Nothing stirs up more debate in the investment arena than the debate of index investing versus active investing. Most people I’ve come across are either for passive investing or active investing.

In the personal finance bloggersphere, quite a few bloggers have taken the position of passive investing.

Passive (Index) Investing Proponents

Free Money Finance is a proponent of index investing and has written quite a few post on this matter. why he likes index funds. Trent from the Simple Dollar also believes in index funds. Blueprint for Financial Prosperity also is invested mainly index funds and has written a post on why he loves index funds.

Bloggers who invest in active funds

The various bloggers have written quite a bit about asset allocation and are mainly invested in actively managed funds. SVB describes her asset allocation. The Sun Financial Diary revealed his asset allocation and active funds to Silicon Valley Blogger.

Pitfalls of Index Funds

We all know the great thing about index funds. They are low cost. But for those investing in index funds, one thing is for sure. Index funds ALWAYS UNDERPERFORM THE MARKET because the match the market’s performance less a nominal fee they charge (0.20% in the case of Vanguard’s funds). For index funds in less liquid sectors like the small cap space, he returns may not really reflect the sector’s returns accurately because of the illiquidity of the sector. Index funds must also recognize that they assume market risk. That means that if a particular index falls 10%, then the index fund should also fall 10% plus the fee.

Risk Adjusted Returns – the missing discussion point

What seems to be missing in this whole passive versus active investing debate is the point about risk adjusted return, With an index funds, you assume market risk. A good active fund manager aims to achieve superior risk adjusted return, ie. achieve similar or better than index returns with lower risk (or volatility). This is a very important point because a fund with better risk adjusted return will outperform in a bear market. When you outperform in a bear market, you will end up ahead in absolute monetary terms (not just fee-adjusted return).

But what are the sophisticated investors doing with index funds?

Despite the “advantages and low costs of index funds”, are the most sophisticated investors jumping on the bandwagen? Well, index funds have certainly grown tremendously over the last few years. Yet, most of the largest funds (endowment funds, pension plans) do not invest solely in index funds. Yes, they do have some portion of their portfolios in index funds. But not 100%. Why?

Index outperform in some years and active managers outperform in others

Why do the largest investors not invest 100% in index funds? It is the exact same reason why investors invest in both growth and value. Growth and value investing are actually negatively correlated. In certain years, growth outperforms and in others value outperforms. The same applies to index versus active investing.

In certain years (like the late 90s), index outperformed. The reason for their out performance was because stocks (especially tech stocks) were overvalued. Active managers simply did not see the rationale for overpaying for expensive stocks. Then from the peak of the S&P and the Dow Jones Industrial index in 1999 to the end of 2006, active managers outperformed the index. In fact, from the peak in 1999, it took seven years for the indices to return to their 1999 peak! That means if you were unlucky enough to invest in an index at the peak of the market in 1999, you would have almost the same amount of money at the end of 2006! You would have lost faith with index funds!

Take the Moderate Position

As with most issues in real life, we should avoid taking extreme and absolute positions in this debate. The largest investors have both active and passive managers. Why should we very mortal pf bloggers argue and take absolute positions in this debate? The only problem with this is that it is not easy for many of us to mix up our portfolio with both active and passive funds. Some are forced to invest in actively managed funds.”>forced to invest in both active and passive funds. Perhaps, this will be a topic for another post.

Recently, a meeting was called for in the main conference room in my company. Then an announcement was made. A laptop or disk (cannnot remember) was stolen from another office (branch) in another state. The list contained a list of employees from our office! We were told that though there was a potential identity theft situation, the chances were pretty remote.

Apparantly, the disk was encrypted. Furthermore, a sample of the encrypton was given to every IT and security personel and none of them could break the code. The company’s thoughts are that the disk was stolen for resale value!

However, as a precaution, we were all asked to inform the credit bureaus and be put on “fraud alert”. So I called up TransUnion. The call was pretty interesting to say the least. I asked a series of questions and had to key in the answer on the phone. I had to key in my social security number, my zip code and probably (can’t remember precisely) my phone number. When the process ended, I was told that I need not inform the other two credit bureaus as this has automatically been done. It was a strange experience to say the least because it was all totally automated and I could not even speak to an operator or customer service representative even if I had wanted to. I was a little apprehensive.

However, I soon received letters from the credit bureaus stating that I had requested to be put on fraud alert. At least, the fraud alert procedures was working.

We were also offered a free one-year subscription to one of the 3-in-1 monitoring service, but I have not done so as I frequently check my reports (once a year with each agency).

This whole incident simply highlights how vulnerable we are to identity theft. Though I have not had my identity stolen, this episode shows it could happen even without me being at fault.

I am actually surprised that I am absolutely sane and not a single bit bothered during this equity meltdown recently. Why? I attribute this to a couple of things.

1. I Know My Risk Profile – I hired an advisor and did a series of questionaires to find my risk my risk profile. I found out that I am not a super aggressive investors. I was a moderate investor.

2. My portfolio allocation is consistent with my risk profile – Because I knew my risk profile, my asset allocation is aligned with my risk profile. I have about 60% invested in stocks, 35% in bonds and 5% in cash (emergency funds and everyday funds).

3. I am diversified – My stock portfolio has large, mid, small cap and international stocks. It has both growth and value components. And yes, I have reits too. The bond portfolio has government bonds, mortgages, corporate bonds, high yield bonds and international bonds.

4. My portfolio is automatically rebalanced – My money is invested in a managed account. The asset allocation in my portfolio is pretty much fixed and it rebalanced automatically. Therefore, there is no need for any decision to now? or get out of the market? I just simply put money in every month.

There are other things that help me keep my sanity as well.

5. I do not have any credit card debt – It really feels good not to have any credit card debt. I plan to stay debt free.

6. I have bought a house I can afford – We bought our house 2 years ago probably at the top of the market. But we can afford the monthly payments and we do not intend to sell it. We took a boring 30 year conventional loan.

7. My income source does not really depend on the stock market – No, I am no mortgage broker or real estate agent (but it will not be revealed). But it helps that it has nothing to do with the housing market. I also have a couple of other income streams which is really helpful.

Having said all this, things were never like this not so long ago. I used to invested on my own. I bought my own stocks. I did my own research. But I underformed during the early 2000s. Worst of all, I realized that if I was really that good, I should be owning a hedge fund and making loads of money (hey – some hedge fund managers take home 9 figures a year). I realize that if I’m not earning top dollars investing, then I should really leave it to the people who are good and making that much themselves!

FInal thoughts – Knowing your risk profile, having an asset allocation that is consistent with your risk profile and having automatic rebalancing will really take the emotions away when markets are volatile. Here are some post from the bloggesphere about the recent market moves and their asset allocation. Some have got it right, while I feel a couple still have a way to go.

For example, Free Money Finance writes a post about articles telling why it’s a great time to invest now. Well, as I (and many) have said, if you have a plan, then market timing should never be an issue. Lazy Man and Money writes a short blurp on why it is the right time to stocks. Frankly speaking, trying to time the market is just a waste of time IMO.

The simple dollar advised a reader to get out of an investment when you are nervous. Once again, the reason this situation arises is because the investor did not know the reason for the investment and the portfolio is not automatically rebalanced. Rather than giving that advice, i would have asked the reader why she got in the investment in the first place? Because if you got into an investment (not trade) for the right reason, this situation should have never arosed.

Jim from bargaineering liquidated his 2050 retirement fund. He says the funds is not long term nor was he panicking. But then he went on to talk about how the climate is awful for investing right now!?

There are some pf bloggers who have laid out how they have their asset allocation done (which is great). SVB from The Digerati Life highlighted recently how she rebalanced her portfolio. A few pf bloggers have also revealed their asset allocation to SVB recently. She posted them on this post about how some pf bloggers are invested. I think these bloggers get it and have a sound asset allocation strategy.

Welcome to the carnival of money stories. Since this is a carnival about YOUR MONEY STORIES, we shall have it in a “show and tell’ format – yes, just like when you were little kids. Your teacher is Moi!

First, a few housekeeping matters : I turned down many submissions because they were not stories. Andy (founder of this carnival) told me to pick only money stories and I quite agree as this is a carnival for money stories. There were many good post I turned down because they were more like “how to” or “descriptive” post which should be posted to the carnival of personal finance.

Directions : To get the most out of this carnival, just imagine have your kids around (if you are a parent) and read the post through the eyes of a child.

Teacher : Alright children, it’s show and tell time. Let’s all form a circle. (After 5 minutes when everything is settled). OK – who wants to go first today? Happy Rock. Alright Happy Rock, come up here and do your show and tell.

Happy Rock : This is box of the copy of Microsoft Money my Daddy bought for me. This is a game for you to see where your money goes. It’s really fun. You can see where your money is coming from and where you spent it. But last week, I changed computers and my money was gone…he he..so I had to Recover from Microsoft Money Server Upgrade.

Teacher : My Wealth Builder, you are next. What do you have for us today?

My Wealth Builder : This is my daddy’s toolbox. Inside, there are hammers, drills and many things. We live in a very old house and this year, my daddy says we are going to do lots of work on our house. Then it will be very beautiful. My daddy decided not to hire any one to do this. Daddy and Mommy are going to do all the work by themselves. This is a book on how to Do it yourself basics and save money.

Teacher : SVB, your next. What will you show us today?

SVB : This is my daddy’s and mommy’s money statement. Daddy and Mommy are always talking about money to me. Last night, they told me How they are rebalancing their asset allocation. I said to my daddy : “but daddy, I do not know what you are talking about?”. And my daddy said : ” Honey, diversifying your portfolio is like having many toys. On some days, you play with your dolls, on other days, you may want to play with your trains. If you only had one toy, what happens when you want to play with something else?”.

Teacher : Thank very much SVB – you are very smart. Now, who is next? How about you Queer Cents.

Queer Cents : This is a cell phone. This phone has a video camera. I use it to take pictures. Yesterday, Mommy and I were at a restaurant and we heard two ladies talking next to us. One of them was asking for Help for an astonishing bad money decision. Mommy says never to listen to what other people say, but they were talking so loud. So I took a picture with the cell phone.

Teacher : You have to be careful Queer Cents. Some people are not happy about having their pictures taken. OK – Money Ning, I see you have something quite heavy to show us.

Money Ning : This is a weighing machine. When you stand on it, it tells you how heavy you are. I am very light. But my daddy and mommy are quite heavy. My daddy and mommy always tell me to exercise and eat well. Daddy says it is very important to be fit and slim. He is worried that his employer might start charging me money for being fat. He makes me do exercise everyday.

Teacher : Well, Money Ning, you look healthy and fit. Now Money and Such, what is this you have here?

Money and Such : This is a for house sale sign. When you want to sell your house, you stick this in your garden. My mommy is a real estate agent. She says before you put your house on sale, you need to know what is your house worth?. Mommy sells lots of houses. But this year, she is not selling many.

Teacher : I see. Millionaire Mommy Next Door, what do you have for us?

Millionaire Mommy Next Door : This is a notebook. Mommy gives me some money every week to some food. She makes me write down how much I spend, how much I got and she wants me to have money left at the end of the week. She always tells me that Evaluation is critical to your success. She give me two dollars every day. So I have ten dollars every week. Two times five is ten. I save about five dollars every week. I use to candy sometimes.

Teacher : Thank you very much. Financial Dominance, what is it you have there?

Financial Dominance : This is a chinese fan. When you are hot, you just move it and you will feel a breeze. We also have fans at home. Mommy says that using fans can Dramatically cut your cooling cost. My house has fans on top. You just turn on the switch and it moves and it is so cool.

Teacher : Very cool indeed. It’s your turn next Fire Finance. What do you have for us?

Fire Finance : This is a credit card. Actually it is my daddy’s old credit card. It looks like a phone card. Daddy says that when I am older, he will teach me all about credit cards, money and grown up stuff. Yesterday, daddy was telling me about Lies about Credit Card Debt on TV. He said never believe everything on TV or what you read.

Teacher : Free Money Finance, what is it you have in your hands?

Free Money Finance : This is a disney ticket. Daddy and Mommy took our family to Disneyland during summer. We really had a great time. I had lots of fun. Daddy says he did not have to spend too much money because he got lots of Disney money saving tips. We sat in so many rides. I like the “It’s a small world after all”, and the “lion king” ride.

Teacher : You must have had a wonderful vacation. Finance is Personal, why are you holding your lunch box?

Finance is Personal : This is my lunch box for show and tell. Mommy says I have to bring my lunch box to school everyday except friday when it is pizza day. She says she will let me my own food two times a week when I am in second grade. My mommy makes really good food for my lunch box. She really knows How to bring your lunch to work without ruining your taste buds. I wish I was in third grade now, so I can lunch everyday.

Teacher : Time will fly very fast. Dough Roller, is that a newspaper?

Dough Roller : This is Barron’s newspaper. Daddy is teaching me about money and how to make more money. Last wee, he taught me how to pick your first mutual fund. He says when I am 20, I will know more about money than all my friends.

Teacher : Uh…well…I guess it is never too young to learn. Edith Yeung, what are those envelops you have?

Edith Yeing : These are my daddy’s bank statement (realistically this will never happen!). My daddy was teaching me how to manage and maintain your bank account. But I still do not know what he is talking about. So I just went to play with my toys!

Teacher : That alright Edith, you are still young. Unclaimed Money, it’s your turn next.

Unclaimed Money : This is a calendar. It tells you the month and the day. Mommy says that you can save money by changing your shopping day. She says different things in supermarkets cost cheaper on some days. So my mommy goes to the supermarket EVERYDAY!

Teacher : Thank you. Stephanie, you’re next.

Stephanie : This is a shoe that Mommy bought for me at the church consignment shopping and garage sales. Mommy spent the day looking for things for me. All the stuff was very cheap. Some of the money Mommy spent went to the church. I love shopping with Mommy.

Teacher : Finally….Money Smart Life, what is that in your hands?

Money Smart Life : This is a picture of a man with no name. Last saturday, daddy sat down with this man he did not know and talked to him for a very long time. Daddy always told me not to talk to strangers and he was talking to strangers himself. I kept asking to me an ice cream, but he kept talking and talking. The man told my daddy how money can change a life.

Teacher : Thank you very children. You all did very well for your show and tell. It’s time for recess and lunch. So let all line up to go to the cafeteria.

This morning, I had a meeting with a someone I had recently met at a conference. We decided to meet a a Starbucks. I parked my car about a block away and was half an hour early. I decided to put two quarters in the parking meter. I thought of putting three quarters, but decided against it.

Half an hour later, my friend showed up. After ing our coffee, we sat down and had a great time chatting about various stuff. Well, time flew and before you know it, we had been chatting for forty five minutes. It was time to go and lo and behold, I found a parking ticket by my windshield.

I looked at the parking ticket and the fine was $26! Alright, it’s not too bad but I was really pissed at myself. Had I just put in another quarter, I would not have to pay this fine. A quarter is a lot better than a $26 fine.

It made me wonder what was going through my mind when I put that two quarters after I just parked. Why didn’t I put three quarters (or even four) just in case? Why did I want to take the risk? In analyzing the situation, I realized that what I did was irrational. There was a good chance that I will end up chatting with my friend and forget about the time. There was also a good chance of me getting a ticket. The fine was substantially more than a quarter. Yet, I found myself trying to save this quarter and it was really for no good reason. Because even if my friend did not show up, the worst I would have been was to lose a quarter. But looked what happened instead.

On hindsight, this is a classic example of being penny wise and pound foolish. Trying to save a few pennies, but end up losing much more. There are many examples in my life where this happened. Like trying to invest on my own for ten years without seeking help. I thought that I could be as good as Warren Buffet or investing was as easy as Peter Lynch said! How much did it cost me? A lot!

What examples of “penny wise pound foolish” mistakes have you made?

The New Apple iPhone is all the rage now. Well, I’ve found a way to save on your monthly Apple iPhone bills. Apple made an agreement with Cingular (now part of AT&T), hence every iPhone owner now has to use Cingular as their wireless carrier.

Unlike other wireless carriers, you have to pay for the full price of an Apple iPhone. With other carriers, you will get a free cellphone if you sign up for say a two year contract. I have found a way for iPhone or wannabe iPhone owners to save some money. And you’ve guessed it – through credit cards!

You can save money on your iPhone and your monthly bills if you have the AT&T Universal Rewards Card. The card allows you to earn five reward points when you use your card for “eligible AT&T purchases”. This is defined as purchases made through AT&T customer service center (1-800-222-3111) or through att.com. hence, as long as you make your iPhone purchase and cingular wireless service directly from AT&T, you will earn five reward points for every dollar you spend on the card. AT&T’s card program is based on the ThankYou Redemption network program from Citibank. It also comes with a 0% balance transfer deal for 12 months (with no balance transfer fee for the introductory period).

If you wish to earn cash rebates instead, you can get the American Express SimplyCash^SM Business Card. This card pays 5% cash rebates on wireless bills, gasoline, office supplies. You also get discounts at American Express OPENSAVINGs merchant partners like Fedex, Delta Airlines and Courtyard by Marriott. (Though this is a small business credit card, you can always apply as a sole proprietor even if you do not have a business).

So there you have it, two credit cards that will save you money on your iPhone bills.

In my opinion, we need to know a few very basic questions with regards to your personal finance. Do you know the answers to these?

How much assets do you need to retire? – This is a more complex question than it seems. You need to know a rough estimate of how much you need (in today’s dollars) to live the lifestyle you want. You need to factor in that you may need to pay your own health insurance, long term care cost. You need to factor in how you intend to live and spend your time when you retire (going on a world vacation may cost more than you think).

You need to know how much you need to save – While nothing is for certain, you need to get an analysis done to know how much you need to save to have a high probability to reach you retirement goals.

You need to know your risk profile – You need to know your risk profile. How much loss on your portfolio are you willing to tolerate. Can you sleep at night if your portfolio declines 10%? You need to know your risk profile so you can formulate a proper asset allocation strategy based on your goals and risk tolerance. The mistake I see most often in the press and bloggesphere is that all the talk is about asset allocation without regards to risk tolerance.

While one can argue that you should be in 100%b equities if you are 30 years old. But if you do not have the risk tolerance for potential declines in the equity markets, you are better off having a more conservative asset allocation because you will be less inclined to get out the equity markets in the worst possible moments.

How much do you need to save for your kids college – This goes without saying. Surely you want your kids to go to the best college you can afford.

How much insurance do you need – You will know this answer if you do a proper financial plan. It depends on your current expenditure and how much assets you need to sustain your current lifestyle.

How much do you spend every month? – As basic as this sounds, most people do not know precisely where their money goes. Treat your expenses like a CFO treats what every department spends. A CFO knows where every penny goes.

How much do you spend on every major category of expenses every month? – Aside from knowing how much you spend every month, you should know to the penny how much you are spending on your mortgage, auto loans, groceries, gasoline, cable, internet connections, phone bills etc every month.

What is your present tax bracket? – Well, you need to know your tax bracket as this will affect whether you invest in municipal bonds or taxable bonds. You also need to estimate what your taxes in retirement will be because that will have an impact on the retirement plan you choose today.

What is the optinum retirement plan? – If you work for a company, then you will most likely go with a traditional 401k. But if you are self employed or own your own business, you have a variety of choices – SEP, Individual 401k, Roth 401k, Roth IRA. You need to know (or someone to explain) the pros and cons of each plan, your estimated taxes post retirement, the amount you want to contribute and figure out the best plan for your circumstances.

How much taxes will you pay when you leave this planet? – As much as we do not hate to face this topic, doing your wills and planning your estate has to be done. You need to know how much taxes you will approximately owe and minimize the taxes.