial to investors There are several circumstances that may lead an investment in A share mutual funds to benefit the issuing company and the person who sold it more than the investor. This is important for anyone thinking about buying an A share mutual fund to understand. Here’s how an A share mutual fund will likely be sold to you, usually by a broker who wants to get a commission. Remember the sales load we discussed above? They’ll usually say that after you invest, you won’t pay any loads for the next 10 years, as you would with other share classes such as C shares who charge a redemption fee when you sell them. They also may make some claim that the 12b-1 fees are lower because of the sales load paid. They may even say that you can invest within the same fund family without having to pay another load. We don’t see the logic of the argument for the following reasons: Even if you don’t, you’re still paying fees throughout the duration of the time you hold the mutual fund in the form of the fund’s internal operations, which tend to be higher than the expense ratios associated with holding other less expensive vehicles such as ETFs. High fees paid have a significant effect on the long-term performance of an investment. From the start, you have to earn the sales load back just to breakeven. Over time, the compound effect is a large detractor from wealth. If you want to avoid paying another load by going outside the fund family, you are inherently limited to whatever the options are within that fund family. Make sure that any performance figures you use, whether in the prospectus, on the website, include the sales load. If not, you may be thinking the returns are higher than they really are. Usually, the company will publish a version of the figures with and without the load. What to do before buying a mutual fund Being an educated investor is of high importance. Before purchasing a mutual fund, do your homework. #1 Read the prospectus. You can find it online or call the company to have a copy sent. #2 Use online tools to determine the cost of what you are buying. Here are two mutual fund cost calculators: Personal Fund mutual fund cost calculator FINRA Fund Analyzer #3 Evaluate the full universe to determine if there are lower cost options available. This may take some time, but it is better to make a wise, informed decision. Websites such as Morningstar provide free research for the public There are better options than A share mutual funds In our view, we think A share mutual funds should be avoided by investors – and in fact, we are not a big fan of investing in mutual funds for our clients whatsoever. As a low fee financial advisor, we invest our clients’ money into low-cost ETFs and avoid high fees altogether. None of our clients’ money is invested into funds with loads, 12b-1 fees, or high expense ratios. We are a fiduciary financial advisor in the Philadelphia area, but we work with clients across the country. We provide fee-only, objective advice to our clients on taxes, wealth management, and financial planning. If you would like to discuss a possible relationship, contact us. Sources Dalbar, Inc. 2020 QAIB Report for the period ending December 31, 2019. Retrieved from here. Finra. Mutual Funds: Share Classes. Retrieved from here. Investment Company Institute. 2021 Investment Company Face Book. Chapter 6: US Fund Expenses and Fees. Retrieved from here. Mutualfunds.com. Decoding Mutual Fund Share Classes. Retrieved from here. U.S. Securities and Exchange Commission. (12 May, 2014). Investor.gov. Investor Bulletin: Mutual Fund Fees and Expenses. Retrieved from here. Capital Group. American Funds. Forms & Literature. Summary Prospectus, AMCAP Fund. Retrieved from here.