Every industry has a catchphrase that explains it all. For the tech business, one of the better quotes you hear is that “software is magic.”
There’s a lot to unpack there, but serious investors should think of software as the ultimate high-efficiency tool. It really is magical to have the kind of investing power that once only elite investment funds employed.
Consider for a moment the simple index fund. It’s just a collection of investments, right? But under that is software that tracks hundreds, even thousands of investments, and keeps them weighted correctly for the fund’s goal, which is to accurately track an entire stock market index.
You could not do this any other way expect by using software. Just imagine the work involved in trading, clearing and rebalancing hundreds of stocks every day by yourself!
Now consider that the best retirement portfolio is one that has a multitude of investment types — stocks, bonds, foreign securities, real estate and others. Index funds not only keep each asset class on track but in combination they can be adjusted to your personal level of risk tolerance.
Now software is edging into what used to be an entirely human domain, measuring risk.
Risk comes in two very different flavors: market risk and behavioral risk. It’s pretty easy to manage market risk. If your investments must be liquidated in the short- to medium-term, your portfolio should own less stock and more income-producing investments and cash.
If your income needs are farther out, say 10 years or more, then stocks are the better choice, since that’s where you get inflation-beating growth. The price of that outcome is volatility, the up and down movement of stocks in any given time frame.
Thus we run into the second problem, which is behavioral risk. If you can manage to “turn off” the stock market in your mind and go about your day, this kind of risk disappears.
Most people can’t. They try to ignore their investments, but the media makes sure they pay attention, usually only after markets fall sharply. That sets off a cycle of engagement that grows more frantic until the emotional investor feels that immediate action is required.
Usually, taking action is a huge mistake. Selling at a low point means locking in permanent losses that cannot be recovered. You feel better because the bleeding has stopped, then stocks recover and you feel immediately worse.
Again, software saves the day. Running a portfolio with online software allows you to better understand how the ups and downs of the market are actually opportunities in disguise. Rebalancing your investments give you a chance to realize gains when they happen and reinvest them in a timely fashion.
Over the years, that simple, repetitive action is what makes a portfolio thrive and compound into a truly great retirement.
By eliminating the drudge work and removing the risk of emotional trades, software gives you peace of mind and power over the randomness of investing.
It’s magic that anyone can use to be a better investor and retire without worry.
A tax bracket is a range of personal income subject to a federal or state tax rate.
People often talk about their individual tax bracket, but the reality is a bit more nuanced. For instance, if you file taxes jointly, say as a married couple, your tax bracket is determined by your combined incomes.
Even more misunderstood is how the IRS applies taxes to your income. Congress sets ranges of income with specific tax rates and the IRS then applies those tax rates to each level.
Thus the first several thousand dollars you earn in a year is subject to a 10% tax rate, then the next big band is taxed at 15% and so on, up to the highest current tax rate. The higher rates apply only to dollars earned above the previous bracket.
The table below shows 2016 projected tax rates, according to the IRS:
So when people say “My tax bracket is 25%,” the reality is that a given rate applies to perhaps only the last few thousand dollars one earns in that year. Your “effective” tax rate is a mix of all of these income bands in a stack minus deductions, so the actual tax rate you pay will be lower.
The reason the IRS has a tax bracket for each income band is to assure that U.S. taxes are progressive, that is, that people are taxed according to their ability to pay.
A single tax rate on income or on a good or service is considered a regressive tax system. Taxes on gasoline, for instance, hit everyone at the same rate per gallon, regardless of ability to pay.
Figuring out your personal tax bracket can be difficult, yet the goal of the IRS is to ensure that everyone who is liable for federal taxes pays them and that the playing field is somewhat level.
There are, however, many ways to reduce your tax bill by lowering your taxable income, such as exemptions, deductions and tax credits.
Cut your income, cut your taxes
For instance, saving money into a tax-deferred individual retirement account (IRA) or 401(k) retirement plan at work will reduce your income in the year that you save. That kind of dollar-for-dollar decline in current income is very valuable because the money you save is subtracted from the top, where rates are higher.
For instance, if you have an income of $78,000 a year and put $18,000 into a 401(k), your taxable income is now $60,000 instead. After taking the personal exemption, deductions and tax credits, it might fall to $50,000.
This means that $28,000 of your income is not taxed this year, while the remaining income is taxed at a lower rate than your total annual income would at first suggest.
Similarly, using your income to fund a health savings account (HSA), pay mortgage interest or claiming a tax credit to pay for child care can lower your income year after year.
The goal of a tax preparer is to find every opportunity possible to reduce your taxable income and thus keep more of your earnings in the lower brackets, driving down your effective tax rate — what you actually pay in taxes.
If you follow the financial news on websites or cable TV, it’s easy to run into the same argument over and over.
Stocks peaked. Get out now while you can. What’s fascinating about these market “top” calls is how consistent they are.
Stocks hit all-time highs on one day. The next day it happens again. Then again.
The problem is, investors confuse stock market indexes with a mountain top. Everyone knows mountains have peaks. From there, all directions are down.
But stock market charts are not mountains. They are two-dimensional representations of numbers.
Those numbers over long periods move up. It can seem like a trick, a trap to avoid. Surely there is a point where stocks can go no higher?
Yes, there is. There can be market bubbles in stocks which go extraordinarily high — sometimes straight up! — then fall extraordinarily low soon after.
These are not peaks, however. They are bubbles, plain and simple. They pop and stocks quickly return to more reasonable levels.
The underlying forces of the economy didn’t change before the bubble started, and they remain the same after a bubble pops. That’s why over longer periods of time — through wars, bouts of inflation, scandals and political crises — stocks go higher and higher.
Jeremy Siegel, a professor of finance at the Wharton School of Business and author of Stocks for the Long Run, puts it this way: Stocks beat bonds, beat gold, beat cash.
In fact, he says, stocks grow in value at about twice the rate of long-term economic growth, thanks to reinvested dividends. That’s why stocks beat inflation.
No substitute for stocks
And there’s no real substitute for stocks over a period of 10 years or more. You won’t find the same growth elsewhere, nor should you try to find it elsewhere.
It’s when people decide that the stock market has peaked that they tend to sell and sell hard. Joining them in the panic is a clear way to lose money.
Yet buying as they sell is locking down future gains at reasonable prices.
A solid, risk-adjusted portfolio of index funds will give you those gains over time. Rebalancing helps you pick up the bargain stocks that others cast off.
Meantime, you can ignore the TV pundits screaming that stocks peaked and you should sell, that every direction is down.
They’ve been wrong for decades upon decades, while stock investors have prevailed.
A required minimum distribution (RMD) is an annual taxable withdrawal from your retirement savings dictated by IRS regulation.
When you open an individual retirement account (IRA), the money you place there is free of income tax in the year you save it. The growth and income on that investment is untaxed, too.
However, upon reaching age 70½ the government will require you to take a specific percentage amount of that money out (a distribution) and continue to do so every year. Taxes are due at your regular income tax rate on those annual withdrawals.
It’s important to consider how a required minimum distribution will affect your income and spending in retirement. Your Social Security income will be taxable, and you will have to take required minimum distributions on your 401(k) or 403(b) retirement savings accounts as well, either at 70½ or the date you retire.
Tax planning in retirement can be tricky. Many people continue to work, which means they generate taxable income even after “retiring” from their long-term career. Some folks take income from Social Security and income from a taxable pension, too.
As a result, new retirees sometimes find that working pushes them into a higher tax bracket. In addition, whether all or any of your income is taxable at the state level is a matter of where you choose to live.
The best of all worlds is to have too much income and nothing to do with it. Yet nobody wants to pay too much in taxes either. That’s why a Roth IRA can be a useful tool for reducing your tax burden in retirement.
Converting to a Roth IRA is not cheap; you owe taxes on the money you convert that year on top of your normal income tax. Yet the money in that Roth IRA now grows tax-free and is not subject to a required minimum distribution, although there are withdrawal rules to understand.
Lowering the impact of RMDs
The IRS uses an actuarial table to calculate how much you will be forced to take out as a required minimum distribution each year. In essence, it’s your account balance divided by a “life expectancy factor” published by the IRS.
It might be a small amount early on, but if your account grows dramatically in value as you age RMDs naturally become larger. Failing to take out the required withdrawal amount results in a stiff penalty — half the money (50%) rather than your actual tax bracket rate.
Nevertheless, you can offset the impact of a required minimum distribution by making charitable contributions with the money instead or through tax-free gifts to your family. Any legitimate way to reduce your income will lower the impact of RMDs in retirement.
Always consult a CPA or qualified tax advisor before taking action. Laws can change and your tax situation can be affected by many factors.
Summer is supposed to be the dead time for stocks, the doldrums. Everyone is on vacation, the theory goes, so nobody is around to buy.
It’s an actual theory, captured in the trader phrases “Sell in May and go away” and what’s known as the “Halloween indicator.” Essentially, the argument goes, it’s best to get out of stocks before summer starts and then get back in before winter, on or about Oct. 31.
The data suggests that’s generally true — except when it’s not. The stock indexes are now setting record highs in mid-August, typically a treacherous month for active traders trying to time their market entries and exits.
So what does all this mean for the retirement investor? That exceptions are exceptions and that’s all. Here are some of the “reasons” that managers think stocks are hitting new highs:
- The U.S. is growing the rest of the world is not
- Earnings are strong, as well as stock buybacks and dividend yields
- Oil is unpredictable, gold is unpredictable, bonds are unpredictable — so buy stocks
- Team USA is cleaning up in Rio
And so on. While these are all “reasons,” they don’t mean much. That the stock market keeps rising despite the risks inherent in the economy is, ultimately, a circular argument.
Buy stocks, they’re going up. They’re going up, so buy stocks.
The flip side of this argument is equally circular. It’s not hard to find doomsayers who consistently predict a stock market crash.
The stock indexes are too high, they claim. They have to fall, so you should sell everything. So people sell, get scared, and sell more. Stocks fall more.
The reality of investing is between these two opposing forces. Yes, it matters that companies are making more money. It matters that other investments seem risky in comparison.
It even matters that investors are in a good mood about the country. Olympic wins don’t hurt that perception.
And that’s how a pattern such as the Halloween indicator is disproved in any given year while seeming reliable over the long haul. Emotions get us into trouble, to the upside and the down side.
The answer is to ignore all of these “factors” that traders use to reach their conclusions. It’s far too easy to ascribe meaning to randomness, to find a reason why the trend you think you see reflects reality.
Winning with stock indexes
Behavioral scientists have long marveled at our human ability to find patterns in randomness. People see religious figures in swirls of toast. Amateur astronomers spot people walking on Mars.
It’s called “apophenia,” and arguably it served some evolutionary purpose over eons, perhaps to spot camouflaged predators in the bush and flee. Better to run from nothing and survive than to hold still and be lunch, right?
Yet seeing patterns in stock indexes can be very dangerous. We tend to pile on in rising markets, buying at ever higher prices. Then we hold on to falling markets and bail out only when the news is the worst. Buy high and sell low. Guaranteed losses.
The solution is portfolio investing. You own a collection of assets and rebalance. You force yourself to sell a portion of your winning investments and use that money to buy into the temporarily losing investments.
You do this over and over, regardless of the news headlines, who’s winning gold medals, the time of year or patterns you think you see in the numbers. That’s how long-term investing should work, and it can work with a discipline and a solid plan.
The S&P 500 is a list of 500 stocks recognized as representative of large-cap companies in the United States.
Created by Standard & Poor’s (S&P), the S&P 500 Index of equities is weighted by market value and can change over time. It is meant to capture a large portion of the total value of the U.S. stock market, currently 80%, and thus serve as an economic indicator in its own right.
Market weighting means that larger companies make up a larger percentage of the index. As a result, if the largest companies see an increase in their stock prices, that will push up the total index disproportionately. A down day for the biggest stocks will push down the overall index.
In practice, the S&P 500 Index is a gauge of daily market performance. Investment funds use it as a benchmark for their own performance over time as well.
“Beating the market,” in trader-speak, means exceeding the return of the S&P 500 Index over a 12-month period or longer.
Why follow the S&P 500?
The S&P 500 is the standard benchmark for the biggest traded stocks in the U.S. economy. The market capitalization of these firms — the dollar value of shares held by investors — is at minimum $5.3 billion each and in many cases much more. At least half of a company’s stock has to be publicly traded to earn a spot on the S&P 500 Index.
Standard & Poor’s has been tracking stocks with indexes since 1923, but the S&P 500 itself was not created until 1957.
The S&P 500 Index is curated by a team of analysts and economists and is broadly recognized as the best way to answer the question, “How did the market do?” today, this month or over many years.
Companies can be removed from the S&P 500 for a number of reasons, such as bankruptcies and mergers, but often it’s the case that small companies become larger and big companies shrink as the economy changes.
For instance, telephone companies used to be the most heavily weighted in the index. Today it’s more often a technology company, an oil driller or a drug manufacturer.
Investing in the S&P 500
Investors should keep an eye on the S&P 500 but not to the point that “beating the market” is your primary goal. Instead, just owning an S&P 500 Index fund provides an annualized return very close to the market at an extremely low cost.
I say “close” because index funds are not free, although very nearly so. Moreover, investors today can construct entire portfolios using only index funds and capture a variety of asset classes at a very low total cost.
Diversification and periodic rebalancing in a portfolio helps to smooth returns and allows long-term savers to build account value steadily and with few surprises.
One word you sometimes hear people use is “contrarian” investing. There’s something very appealing about it, the allure of insider information and being right when others are wrong.
It’s also a lonely and difficult way to invest. Sure, you can look at market history and see the exact moment when Apple was a buy or a sell, or when gold was a good deal and even that moment when the indexes bottomed at last.
Hindsight is 20/20, and the past is literally uninvestable. Until we have time machines, either you are a true contrarian or you are not.
A true contrarian investing strategy is exactly what it sounds like: Look at what the mass of investors are doing and do the opposite. If the market is breaking records, sell it short. If a stock is falling like a rock, buy it up.
Whatever happens, stick to your guns. Even if the world crashes, that’s your greenlight to buy more. Easy to say, very hard to do.
But contrarian investing can be simple. In fact, a truly well-managed portfolio is always doing the opposite of what the crowd is doing.
The difference is incremental steps. The first part of the process is to create a portfolio with a variety of investments. The easiest and lowest cost way to achieve this is with index funds, and there are index funds for nearly everything these days.
A portfolio will contain some very different investments. It’s likely to have a fair amount of large-cap U.S. stock, but also bonds, real estate, foreign stocks and bonds and other asset classes.
Contrarian investing winner
Here’s the thing: Rebalancing your portfolio, ultimately, is a contrarian investing move. Your portfolio will become unbalanced. Stocks will move in one direction, bonds another. Real estate will get hot and cool off.
Investors will love foreign stocks until they hate them. Then they’ll sell them like there’s no tomorrow.
Portfolio rebalancing will lead you to buy assets that are out of favor. Incoming dividends and interest will need to be allocated somewhere, right? If one asset class or another exceeds your predetermined limits, you will sell off those gains and distribute them to the “losers” in your portfolio.
You will be a contrarian investor, but one that takes small measured steps and avoids the damage of emotional trading. It’s a win-win that really works.
Investing for the long term, particularly for retirement, seems to be a game of buying low and selling high — and it is. Stocks you buy today should be worth much more in future years when you go to sell them.
But there’s another factor in investing that most people gloss over, and that is yield. Understanding what is yield and how it affects your investment planning is crucial to getting the results you want.
Yield covers a lot of ground. Broadly speaking, yield is cash you earn from an investment without having to sell it. If you own a business, this would be the profits, the money the business keeps after paying overhead such as taxes, payroll and insurance.
Yield is easy to calculate. Consider the total investment amount, then the amount of cash that flows from it. The cash over a year is expressed as a percentage.
For instance, a bond that you bought for $10,000 generates $600 a year in interest. That’s a 6% yield.
Most of us are quite used to thinking of the inverse, the interest rate we pay for a mortgage or on a loan. For a banker, that’s yield on the bank’s investment in your ability to repay the loan.
In a retirement investment portfolio, yield is coming from all directions. Dividend-paying stocks generate cash quarterly. Government bonds pay interest periodically, too.
Then there are other investments that pay interest, such as real estate holdings, high-yield debt and preferred stock. Each of these instruments is doing the same thing, earning a return on capital and giving that cash to investors.
You don’t have to sell a real estate investment trust (REIT) to get cash. You can keep your corporate debt and still get paid. The face value of these investments might go up or down, but the cash flow usually continues.
When you are a younger investor, however, it’s often best to automatically reinvest your incoming yield. If you have an income from work, that yield cash is far more valuable to you in the form of new shares.
Yield and risk
Most investment programs automatically buy shares of an investment with your yield, and often fractions of shares, to make sure that your yield is put back to work. The only thing you need to do is make sure that your portfolio stays on track by rebalancing it from time to time.
Your holdings will change as a result of changing market values, but also as a result of reinvested yield. Rebalancing ensures that you don’t unwittingly increase your risk by overloading in a single investment type.
As you get older, yield income will be part of your retirement picture. Rather than sell holdings to generate income, you will be able to take out cash that would have otherwise been reinvested.
Yield is not risk-free. The cash is due to you, but high yields often are unsustainable. Stock dividends can be cut. Bonds can default. There is no free lunch.
Nevertheless, a steady, sustainable yield is a major part of total return, the combination of yield and appreciation that makes investing for retirement pay off over the decades. Diversification and prudence get you income and growth with no surprises along the way.
An amazing number of Americans — 54 million — think of real estate and cash as their top two choices for long-term investments, that is, for longer than 10 years.
The problem is, cash and a home are not investments. They offer stability, yes, and absolutely a roof over your head. But neither of these “investments” is going to grow over time.
Cash, for one, is going to be worth less by exactly the rate of inflation. A home bought at the right price might keep up with moderate inflation, but usually not after you subtract the cost of maintenance and taxes.
Yet according to a new survey by Bankrate.com, the “preferred investment” for money not needed for 10-plus years among Americans was real estate (25%), cash (23%), then stocks and precious metals (at 16% each) and, finally, bonds (5%).
Now consider the documented return on investments as tracked by J.P. Morgan. Over 20 years through 2015, real estate did great, at a 10.9% annualized return. But that’s real estate investment trusts (REITs), a type of broad investment vehicle that owns mortgages, commercial property and other real estate ventures, not a given single-family home.
No, you have to go down the chart quite a way to get to “homes,” which returned 3.4%, just a bit more than long-term inflation.
Precious metals, a code word for gold among individual investors, returned 5.2%. Remember, that’s over 20 years, so if you bought gold and never sold it for two decades, you would have earned that meager return. Hard to say what would have happened if you jumped in and out of gold, as many do. Likely something worse.
Bonds, the “loser” in the Bankrate survey, came in at a 5.3% return, edging out gold. Meanwhile, the S&P 500, the broad stock market index, returned 8.2% on average each year over two full decades.
Let’s say you followed the advice of those 54 million Americans. If so, your investment portfolio would have been earning somewhere between the inflation rate (your house) and a negative return (cash).
A charitable guess would be a return of about 1% vs. a stock return of 8.2%. Now let’s see what $100,000 invested at these rates becomes over 20 years.
A 1% investment, however safe it feels, turns into $122,019. All that waiting nets you enough money to buy a used Honda.
Meanwhile, the stock market would have turned that same $100,000 into $483,666. You didn’t add another penny the whole time. If you had added, say, $900 a month, you would have ended up at more than $1 million at the end of those two decades.
That’s the power of compounding, the mathematical fact that money turns into more money.
When you own stocks, you earn dividends. Those dividends roll into your account quarterly and get automatically reinvested into stocks. If the market is higher, you get less stock. If it’s lower, more.
But the neat thing is the automation of it all. If you own index funds in a portfolio, the incoming dividends and interest payments will pile up in their corresponding asset classes with no action on your part.
All you have to do is rebalance from time to time and that’s it. The compounding will be slow at first and then, like a tsunami, turn into a giant wave of money toward the end. That’s way safer than any roof or cash savings account when it comes to your retirement.
Hire a financial advisor and you are likely to hear one of two sales pitches: Either “I can beat the market” or “Your money will grow faster with active management.”
Both of these statements say the same thing, that is, that a human being making decisions is better than having nobody in charge, say, with an index fund.
It makes sense to us, since we also are human beings. Who wants to turn their money over to a machine? Beating the stock market is the point, right?
Increasingly, though, the evidence shows that we humans are prey to all kinds of mental traps, many of which ensure that we underperform the markets, often badly. Hedge funds, for instance, are losing billions as investors flee their high fees and amazingly poor results.
Let’s broaden the argument just a bit, for clarity’s sake. If you drive five miles over the speed limit, you’ll get to your destination slightly sooner. You probably won’t have any trouble in traffic and the chances you get pulled over are low.
Now make it 10 miles an hour faster. Most cars are going 60 and you’re now clocking 70. It’s starting to feel a little less secure, naturally.
Now hit the pedal and do 80. The slower cars are dropping away in your rear-view mirror. You dodge traffic in front, but it’s going okay. No police in sight. You will get to your destination sooner for sure.
Yet behind any bush or billboard could be a motorcycle officer. If any other car zigs instead of zags, you’re in trouble. The slightest bit of oil or rain on the road could wrap you around a tree. You could, in fact, die.
Beating the stock market is like that. Buying and selling stocks might get you to your destination a tad sooner. But even a simple mistake could demolish your month, your year, even empty your account!
The thing is, people forget that active investment increases risk. “No risk, no reward” is the argument, and that’s true. But you’re already taking a risk just by investing. Why double or triple your risk?
Using an actively managed mutual fund, while diversified, is basically driving faster but with one foot on the brake. You pick up speed but the fund fees are dragging you backward.
Trading your own accounts with no thought to diversification is taking it to 80 and hoping the road is dry and the cops are somewhere else. It will work until it fails, then it will fail spectacularly.
Investing should be boring, like a long drive. A solid portfolio of index funds is the equivalent of getting into a safe, comfy car with air bags and new tires and then driving it at the speed limit, mile after mile.
You’ll get there and be alive to enjoy the destination, no regrets, no tickets, no insurance claims. That’s what real retirement investing is about.