Monday, November 29, 2010

Don't Try to Pick Up Quarters Off the Street

I was walking on the street this weekend when I noticed a quarter on the ground. My initial thought was to pick it up...but then my knowledge about the stock market immediately kicked in. I suddenly couldn't decipher if I was having a deja vu, dreaming, or actually experiencing this! I thought to myself: If the world of walking the streets of Dallas is anything like the stock market that quarter shouldn't be there. Furthermore, even if it really was there, the action of bending over and picking it up would not overcome the costs (in this case energy and time) of receiving 25 cents. I quickly snapped out of my mental intuition and rightfully picked up the quarter. Oh well...

On the other hand, individual and professional investors believe they are all good at picking up quarters off of the ground or picking the next Microsoft or predicting interest rates or figuring out that international stocks will beat domestic. But they fail to realize two things, 1) those free quarters or opportunities do not consistently exist and 2)the cost of trying to find those quarters will dig you a deeper hole.

When talking to individual investors some feel they are the next stock picker dejour. Again, they fail to realize that there never was and never will be a stock picker dejour - someone who can predict the future and position their portfolio appropriately for the next 20-30 years, beating a portfolio of low-cost, diversified index funds.

One of the biggest mistakes an investor can make is believing that they have the "skill" or "knowledge" to outperform the market (perform better). Usually this conviction arises by looking in the rear view mirror while driving forward. Investors plow into funds after strong performance and depart after weak performance. Just because a fund has had great performance in the past does not mean it will continue to do so. Furthermore, once you invest in a fund you do not instantly achieve the past returns of the fund. If investing worked that way everyone would be rich.

An active manager attempts to outperform the market (index) by assembling a portfolio that is different than the market. They construct their portfolios through innumerable methods: account records, earnings, the CEO, rating services, the alignment of the stars, literally anything their brain can trick them into believing that a pattern or rationale exists for.

I have asked dozens of investors why they believe they have more information than millions of other market participants. I ask why they think they can outperform the market even though the odds (2 out of 10 each year) are against them. I ask why they think quarters are free. I have never gotten a response to this question.

Wednesday, November 17, 2010

Can You Beat the Market? It's a $100 Billion Question

Investors collectively spend around $100 billion a year trying to beat the stock market. That’s the finding of a rigorous effort to measure the total costs of Americans’ efforts to surpass the returns they would have received by simply holding a stock index fund. The huge price tag helps explain why beating a buy-and-hold strategy is so difficult.

The study, “The Cost of Active Investing,” began circulating earlier this year as an academic working paper. Its author is Kenneth R. French, a finance professor at Dartmouth; he is known for his collaboration with Eugene F. Fama, a finance professor at the University of Chicago, in creating the Fama-French model that is widely used to calculate risk-adjusted performance.

In his new study, Professor French tried to make his estimate of investment costs as comprehensive as possible. He took into account the fees and expenses of domestic equity mutual funds (both open- and closed-end, including exchange-traded funds), the investment management costs paid by institutions (both public and private), the fees paid to hedge funds, and the transactions costs paid by all traders (including commissions and bid-asked spreads). If a fund or institution was only partly allocated to the domestic equity market, he counted only that portion in computing its investment costs.

Professor French then deducted what domestic equity investors collectively would have paid if they instead had simply bought and held an index fund benchmarked to the overall stock market, like the Vanguard Total Stock Market Index fund, whose retail version currently has an annual expense ratio of 0.15 percent.

The difference between those amounts, Professor French says, is what investors as a group pay to try to beat the market.

In 2006, the last year for which he has comprehensive data, this total came to $99.2 billion. Assuming that it grew in 2007 at the average rate of the last two decades, the amount for last year was more than $100 billion. Such a total is noteworthy for its sheer size and its growth over the years — in 1980, for example, the comparable total was just $7 billion, according to Professor French.

The growth occurred despite many developments that greatly reduced the cost of trading, like deeply discounted brokerage commissions, a narrowing in bid-asked spreads, and a big reduction in front-end loads, or sales charges, paid to mutual fund companies.

These factors notwithstanding, Professor French found that the portion of stocks’ aggregate market capitalization spent on trying to beat the market has stayed remarkably constant, near 0.67 percent. That means the investment industry has found new revenue sources in direct proportion to the reductions caused by these factors.

What are the investment implications of his findings? One is that a typical investor can increase his annual return by just shifting to an index fund and eliminating the expenses involved in trying to beat the market. Professor French emphasizes that this typical investor is an average of everyone aiming to outperform the market — including the supposedly best and brightest who run hedge funds.

Professor French’s study can also be used to show just how different the investment arena is from a so-called zero-sum game. In such a game, of course, any one individual’s gains must be matched by equal losses by other players, and vice versa. Investing would be a zero-sum game if no costs were associated with trying to beat the market. But with the costs of that effort totaling around $100 billion a year, active investing is a significantly negative-sum game. The very act of playing reduces the size of the pie that is divided among the various players.

Even that, however, underestimates the difficulties of beating an index fund. Professor French notes that while the total cost of trying to beat the market has grown over the years, the percentage of individuals who bear this cost has declined — precisely because of the growing popularity of index funds.

From 1986 to 2006, according to his calculations, the proportion of the aggregate market cap that is invested in index funds more than doubled, to 17.9 percent. As a result, the negative-sum game played by active investors has grown ever more negative.

The bottom line is this: The best course for the average investor is to buy and hold an index fund for the long term. Even if you think you have compelling reasons to believe a particular trade could beat the market, the odds are still probably against you.

Tuesday, November 16, 2010

China, Ireland, Spain, Greece - Uniquely Looking at the World Map

How should we view the world economy? The rise of China and decline of the United States seems to be prevalent in the news recently. Fears of Ireland are a hot topic. Months ago Greece was worrisome. Spain's fate was in question at sometime as well. Statistics don't help either. Population growth, GDP, trade balances, etc. - how can we determine what the world map looks like?

Viewing the world map by relative market capitalization illustrates the importance of building a globally diversified portfolio and avoiding biases that may arise from attention to other economic statistics.


This cartogram depicts the world not according to land mass, but by the size of each country’s stock market relative to the world’s total market value.

Population, gross domestic product, exports, and other economic measures may influence where people invest. But the map offers a different way to view the universe of equity investment opportunities. If markets are efficient, global capital will migrate to destinations offering the most attractive risk-adjusted expected returns. Therefore, the relative size and growth of markets may help in assessing the political, economic, and financial forces at work in countries.

The cartogram brings into sharp relief the investible opportunity of each country relative to the world. For example, China and Spain have a slight larger market capitalization than Microsoft! Greece is virtually non-existent. The world map avoids distortions that may be created or implied by attention to economic or fundamental statistics, such as population, consumption, trade balances, or GDP.

By focusing on an investment metric rather than on economic reports, the chart further reinforces the need for a disciplined, strategic approach to global asset allocation. Of course, the investment world is in motion, and these proportions will change over time as capital flows to markets offering the most attractive returns.

Monday, November 15, 2010

What Is the Investment Impact of Our Federal Deficit?

By Larry Swedroe

One of the widespread concerns I keep getting asked about is the impact of our federal deficit on investments. A new study by Marlena Lee of Dimensional Fund Advisors demonstrates that the impact isn’t what you would think.

Before we discuss the study, it’s important to note that the fact that our deficit (and the resulting debt) is a major problem is just that — a piece of information and nothing more. What you have to understand that it’s not information you should use to alter your investment plan. The reason is that if you know the information (and it’s not insider information), you can be 100 percent sure the big institutional investors that do most of the trading and therefore set prices also are aware. Thus, that information (and the risks it brings) is already embedded in prices.

It’s critical to understand that it doesn’t matter if news is good or bad, only if it’s better or worse than already expected. We see this all the time when a company reports earnings down 20 percent (clearly a bad number), yet the stock price increases because the market expected an even worse figure. The reverse is true when there is good news, but the stock price falls because the news wasn’t as good as expected.

Federal Deficits and Debt
We begin by noting that the U.S. — with a debt-to-GDP ratio of about 90 percent — isn’t the only major industrial country with a deficit/debt problem. The 28 countries in the Organization for Economic Cooperation and Development have debt-to-GDP ratios ranging from 23 percent (Australia) to 199 percent (Japan), and more than half the countries have deficits in excess of 70 percent.

Interest Rates
In her study “The Economics of Fiscal Deficits,” Lee concluded that today’s deficits don’t provide us with valuable information about either future yield curves or future bond returns. In other words, today’s interest rates already incorporate information about fiscal policy.

Economic Growth
It turns out debt has very little impact on economic growth until it exceeds 50 percent of GDP. However, even at as much as 70 percent of GDP, debt levels only explain about 12 percent of the variation in GDP growth.

Equity Returns
While deficits/debt negatively impact economic growth, there’s actually a negative relationship between a country’s growth rate and its stock returns. The explanation is similar to the reason value stocks produce higher returns than growth stocks despite producing much lower growth in earnings: Markets don’t price growth, they price risk!

For developed MSCI countries from 1971 through 2008:

  • High-growth countries (average real growth of about 1 percent) produced equity returns of 12.9 percent
  • Low growth countries (average real growth of about -4 percent) produced stock returns of 13.5 percent.

For emerging market countries from 2001 through 2008:

  • The high growth countries (average real growth of about 2.5 percent) returned 19.8 percent
  • The low-growth countries (average real growth of about -5 percent) returned 24.6 percent.

Remember this the next time you are tempted to jump on the China or Brazil bandwagon.

While the talking heads from Wall Street and the financial press continue to produce dire forecasts based on the deficits, the historical evidence demonstrates that today’s deficits and debt levels don’t provide any valuable information about the future returns to either stocks or bonds. Thus, you should stick to your well-thought-out plan and ignore the noise designed to get you to act when doing nothing is in your best interests.

Thursday, November 11, 2010

Faced With the Decision of Selling an Inherited Asset?

Thanks to my favorite writer Larry Swedroe, I thought it might help to provide an explanation of the right way to consider whether you should buy, hold or sell investments. No, I am not advocating to try and time the market.

Put yourself in the following situation: You’re a wine connoisseur and purchase a few cases of a new release at $10 per bottle to store in your cellar to age. In 10 years, you learn the wine is now selling for $200 per bottle. Do you buy more, sell your stock or continue to hold it?

Faced with this type of decision, very few people would sell the wine, but very few would buy more. (Of course, given the appreciation in the wine’s value, you might choose to save it to drink on special occasions.)

The decision not to sell or buy isn’t rational. This is known as the “endowment effect.” The fact you already own the wine shouldn’t impact your decision. If you wouldn’t buy more at a given price, you should be willing to sell at that price. Since you wouldn’t buy any of the wine if you didn’t already own any, the wine represents a poor value to you. Thus, it should be sold. The same thing is true of any investment you currently hold: In the absence of costs, the decision to hold is the same as the decision to buy.

The endowment effect often causes individuals to make poor investment decisions. For example, it causes investors to hold assets they wouldn’t purchase.

The most common example of the endowment effect is that people are often reluctant to sell stocks or mutual funds they inherited. I have heard many people say something like, “I can’t sell that stock, it was my grandfather’s favorite and he’d owned it since 1952.” Or, “That stock has been in my family for generations.” Or, “My husband worked for that company for 40 years, I couldn’t possibly sell it.” Another example would be stock accumulated through stock options or some type of profit-sharing/retirement plan.

Financial assets are like the bottles of wine. If you wouldn’t buy them at the market price, you should sell them. Stocks, bonds and mutual funds aren’t people — they have no memory, they don’t know who bought them, and they won’t hate you if you sell them. An investment should be owned only if it fits into your current overall asset allocation plan. Thus, its ownership should be viewed in that context.

You can avoid the endowment effect by asking this question: If I didn’t already own the asset, how much would I buy today as part of my overall investment plan? If the answer is, “I wouldn’t buy any,” or, “I would buy less than I currently hold,” you should sell. That is true of a bottle of wine, a stock, a bond or a mutual fund.

David Tepper Wants Us to Believe It Was Easy to Beat the Market

Stay tune. I have asked several experts to try to explain his Hedge Fund’s 30%/year return for a 17 year period. Before you rush out and try to get into his fund, read this very carefully (click the title):

Also, Read this Article Titled - "'Hedge Fund Liars"

And, for even more information, contact us at Arianna Capital for a white paper on why hedge funds often fail.

Hebner, Mark. "David Tepper Wants Us To Believe It Was Easy To Beat The Markets." Index Funds Advisors Blog. Word Press, 9/26/2010. Web. 11/11/2010. .

Tuesday, November 9, 2010

You Might be Misled by the Lipper Average (as Seen on T.V.)

Q: When I hear financial companies advertising on T.V., they mention the fact that their funds have beat the 10-yr Lipper Average, what is that and what does it mean?

As Larry Swedroe points out, there are many misleading ways to report performance. The Lipper Average is simply the average level of performance for all mutual funds, reported by Lipper Inc. But let's take a closer look at what data Lipper uses.

In 1986, Lipper reported that 568 stock funds had an average return of 13.4 percent. However, in 1997, Lipper showed the 1986 return to be 14.7 percent. This happened because 134 funds from the original batch disappeared, and their returns were removed from the database. This skew happens by showing the performance of only those funds that are currently in existence. This is known as “survivor-ship bias.” Funds that have poor performance disappear, most often by merging a poorly performing fund into a better performing one. Fortunately, we now have publicly available databases for mutual funds that are free of survivor-ship bias.

Beware, mutual fund companies use other tactics to misled individuals. Including comparing returns to inappropriate benchmarks. For example, a private equity fund, hedge fund or even a value fund might compare its returns to the S&P 500 Index. Each of these funds takes on much greater risk than that benchmark, including the use of leverage. Thus, their returns should be compared to more appropriate, risk-adjusted benchmarks. Many investors have been fooled by this trick.

Also, there’s a third, less well-known bias in mutual fund reporting called incubator bias. Here’s a hypothetical example: A mutual fund company uses its own capital to seed multiple small-cap funds. Each fund might own a different group of small-cap stocks. The fund family incubates the funds, safe from public scrutiny. After a few years they bring public only the fund with the best performance. Magically, the poor performance of the other funds disappears, never to see the light of day.

Unfortunately, the SEC allows fund families to report the pre-public performance of these incubator funds. Thus, we have the potential for a huge distortion of reality, as only successful fund histories make it into the public databases. This is a real problem since the historical evidence is that the past performance of mutual funds has proven not to be prologue.

The bottom line is mutual fund companies attempt to deceive investors through advertising. Of course, there’s a very simple way to avoid the tricks: Just follow the advice you find here and never invest in actively managed funds.

Monday, November 8, 2010

Is the Grass Grenner on the Other Side - 401(k) or Joint Account?

Q: Would it be better to invest my money with a wealth manager offering lower cost, passively managed funds or contribute to my 401(k), where I have expensive, actively managed funds?

The obvious advantage with the 401(k) is the tax-deferment of pre-tax contributions. If you choose to contribute to a Joint account rather than a 401(k), the Joint account would be funded with after-tax dollars, in which you would take quite a hit comparatively. I realize most 401(k)'s are poor, offering expensive, under-performing funds - along with high management fees. Unless the 401(k) has an outlandish wrapper/management fee of 5-6%, at which point your account would never grow, it would not be worth it to fund a Joint account as opposed to your 401(k).

Although the investment choices are most likely more prudent with your wealth manager, the performance may not overcome the taxation of these dollars once the account is contributed to. Eventually, providing the 401(k) fees are high enough and fund performance low enough, over the long-term the Joint account may overcome the 401(k) value. But this "strategy" would rely on superior investment performance, although this could happen, it is not a chance I would suggest taking given numerous other factors e.g., offering of a better 401(k), rise of taxes, etc.

Portfolio Endurance

The need for retirement planning doesn’t end with the onset of retirement. A new retiree’s focus shifts from building wealth to managing and preserving it. One major challenge is to make the investment portfolio supply cash flow for the duration of life — and through different economic and market conditions.

Experts have studied portfolio longevity or endurance to help retired investors reduce the odds of depleting their wealth too soon. The studies evaluate how a portfolio might endure under the stress of changing markets and spending levels. The resulting models estimate portfolio survival in terms of statistical probabilities.1 While the technical details are beyond the scope of this article, the general conclusions are more intuitive.

Three main factors drive portfolio endurance: asset mix, spending level, and investment time frame. Certain aspects of these factors are within an investor’s control while others are not. Let’s briefly consider them.

Asset Mix
Asset mix describes the ratio of stocks to bonds in a portfolio. This determines risk exposure and expected performance, and is one of the most important decisions investors of all ages can make. Historically, stocks have outperformed bonds and outpaced inflation over time. This return premium reflects the higher risk of owning stocks. Consequently, the larger the equity allocation, the greater a portfolio’s expected return—and risk.

Keep in mind that risk and return go together. A higher allocation to equities increases the risk of experiencing periods of poor returns during retirement. But if you can handle the risk, having more equity exposure in a portfolio enhances its return potential. Growth can bring higher cash flow, inflation protection, and portfolio endurance over time. This is why most advisors believe that most investors should have an equity component in their portfolios, with actual weighting depending on one’s time frame, risk tolerance, and spending flexibility.

Spending Level
Portfolio withdrawal is typically described in terms of a specified dollar amount (e.g., $50,000 per year) or a percent of annual portfolio value (e.g., 5% of assets each year). Neither method is ideal, however—and for different reasons. Briefly consider each one:

· Specified dollar amount: withdrawing a fixed amount each year and adjusting it for inflation can provide a stable income stream and preserve your living standard over time. But the portfolio may survive only if future withdrawals represent a small proportion of the portfolio’s value. One academic study quantified this amount. It found that a retiree with at least a 60% stock allocation can withdraw up to 4% of initial portfolio value (adjusted for inflation each year), and enjoy a high probability of never running out of wealth. Choosing a higher withdrawal amount is not likely to be sustainable, especially if the portfolio faces an extended period of negative returns.

· Percent of annual portfolio value: withdrawing a fixed percentage of assets based on annual asset value makes it unlikely that you will deplete retirement assets because a sudden drop in market value would be accompanied by a proportional decline in spending. But this method can produce wide swings in your living standard when investment returns are volatile.

Retirees who need relatively consistent cash flow may want to combine these two methods. One way is to withdraw cash flow according to a rule that combines past spending (e.g., an average of the past thirty-six months of cash flow) with a payout rate applied to current portfolio value. You can weight these factors to favor your preference for either more stable cash flow or a greater chance of portfolio survival. In effect, you are customizing your withdrawals to smooth out consumption while responding to actual investment performance.

Investment Time Frame
Investment time horizon may be the hardest to estimate, especially if it is the same as your lifespan. In this case, you can only guess how long your portfolio must support spending. If you plan to bequeath assets, your investment time frame may extend beyond your lifetime. This may influence your risk and spending decisions as well.

Time frame forces a tradeoff between the short and long term. Retirees with a longer investment time horizon might choose a higher exposure to equities. But they may have to offset this risk by being more flexible about spending over time. Elderly retirees and others with a short time horizon may choose a less risky allocation or a higher payout rate, although they can experience rising spending levels, too. In any case, retirees should think carefully about equity exposure and avoid taking more risk than they can afford.

Planning involves assumptions about the future—assumptions that may not pan out. Although you cannot avoid making assumptions, you can ask whether they are realistic and consider how your lifestyle might change if future economic and financial conditions are much different than projected. For instance, you may assume an average return based on historical performance. But there is no certainty that future portfolio returns will resemble the past, regardless of time frame. Moreover, short-term results may vary drastically, which could force hard financial choices. Investors should think in terms of probability, not history.

Managing asset mix, payout, and time horizon inevitably involves tradeoffs. Exhibit 1 below illustrates the dynamics. For example, a bond-dominated portfolio with a lower expected return may suit investors with a shorter time horizon, or require them to accept a lower payout rate to increase the odds of portfolio survival. A portfolio with a higher allocation to equities may be appropriate for someone with a long time horizon or a strong desire for a high payout rate, but a higher assumption of risk also results in greater uncertainty about future wealth. Retirees who take this route must be able to handle the risk emotionally, and they should be ready to adjust their lifestyle in response to market downturns. In fact, investor flexibility plays a role in all of the tradeoffs.

Exhibit 1: Basic Tradeoffs in Portfolio Survival

Finally, although you cannot fully control these and other factors involved in portfolio endurance in retirement, having more wealth can improve the odds of having a less stressful financial life. A more substantial nest egg might enable you to take fewer risks, enjoy a higher sustainable spending rate, or extend the productive life of your portfolio.

Wednesday, November 3, 2010

The Amusement Park of Jim Cramer

Jim Cramer is the epitome of "financial pornography". Jim Cramer’s predictions sometimes swing dramatically from optimistic to pessimistic, and back again, over short periods. His army of viewers, a strong 600,000, watch to get their dreams filled with hot air or for just mere entertainment, who knows. One thing is for sure, he knows how to lure viewers in the same way a casino does. Moreover, the show exploits the innocence of investor psychology. In the same manner a casino prevents outside light entering the gambling floor in attempt to control a gambler's internal clock, Jim Cramer's show has fabricated the same fanatical experience.


From the color red to loud alarms Jim Cramer fascinates his viewers with psychological tricks. Who wouldn't be entertained by a circus act? The graphic above gives a list of triggers to look out for - in Mad Money and the investing world in general. Jim Cramer's effect on investors perfectly displays Nobel Laureate, Daniel Kahneman's findings on behavioral biases. A portion of Mr. Kahneman's research concluded that humans are not wired for long-term investment decisions because we tend to try and make create patterns out of random events. Furthermore, our perception flaws our judgment about decisions. Casinos, game shows, and now Jim Cramer play on the psychology of humans.

Mr. Cramer makes hundreds of buy-hold-sell recommendations on individual stocks each month via his show. What have his results been? According to CXO Advisory, his Accuracy Rating is 47%, meaning you would be better off flipping a coin in order to make a decision than listen to the entertainer. You'd be better off spending your time watching Sportscenter.

The Best 529 Plan Goes to... West Virginia!

By Arianna Capital

Saving for college can be quite an endeavor. Luckily, this article will aide anyone looking to pursue a college degree. There are several options like the Coverdell ESA, UGMA/UTMA, or the 529 plan. We will focus on the 529 plan today.

A Little Bit About 529s
Nearly every state has a 529 named for the IRS code that brought them about. The funds can grow tax free if used to pay for higher education qualified expenses. They can also be used to pay for thousands of post-secondary education across the globe. However, not all 529s are the same.

The West Virginia Award

After scouring the nation for the best option to help our clients save for their kids' future payments we found a diamond in the rough - West Virginia 529. It is special for several reasons. First of all it has low fees. This is an extremely important factor when searching for investment options. Secondly, West Virginia offers DFA funds. In previous posts we have written about the academia and science behind these funds. They don't try to offer the next best flavor of the month. Instead, they control what they can control in taxes and fees, and they let markets work for an expected return for providing financial capital. I have yet to come across better funds. Third, they are very simple to use. We all have busy lives. It may happen that we forget to rebalance the portfolio, or the child gets closer to college-age. Enter the age-based portfolio option, like that offered by West Virginia, which automatically does all of this for us.

Other Tips
When selecting a 529 plan there are three other things you need to watch out for.
1. Always buy a direct plan. Advisor sold plan only create wealth for the advisor. West Virginia makes it so easy that an advisor is really not necessary here.
2. Look for a state tax break. If your state gives a tax deduction or credit for contributions, look at home first. If the fees aren’t too much higher than West Virginia's, the value of the tax deduction or credit may outweigh the higher fees. In Texas, this is a mute point.
3. Consider an age-based option. This aids the values of simplicity and diversification.

Investing in 529's is a wonderful idea when planning for college to achieve tax-advantages returns. Make sure you choose carefully and watch out for costs and emotional decision making.

Tuesday, November 2, 2010

The Flaws of Variable Annuities

Ever walked the streets of New York City? Did you experience the snake-oil salesman luring you in with their fake Rolex watches and designer purses? Sounds familiar to the variable annuity market thanks to commissions of 5% or more.

Historically, variable annuities have gone from bust to boom. It seems as if variable annuity providers are in an "arm-race" to construct and sell the sleaziest, most deceiving product. Perfect timing uh? A 100-year event, like the market fall of 2008, can sure get people thinking differently about the complex, costly alien-like products. After all, an astonishing $33 billion in variable annuities was sold across the distribution channels in the fourth quarter of 2009. If only individuals knew what they were getting themselves into.

First, a primer. A variable annuity is basically a tax-deferred investment vehicle that comes with an insurance contract, usually designed to protect you from a loss in capital. Thanks to the insurance wrapper, earnings inside the annuity grow tax-deferred, and the account isn't subject to annual contribution limits like those on other tax-favored vehicles like IRAs and 401(k)s. Typically you can choose from a menu of mutual funds, which in the variable annuity world are known as "subaccounts." Withdrawals made after age 59 1/2 are taxed as income. Earlier withdrawals are subject to tax and a 10% penalty.

Variable annuities can be immediate or deferred. With a deferred annuity the account grows until you decide it's time to make withdrawals. And when that time comes (which should be after age 59 1/2, or you owe an early withdrawal penalty) you can either annuitize your payments (which will provide regular payments over a set amount of time) or you can withdraw money as you see fit.

So, what's the catch? The average expense on a variable annuity subaccount (including fund expenses and insurance costs) is typically one percent more than the average mutual fund expense ratio. Additionally, many variable annuities extract ongoing fees for administration and maintenance on the contract. An annual commission is also usually withdrawn from the account as well.

Proponents of variable annuities may point out the advantages of a death benefit. The death benefit basically guarantees that your account will hold a certain value should you die before the annuity payments begin. With basic accounts, this typically means that your beneficiary will at least receive the total amount invested — even if the account has lost money. For an added fee, this figure can be periodically "stepped-up" or earn a small amount of interest. (If you opt not to annuitize, then the death benefit typically expires at a certain age, often around 75 years old.)

Investors who bought annuities and then happened to pass away within the next two months probably got their money's worth. But considering the fact that over the long term the stock market will deliver positive returns, most folks need this insurance about as much as a duck needs a paddle to swim. While all variable annuities come with a standard death benefit, the average price for additional death benefits is 0.43%, according to Morningstar. On $1 million, if this $4,300 was used to buy a life insurance policy independent of an annuity, a healthy 50-year old man could definitely hold a policy of greater than $2 million, making the benefits of a death benefit a mute point.

Want to get your money back quickly once you invest? Tough luck. The surrender fees typically apply for 5 to 10 years. Withdrawing your funds before this time frame will result in huge fees. The surrender fees usually tier down as the years pass, but getting dinged by a 1% surrender fee in the last years can really eat into your assets. Not only that, but withdrawal before age 59 1/2 will result in a 10% penalty fee.

Gains in variable annuities are taxed at ordinary income tax rates. For most investors, that's a whole lot higher than the long-term capital gains tax rate they pay on their long-term mutual fund gains. And the tax difference can easily eat up the advantage of an annuity's tax-free compounding. Residents of some states may pay even more taxes on non-qualified variable annuity accounts. Some states also add a tax for variable annuities purchased within a qualified account, like a IRA.

Variable annuities continue to be a poor solution for a variety of factors. Some of which are not mentioned, such as estate planning issues and investment options, entailing higher expense ratios and underperfoming funds. Bottom line, ask the seller of a variable annuity how we much they will be compensated and from whom. If a conflict of interest exists, usually the solution wasn't designed with your best interests in mind.