There’s a funny story about Thomas Edison. When he was a child, apparently, he decided one day to set fire to the barn on the family’s property. After it burned to the ground, his parents were furious. “Why would you do such a thing?” his father asked. Young Edison replied, “I wanted to see what would happen.” This story may be apocryphal, but I was reminded of it recently when I came across a study titled “Not Learning from Others.” A group of economists wanted to understand more about how people learn.
The researchers set up an experiment in which teams of people were told to estimate how many marbles of different colors were contained in a jar. There were two people on each team. To start, each of the team members had to guess how many red marbles they thought were in the jar. Then, one of the team members was permitted to draw some of the marbles out of the jar while the other team member observed. Finally, each team member was asked to submit an updated guess on the number of red marbles they thought were in the jar. Importantly, the team members were able to speak freely and to share information with each other throughout the experiment. The only difference was that one of the team members was responsible for pulling the marbles out while the other just observed.
What happened? Even though the two team members were sitting side-by-side and openly sharing information, their answers differed markedly. The team members who could only observe ended up making guesses that were significantly less accurate than those of their teammates’. The conclusion—which wasn’t altogether surprising—was that people learn better when they are hands-on with a problem.
How could you apply this finding in managing your personal finances? Below are five ways in which you could become more hands-on with a variety of financial topics.
Look under the hood. Mutual funds and their cousins, exchange-traded funds (ETFs), offer investors a diversified basket of investments. But how exactly do funds operate? While it might sound like a cure for insomnia, I recommend reviewing the most recent annual report issued by one of the funds in your portfolio. These are all available online. On this page, for example, you can find links to reports for all of Vanguard’s ETFs. To be sure, these reports are lengthy, but you need not read every page. Instead, I’d focus on these three sections:
- Schedule of investments – a detailed list of the fund’s holdings
- Statement of operations – the fund’s profit and loss statement
- Financial highlights – how the fund’s expense ratio is calculated
To gain a more granular understanding of the differences between index funds and actively-managed funds, you might compare two annual reports—Vanguard’s Total Stock Market Fund, for example, and Fidelity’s Contrafund. Among the interesting differences you’ll find: Contrafund isn’t limited to public-company stocks. It owns shares in quite a few private companies, including ByteDance Ltd., the Chinese company behind TikTok.
Make a pick or two. Is stock-picking a good idea? According to the data, no. But do I recommend it—sometimes? Absolutely. Here’s why: Every year, organizations like S&P issue reports highlighting just how difficult it is for professional money managers to beat the market. But as the marble study showed, there’s a difference between reading other people’s research reports and experiencing something for yourself. If you buy a handful of stocks and follow them over time, that will, I think, give you a truly hands-on understanding of the nature of stocks.
Follow the math. Last week, I suggested that investors work to answer three key questions as they review their tax returns:
- Am I itemizing deductions?
- What was the marginal tax rate applied to my ordinary income?
- What was the marginal tax rate applied to my long-term capital gains and qualified dividends?
I noted that the answers to these questions are usually provided by accountants and by most tax software. While that’s true, I also suggest that everyone try—at least once—to follow the math on their tax return. You certainly don’t need to add up every number, but see if you can follow the logic behind these three questions and behind these other key figures:
- Total income
- Adjusted gross income
- Standard deduction or itemized deductions
- Taxable income
- Total tax
I view this a little like changing the oil in your car. You don’t need to do it every time, but if you go through the steps even once, it may give you a deeper understanding of how the car works.
Check the turnover. Why do actively-managed funds underperform so frequently? One reason is because it can be so maddening to pick the right stocks. Another reason is timing. If a fund owns the right stock but at the wrong time, that will still detract from returns. And if a fund manager buys and sells too frequently, that can leave fund shareholders with an unwelcome tax bill. While there’s no way to know what a fund manager will do in the future, you can use the past as a guide.
One figure to look for is the fund’s turnover ratio. It refers to the percentage of a fund’s value that the manager buys and sells each year. You can find turnover information on a fund company’s own website or on the website of research firm Morningstar. Morningstar reports, for example, that the Vanguard Total Stock Market Fund had turnover of 3% last year, while Fidelity’s Contrafund had turnover of 25%. That, in a nutshell, is the difference between an index fund and a typical actively-managed fund.
A related figure is a fund’s capital gains distribution rate. This is the percentage of a fund’s value that is distributed to shareholders each year. This is important because fund managers can choose to take gains (or losses) of any size at any time, and as a shareholder in the fund, these decisions are both out of your control and entirely unpredictable. That’s why it’s important to consult past distributions before buying into a fund. While not a perfect predictor, these can be an indication of what you might expect in the future. Note: These tax considerations are only an issue for funds you hold in your taxable account.
Know the drivers. Part of what makes a stock-bond portfolio such a powerful combination, in my view, is that stocks and bonds are so different. More to the point, their prices are driven by different factors. Stock prices are driven by changes in companies’ earnings per share (EPS) and by investor sentiment. Investor sentiment is captured in a stock’s price-to-earnings ratio (P/E). To learn more, you might pick a company and look through its profit and loss statements, which are all available online. There, you’ll see how EPS is calculated. Then look at a chart of the company’s historical P/E ratio.
Bonds, on the other hand, are driven by changes in market interest rates, time to maturity and creditworthiness of the bond issuer. Textbooks have been written on each of these factors, but there’s no need to go that far. Just be sure you understand the composition of the bonds you hold to be sure they’re aligned with your goals.
There’s no need to monitor any of these figures every day, but it’s important to know generally what’s going on under the hood of the economy and of investment markets. And fortunately, learning about personal finance doesn’t require setting anything on fire.
