Investment advisors brace for these moments in the markets. The stock market erases the year’s gains. The phone starts ringing. It’s time to do some hand-holding.
Which is fine. It’s a financial advisor’s job to be the rock in a high tide and to help long-term investors see beyond the headlines.
Advisors spend a lot of time explaining what to do when stock markets slide. Yet it can be summed up in a single word — “nothing.”
That’s right, nothing. If you are properly invested on a Tuesday when the market is at an all-time high, you are still properly invested the next Friday when it has lost hundreds of points.
Warren Buffett has talked about this phenomenon at length over the years. He cites his mentor, the late Benjamin Graham, who tells the story of Mr. Market.
In Graham’s story, you are a business owner. Your equal partner is a wildly unsettled fellow named Mr. Market.
When sales and profits are up, Mr. Market values the business very highly. He’ll never sell. Never! You can offer to buy him out all day, every day and he won’t hear of it.
When the opposite occurs, as you can imagine, Mr. Market is ready to liquidate. He begs you to take his half of the business at any price. Pennies on the dollar, please just let him out.
As Buffett explains, the stock market is your fictional partner, Mr. Market. At some points during a given week, month or year, things are going great and he’d never sell. Then a reversal comes and he can’t wait to cash out.
As Graham explained, the stock market is a voting machine in the short term but a weighing machine in the long term. Opinions of the value of the companies that comprise the market can move wildly in the short run.
But, over time, the true value of the companies in the index is apparent. The data over the very long term suggests that stock valuations go up at about twice the rate of economic growth. That’s largely thanks to reinvestment of dividends.
The other major point to make is that money begets money. If you earn a competitive market return and fail to panic and sell when prices decline, you can be relatively assured that your money will compound, that is, it will double in value as time passes. And double again.
Whether that’s in a few years or more than a decade is a function of how much stock exposure you can tolerate and your ability to stay in the markets as they go up and down in the short run.
But compound it does, ultimately leading to powerful wealth creation and the ability to ignore Mr. Market with confidence. What would Warren Buffett do in a stock correction? Mostly, nothing.
It’s really that simple.
The headlines are enough to give any stock investor pause. Volkswagen’s CEO stepping down over emissions cheating, a crazy biotech startup raising drug prices 5,000%, Caterpillar flummoxed by the global slowdown, and so on.
It’s enough to make you want to sell it all and just sit in cash. Yet you know that’s a mistake, too. How can anyone stomach stock scandals and stay an investor?
Easy enough: diversification.
I am reminded of a friend with a young son. Like any pre-teen, the boy is caught up in brands. Clothing brands, electronics brands, car brands — you name it.
He’s just testing out ideas, searching for an identity. So he asks his dad, “Hey, do we own stock in Nike?” Yes, answers the father. “Adidas?” Yes, the father says, adding, “Before you ask, we own all of the major shoe brands, the sock makers and the store that sells them, too.”
That’s diversification. By owning an index fund, the family has invested in nearly all major companies worldwide. They don’t own very much of any given stock — index funds are weighted to represent the size of each company’s stock “float” relative to the others — but they do own them all.
In exactly the same way, the long-term stock investor is effectively insulated from stock scandals by diversification. If you own a foreign stock index fund, you own Volkswagen. If you own a U.S. blue-chip stock fund, you own Caterpillar.
You probably don’t own that startup pharmaceutical company making headlines last week for all the wrong reasons, but here index funds protect you again. You can own small cap stocks through an index fund, but generally not microcaps and startups. Too risky.
Volkswagen took a hit from the emissions mess it managed to get into. They have nobody to blame but themselves. And the stock will recover.
Moreover, for the long-term index investor a temporary dip in one large stock is no reason to panic. In fact, it’s an opportunity.
Ignore stock scandals
That’s because a stock index fund rebalances internally, repurchasing shares using incoming dividends. All things being equal, some of those shares will be cheaper for a while. Then they will rebound. Volkswagen is not going out of business. Neither is Caterpillar.
Likewise, a portfolio of uncorrelated asset classes allows the long-term investor to put even more money into temporarily cheap assets. If stocks as a group fall hard enough, long enough, cash inflows from other asset classes can be liquidated to buy more.
That’s rebalancing, a powerful strategy for increasing return.
So don’t sweat the crazy headlines you might see about car companies gone rogue or whatever is leading the business news. Unless you have your entire retirement invested in one stock — as some company employees unfortunately do — you simply aren’t exposed to serious risk.
On the contrary, you’re doing just fine, retirement intact.
If you’ve been paying attention to the financial news, even in passing, you’ve probably heard a lot of chatter about the Federal Reserve, aka, “the Fed.”
Your understanding of the role of our central bank in your finances might not be deep, and that’s okay. But a little more understanding wouldn’t hurt.
Here’s the simple version. You don’t need to worry about the Fed at all.
Why? Think back about five years. Do you recall what the Federal Reserve was doing or not doing in that time frame? Ten years?
You shouldn’t remember. If you do, you probably are an economist or, possibly, a full-time stock trader.
The rest of us have no idea and with good reason. What the Fed does in the short term doesn’t matter at all to the long term of our investing lives.
By now you’re probably wondering why the media pays so much attention to the Fed. There are two answers: It’s their job, and because of interest rates.
The media’s job is to fill the pages of newspapers, our smartphones and computer screens and the airwaves with current information. The actions of the Federal Reserve is in fact news.
It’s news to big banks and institutional investors. It’s news to global bond markets. It’s news to lenders of all types and, to a degree, it’s news to consumer borrowers.
You fall into that last category, but even so the decisions of the Federal Reserve don’t matter. What matters to you, really, is the interest rate.
Interest rates affect how much you pay to borrow money, for housing, for a car, on your credit cards and so on. They don’t change quickly and, when they do, that’s only one factor affecting your ability to borrow.
Your credit history matters a lot. So does the amount and purpose of the loan and what collateral you have to offer.
But now we’re pretty far removed from your investments. So why do professional investors fixate on the Fed?
For them, a small change in the interest rate is a big deal. Often, those folks are managing billions of dollars of other people’s money. They’ve taken decisions in the past that presume a certain borrowing cost.
In some cases, they’ve leveraged investments, or they’ve taken risks they now regret. A small change in borrowing costs can have big ripple effects on their portfolios.
No worry about the Fed
A prudently invested retirement saver has no such concerns. If interest rates begin to rise, they will do so steadily. All that really means is that bonds will pay more interest.
That’s a good thing, all in all. If you’re invested appropriately in the bond market, a move toward higher rates signals steadier income and less dependence on rising stock prices.
If you’re invested inappropriately, well, your bond holdings can drop in value. But that’s not the typical long-term retirement investor, particularly one that is diversified and rebalances regularly.
So feel free to ignore the news about the Fed and its latest action or inaction. All things being equal, don’t worry about the Fed. You won’t care in five years, and you shouldn’t care now.
Retirement investors are hit with a barrage of arcane terms, and among the most arcane is “real return.”
What do we mean by “real” when it comes to money? Not counterfeit?
No, real return is what you actually have after subtracting the costs of investing and the effect of inflation. It’s the spending power your end up with at the end of the process, minus all the drag.
Real return is a big deal, and you should understand all of the sources of spending-power drag on your ultimate return. The reason why is compounding: Every penny you keep is reinvested in your name.
Conversely, every penny you lose to costs and inflation is a real loss, now and well into the future. Lowering your cost of investing matters — a lot.
Let’s start with inflation. You cannot avoid or erase it. Your money will lose value over time no matter what. But you can overcome it with growth.
Inflation is fairly constant. You can expect inflation of roughly 3% per year. It might be more in some years than others, but over the long run it’s predictable.
That’s why you own stocks in a portfolio. Over the long, long run, research has shown, stocks return about 6.6%. How? By reinvesting dividends.
When you own a stock, you get to experience appreciation as the price of the stock rises over time. That’s a reflection, in part, of growth of the economy itself. But companies don’t just get by, they make money.
If you take that money out as dividend income, you can bet your stock investments will perform at about the level of inflation over time. Reinvest the dividends and you get that internally compounding power that drives a portfolio higher.
What else drags your balance down? Fees. When financial advisors charge you for their management and advice, they take money from your account like clockwork.
Problem is, the fees are not based on their performance at all. If your portfolio is flat for the year, a zero percent return, they still take their portion of it as payment.
In many cases, that’s 1% for the advisor and another 1% for the mutual funds they buy in your name. What’s 2% of your portfolio? A lot of money!
Keeping real return
If you have a $100,000 balance in an individual retirement account (IRA), that fee will be $2,000. If your investments end the year up 2%, the fee wipes out the gain completely. Your actual cost of management is not 2%, it’s 100% of your gains.
Finally, consider taxes. If you invest in a taxable account, that’s great. But don’t ignore your workplace 401(k) or personal IRAs in favor of taxable investments.
Investment taxes are hefty indeed, and they are levied on both capital gains and on dividend income. If you can, max out your tax-deferred accounts, such as traditional IRAs, and tax-free accounts, such as Roth IRAs, first.
The end result of cutting financial drag on your retirement accounts it more money. If you have years to go before retirement, a lot more money, thanks to compounding. The key is to make decisions early and stick to your plan.
One criticism of index funds as a long-term investment tends to be a perverse kind of compliment.
“You’ll never beat the market that way,” some say. Yes, that’s right. You won’t. But the fact is, nobody else does either, and they pay a pretty penny trying.
Over five-year periods, basically no actively managed mutual funds are able to demonstrate — after fees — any kind of consistent ability to “beat the market.”
One or two can do it, out of thousands out there, but your chances of choosing those funds at the right point in their trajectory as an investment vehicle is essentially zero.
The rest, sadly, fall far short of the market averages year after year, largely because of their hefty fees, costs you shoulder as an investor whether the fund has a good year, a bad year or anything in between.
“Well,” critics will say, “indexing sounds fine in a bull market, but what about when stocks drop?”
The honest, obvious answer is, the index fund will drop, too. But actively managed mutual funds don’t own some magical alternative investment. They hold stocks, too.
Chances are, they hold far fewer stocks than the index fund. That concentration of investments often means that actively managed funds have bad years even in good times.
Sectors they prefer go out of fashion. Macroeconomic events intervene and make things hard for their chosen few investments.
Other times, they are rewarded for a narrow focus, but too often the only way to win here is to be the earliest investor in and to get out well ahead of the crowd.
That’s nearly impossible. If you manage to do it once, even twice, that’s nearly a miracle. Then the third time comes around and wipes out the gains from the first two victories, plus some extra.
You’re back to square one, or perhaps negative one. That’s why actively managed fund investors can go a decade and then wonder why they so dramatically underperform the market as a whole.
Meanwhile, the index fund investor is keeping costs low and reinvesting over the years. When stocks are expensive, more money goes into bonds and other non-equity holdings. When things reverse and stocks are cheap, the opposite happens.
Compounding takes care of the rest. That’s where the real gains come from when investing for the long term: Reinvested dividends and compounding. Not stock picking. Not forecasting and sector bets.
It’s not “interesting” to do this kind of investing. It’s not a hobby people really cotton to. But index funds work and they work well, if your aim is to retire on time.
Retirement investors want to grow their portfolios. They want that growth to come from steady capital appreciation — that is, higher stock prices.
What they don’t want is “volatility,” the movement of stock prices both up and down. The tendency is to equate volatility with risk, and risk with loss.
Let’s break that down a bit. Volatility is not risk. Rather, it’s the relative movement of stock prices up and down over time. That is all.
Some stocks move up and down more frequently than others. Some move in broader percentage swings than others. Frequency and breadth of price movement can make a stock seem “risky” compared to those that move slowly and steadily higher.
Yet you need those roller coaster stocks in your portfolio. They often represent the future of the economy, the small-cap stocks of companies just starting out, taking on problems from fresh angles, at times inventing the economy we will live in the decades ahead.
Some will profit wildly. Some will collapse and die. That’s capitalism. Without that, the whole world would move at the snail’s pace of tried-and-true older companies that were once the groundbreaking startups.
Volatility is not risk, if you diversify properly. Owning exposure to small-caps through an index fund gives you a grip on our future economy and its rewards, yet it doesn’t expose you to the immense risk of betting on just two or three companies, any one of which could be crushed by competitors.
You can smooth out volatility, too, by owning a variety of stocks, making small-cap exposure just part of the overall picture. Holding slower moving blue-chips stocks often means collecting nice dividends.
When small-caps dip, reinvested dividends are like rocket fuel, allowing you to buy more shares at a cheaper price. When you rebalance a portfolio, the same thing happens. Cash is distributed across your investments, including small caps if they are temporarily bid down.
Risk is not volatility. Risk is selling out when prices fall. Risk is your emotional reaction to volatility. If you can ignore the stock market completely, that risk falls to zero.
Again, diversification helps. Owning hundreds of small-cap stocks in an index fund means your exposure to any given single company is not meaningful.
Less concentration means less risk of emotional overreaction. In the end, you protect yourself not by ignorance but by choosing the side of limited emotional liability. A portfolio process helps you get there consistently and inexpensively.
Over the years, your portfolio will rise and fall in value. Early on, stock price declines are a chance to increase your position at a bargain price. As you near retirement, you will own less stock overall and be less exposed to that volatility.
Less volatility late in life equals less emotional risk, and that helps you retire with more.
What’s the “right” amount to pay for an investment? Aren’t investments free or nearly so?
You might be surprised to learn that what you pay for your investments can vary dramatically, and not always for good reasons. While we’re quite used to comparison shopping for groceries, clothing or a new car, we aren’t really that good at comparing investment pricing.
That has to change. When you overpay for an investment, you automatically lose some of the implied return on that investment. If the investment loses money, you lose even more when you pay too much to own it.
What are the costs of investing? Here’s a simple cheat sheet to consider:
Commissions: This is the fee you probably think of first. If you buy or sell a stock, your brokerage will charge you for the transaction. Same with mutual funds, although probably more. Even if a fund is “commission free” it costs something to process, so the cost is built instead into annualized platform fees. Cost: Zero to $50 per transaction.
Mutual fund fees: A biggie, and poorly understood. Every mutual fund you own has some kind of internal cost. It can range from very low with money-market funds to very high, say, for an emerging market fund that covers 15 countries. Cost: Zero to 3% of assets or more, annually.
Sales loads: A “load” is basically an admission fee, charged by your broker for the work of making an investment available to you. These can be pretty stiff and often are taken out at the beginning of the investment, plus “12b-1″ marketing fees which repeat annually, forever. Cost: Up to 8% of your assets.
Financial advisor fees: Advisors should be paid for their work recommending investments and helping with planning and portfolio construction. While many financial advisors work for an hourly fee, others will charge an annual fee based on your assets under management. Cost: Typically 1% but could be more.
Taxes: Finally, if you trade in a taxable account, you can expect to be taxed on your gains both short-term and long and on dividend income you realize during the year. This can vary according to the tax law and the amounts gained and lost, but it’s part of the total return equation. Cost: Zero to 20% of realized gains.
Lowering your cost of investing is paramount to building a retirement. You can’t compound money you don’t have because it left your account in the form of a fee.
How? Start by saving into tax-deferred and tax-free IRAs and workplace 401(k) plans. Then try to use only index funds with fees that are a small fraction of those charged by actively managed mutual funds. The ETF versions of index funds often trade commission-free.
Finally, you can avoid financial advisor costs by using low-cost online software to create and rebalance a retirement investing plan. The difference can be striking — and knock years off your expected retirement date.
One of the most interesting words in the investing business is “risk.” It connotes danger, but also opportunity. And we misunderstand it at nearly every turn when saving for retirement.
Consider this old riddle from your elementary school science teacher. What weighs more, a pound of feathers or a pound of lead?
The unthinking student blurts out “lead!” while the more cautious kids stop to think. It has to be trick question, right? So they don’t answer at all.
Of course, a pound of feathers and a pound of lead weigh the same — one pound. That’s the joke.
We can extrapolate this to the investing world and find many active investors falling for the same tricky riddle regarding risk. Which is the riskier investment, $1,000 in the stock market or $1,000 in the bond market?
Both carry risk, and that risk can be equal easily enough. The answer you need requires more information.
Are you a long-term investor? Or a speculator trying to trade your way to riches?
Are you in need of cash today, tomorrow or next month? Can you reinvest dividends and interest payments?
Do you let your emotions take over when investments don’t perform to expectations? Do you ignore your investments until the news is truly, unbearably bad, then take action?
Can you sell an investment in a timely fashion and reinvest the cash in other investments that have declined in value? Can you in fact sell high and buy low, over and over, in a disciplined way?
All of these factors will drive the outcomes of a stock or a bond investment. A stock investment that is reinvested after it pays its dividend can, over the long-term, easily outpace bonds.
But that investment is likely to rise and fall in market value over the intervening years. It takes guts to buy more when it falls in value, and to sell off a portion when it is higher than its long-term average.
Bonds will be less volatile, but they are not risk-free. Interest rates have been rising steadily for decades, driving up bond prices. It has been remarkably easy to be a long-term bond holder.
That could change. A sharp change in the interest rate will make it harder to justify holding a long bond that pays less, perhaps even less than inflation. If enough people abandon that particular bond, its value will drop.
A portfolio approach allows retirement investors to own stocks, bonds, real estate and foreign equities and debt. Rebalancing forces the discipline of selling high and buying low.
It also depersonalizes the process, allowing you to feel less personally attached to any given position. Diversification not only reduces single-company risk, it reduces “attachment risk” that comes from owning a small number of companies for many years.
Most importantly, a diversified portfolio allows the long-term retirement investor to get the best possible result with the least amount of risk and stress — no riddles required.
You know the mantra: Low fees means money money for you. Every dollar counts.
We usually like to spend less on things we consider ordinary. Who doesn’t love a store-brand bottle of ketchup at a dollar cheaper than the national brand? It feels good to save money.
Except when we don’t. Certain kinds of products just seem wrong to spend less on. Wine, for instance. We know for a fact that plenty of $10 bottles are just fine, and that a $7 bottle of red isn’t going to be 30% lower in quality.
Yet we somehow believe that a $14 bottle is much better and that $40 bottle, wow, it must be amazing.
In fact, it’s all pretty much grape juice in a fancy bottle with alcohol in it. Time and again, blindfolded wine experts cannot distinguish cheap wines from expensive ones in taste tests.
A similar thing goes on with investing. We know that the cheaper index fund is going to give us the market return every year, like clockwork. Yet we somehow believe it’s worthwhile to pay 2% of our money to a stock broker to see if he can beat that number.
Some years they can. Other years they can’t. Chances drives these outcomes. Yet they take their 2% cut every year, year in and year out. It adds up to a lot of money.
The true effect of those high fees is worse than taking cash out of your account in any given year. What really happens is that your cash is not reinvested on your behalf.
It’s just gone, and that’s it. The years of compounding you would have received from that extra money never happens.
Let’s imagine an investment portfolio of $250,000. The owner of this portfolio has hired a manager who takes 1%. He in turn buys a selection of mutual funds that, added up, take another 1%, each year.
Right off the bat, you’re talking about $5,000. Over 20 years the advisors get to keep and invest that $5,000 for themselves, each and every year. It thus compounds into $371,487, money you never see again.
Let’s say they manage to get you a pretty good overall return, historically speaking, of about 8%. They take 2%, remember? Inflation is going to eat up about 3%. So you’re left with 3% for yourself.
That 3% compounds into $451,528. You’ve taken all the risk here and yet the advisors have kept the equivalent of 82% of what you’ve earned without taking on any risk at all. They’re guaranteed that 2% just for showing up.
Viewed another way, they’ve take 45% of your total earnings for effectively on reason at all. After inflation, your money has earned about $823,000, of which you’ve kept just over half.
That’s right, 55% of your money is yours, and 45% has gone to your advisors. Fees matter. Lower them, and you’ll retire with more, automatically.
If you read the financial press on any given day, you will find that most of the “news” revolves around specific investments.
Is it time to buy China? Time to sell technology? Will that blue-chip stock beat estimates? Are commodities going up — or down?
What drives all of this coverage is not any kind of knowledge regarding the answers to such questions. Really, what drives things is reader interest in the topic.
If financial news purveyors sense that a lot of people have bought into a given investment theme, they order up more coverage of that investment. It’s supply and demand.
All people want to know, in the end, is if it’s time to sell an investment or, conversely, time to buy. They want certainty in an uncertain world.
They need to know this because they have to sell an investment in order to realize a profit. Beyond that, they want to avoid being the last to sell and perhaps getting stuck as the face value of the investment declines precipitously.
A rapid decline, of course, feeds the other side of the equation. If it’s past time to sell an investment, it is time yet to buy? And so the cycle begins anew.
Investments thus go up and down in value in a broadly predictable way. Once people have sold off enough of a certain company or investment type, the buyers rush in and push it back up.
Somewhere in the middle is what’s called “fair value” by the experts. It’s a faintly ridiculous idea, fair value. Was it unfair when the investment went down 40% in a month? What is unfair when someone sold it after doubling their money?
No, it was simple the value at that moment. Somewhere in between there is an equilibrium, a price that half the market thinks is too high and half the market thinks is too low.
You could try to figure it out with various market-measuring equations, such as P/E ratio or book value. And you’d be close to right sometimes and horribly wrong other times.
Or you could rebalance and avoid all the hassle. Rebalancing ignores market statistical guesswork. It avoids trading and attempting to out-hustle the crowd.
It doesn’t take rocket scientists or PhDs to rebalance. It take a few days out of the year to do. The rest of the time you can safely ignore the news, such as it is.
Rebalancing is nothing more than deciding how much of an investment type you want to own in a portfolio — say, 60% stocks and 40% bonds — and sticking to it.
When the market chases stocks higher, you periodically sell off the excess. The cash is used to buy bonds. It doesn’t matter if bonds are “cheap” or “expensive.” All you are doing is rebalancing by selling high to buy low.
When bonds move higher and stock lag, you reverse the procedure. Did you catch that last part? Again you are selling high…to buy low.
That’s the only way to really make money in the investment world. The best time to sell an investment is when you have too much of it. Anything else is market timing, a sure ticket to long-term losses.