How can you retire on time and be comfortable in retirement? By saving and investing, of course. But before you put away money in your retirement accounts, you absolutely need to build up your emergency savings account.
More than eight in 10 households (82%) experienced a financial shock in the past year according to new data from the Pew Charitable Trusts. Typical problems included an unexpected decline in income, a hospital visit, the loss of a spouse or a major house or car repair.
More than half of those folks said the resulting financial damage made it hard to make ends meet. Pew talked with 7,000 households and focus groups in three large U.S. cities for the study.
Meanwhile, nearly six in 10 say they are unprepared now for a financial emergency, yet they say retirement remains a major concern.
Here’s the thing: Financial emergencies happen. You will lose the use of your car for some reason. You or a member of your family will end up in an emergency room and need costly care. Somebody will lose a job.
Optimism is great, but at some point in the next five or seven years something could happen. I hope your life is a easy-sailing breeze forever, but you know you will, at some point, have to come up with a few thousand dollars on the spot.
If you have no cash in the bank, that money will come from a relative or from selling something or in the form of a loan you probably don’t want to take out at unfavorable terms. It will hurt you financially and mentally.
If you have already started saving into a 401(k), chances are you will raid the account to get the cash by taking a loan out or by simply emptying it and paying the penalties. That’s what is known in the benefits world as “leakage.”
According to one study, leaks from plans amounted to 40% of our own contributions. That’s real pain over the long term. Aside from the cost of the taxes and penalties, you lose the ability to compound money into a retirement in the future. Time is what you really lose.
How hard would it be to prepare yourself for a nearly inevitable problem? It might take a few months to cobble together the cash, but imagine how much better you would feel sitting on $1,000 in a savings account. Or $2,000.
Keep on going. Before you invest a cent, get your balance up to the equivalent of six month’s salary if you can. Now you’re bulletproof. Your retirement plan or IRA can take in every cent you save and you can rest assured that a short-term emergency isn’t going to demolish your long-term goal — a safe and comfortable retirement.
It has been a very, very cold few months, particularly in New England. Boston is buried in snow. Niagara Falls has frozen over. Even the South is getting hit with ice.
What does this have to do with retirement investing? Everything. The thing is, despite the extreme cold in some parts of the country, we’re still living through the sixth-warmest December to January period on record, according to government data, and precipitation is well below normal.
I know, I know. Tell Boston that. But it’s just a fact of life. The extremes do not dictate the averages. They stand out, yes, but they don’t drive matters and often distract us from the facts.
Portfolio investing is like climate, while stock picking is like weather. In that sense, a few bad investment choices can result is very, very poor outcomes if you’re not careful.
For instance, we invest with the intention of holding things until we have a decent profit and then selling, but it rarely works that way. Instead, the opposite often occurs. By concentrating risk around a small number of positions, we focus our anxiety on those few stocks.
When they rise, we feel vindicated and do not sell. Then they fall and we feel fear.
If a stock falls hard and seems to have no bottom, then we tend to panic and, somewhere near the absolute bottom, we sell. It’s that moment in the middle of the night during a big winter storm. The power goes out, the pipes freeze and we ask ourselves, “Why do we even live in this part of the country?”
Portfolio investing, in contrast, take a big step back and looks at all of the data, the highs and the lows, and appreciates the fact that some stocks go up, some go down, some generate income and some do not.
As certain asset classes come into favor, a portfolio investor recognizes that the trade is getting crowded and sells off a portion by rebalancing. That money is distributed steadily to investments that are out of favor for whatever reason.
Portfolio investing balance
And so the seasons, and the markets, grind on. As a long-term portfolio investor you are much less concerned about outlier moments year to year. Yes, “disasters” happen. Bad markets come and go like monsoons, unpredictable but understandable.
Being properly invested for the long run allows you to worry less about transitory events in the markets and, in time, to appreciate the true power of long-term investing. Compounding steadily builds your wealth while owning a cost-efficient, risk-adjusted portfolio positions you for all events, whatever the market “weather” of the moment.
It’s very cold right now in much of the country. But the sun will shine again and you will in time forget shoveling the walk and in fact be happy about where you happen to live. The same should go for your retirement portfolio.
Retirement investors often struggle with understanding the right mix of investments for their goals. And that’s understandable. If investing were easy anybody could do it, right?
Wall Street takes full advantage of the nagging doubt we feel about our investment choices. If you are a self-directed investor, the overwhelming message from investment sellers is to “take action” before it’s too late!
That leads to a lot of turnover as investors scurry from one fashionable investment to another, hoping to be early enough to have bought low and to stay long enough to sell high.
The bottom line, however, is simpler than that: The very movement of people from investment to investment is how Wall Street makes money.
Buying and selling generates commissions which go directly into the pockets of brokers. Often, too, those same brokers attempt to convince you to buy one mutual fund over another. What they don’t explain is the money they are paid for making the recommendation — by the mutual fund itself.
You might want to believe that such practices are rare, but they are alarming commonplace. You might also want to believe that the government regulates against conflict of interest. While there are regulations, at best they require notification of compensation practices, terms which are promptly buried in small print.
How can you undo the damage? It’s pretty simple really. Don’t worry about the name brand of your investments or the strategies they employ. Just own index funds in a portfolio.
Using index funds you are assured of two things. One, you own the entire market, so the upside experienced by some sectors will be yours. So will the downside, but that’s why you rebalance, as I will explain.
The other big advantage is cost. An index fund will cost you a tiny fraction of what an active mutual fund will charge and give you the full market return, not a “maybe” return that is nevertheless socked by high fees. It’s consistent investing.
As to the mix of investments, that’s where rebalancing comes into play. If you are 22 years old and have decades of working ahead of you, it makes sense to own mostly stocks. If you are 62 and looking to retire in a few years, then you will need a portfolio that is lighter on stocks, of course.
Both portfolios are going to own foreign investments, commodities and real estate, in small degrees. These types of investments are proven to give your portfolio a solid boost while not necessarily increasing risk.
Then, the rebalancing does it magic. Rather than try to guess which investments will “win” in a given period of time, you own them all and participate in their growth. If one or another outpaces the group, rebalancing means you get to sell high programmatically.
It also means you are buying low by distributing the gains across investments that have lagged. Over time, that kind of discipline will provide you with an extra return, year after year, rather than losing money in fees to active managers.
It’s a bit of inside baseball in the money management world, but some advisors lean toward using index funds for their clients and some prefer exchange-traded funds (ETFs).
We use ETFs at MarketRiders, but we use ETFs that act and work like index funds. These are the widely held ETFs that track the big indexes that make up a portfolio: U.S. stocks, bonds and foreign indexes, as well as commodities and real estate.
Why not use index funds instead? Cost. If you own index funds created by your brokerage firm, it very often will be free to you to buy and sell those funds. No harm, no foul.
But if you have your money at one broker, say Fidelity, but buy and sell index funds created by anyone else, well, that will cost you. Often, it’s $50 each way, buying and selling. It adds up.
Depending on your broker, you will be able to buy and sell most index-style ETFs commission-free. Those that do charge a commission you will find are much less expensive to trade, perhaps $7.95 or less. If you have a large balance in your retirement plan, perhaps nothing at all.
Thus, if you know that the eight or 10 index funds offered by your brokerage are exactly what you need, go for it. However, if you like the idea of taking advantage of a mix of fund providers, ETFs are the far better choice. Cost is how ETFs beat index funds.
You’ll want to rebalance from time time. That’s when a widely held, inexpensive ETF really shines. You can buy and sell the funds at no or little cost and do so any time of the day. An index fund holder must accept the daily closing price, whatever it might be.
Own the market
We love index funds and believe that workplace 401(k) plans should use them extensively. If you are in an IRA that you must direct yourself, however, the choices are less clear.
Both types of investments do the same thing the same way. They allow you to “own the market” rather than attempting to get in and out of specific stocks. They both allow you to own a long-term portfolio rather than encouraging short-term trading habits.
However, if you are a do-it-yourself investor and like granular control and lower costs to boot, then ETFs are the best way. That’s why we recommend them to our own clients for their portfolios.
It seems like 99% of the financial pages on the Internet are devoted to a single idea — that you can beat the market just by owning the right stocks at the right times.
That’s great marketing, I suppose. It’s action-oriented (do something!), specific (buy this stock now!) and utterly unfalsifiable. Nobody knows if a given stock will go up or down, so it can’t be proven that it won’t go up.
But flip that logic for a second. It also can’t be proven that the stock won’t go down instead. Investing history is littered with companies that lost market value and never, ever recovered. They just went out of business. It happens to a lot of “hot” investments.
A much larger number of companies have a moment in the sun and, years later, find their fortunes revived by chance, good management or both. The problem is, you spent a long, long time in that investment earning nothing — no dividends, no price appreciation.
Would you, could you hold on to a single stock in a large enough concentration to matter to your portfolio through a decade of poor returns? Probably not. In fact, the much more likely outcome is that you will wait until the stock hits its lowest point and then sell, locking in the loss forever.
Or the reverse, you buy a stock as it hits its all-time high point. From there, it’s often all downhill for a long, long time.
It’s for this reason that individual investors do so poorly, earning 2.5% compared to more than 9.2% for the S&P 500 over the 20-year period ending in 2013. Our brain tells us to buy what has gone up and sell what has gone down.
In fact, it’s the other way around. We should be selling the gainers in order to buy more of the relative “losers.” That’s portfolio management by rebalancing, a standard practice among the world’s top endowments and pension funds.
Investing secret weapon
As for the time aspect, that’s the key. Don’t wait for the “right moment” to buy. Instead, own the market all the time through a well-designed portfolio that includes stocks, bonds, real estate and foreign assets.
Rebalancing with discipline over long periods will bring you a stock-like return without the stock-like risk involved in owning just the S&P 500. You are more likely to stay in during down markets and more able to capture the upsides of strong recoveries.
More importantly, you will in time begin to accept the truth about all those Internet headlines telling to take action now — it’s a mistake. Rather, you are taking action prudently by staying invested in a risk-adjusted way. It’s your investing secret weapon: patience and avoiding emotional mistakes.
It’s one of those rare moments of humility on Wall Street, a placed where “indicted but never convicted” is a badge of honor. A hedge fund chief who lost all of his clients’ money told them he was sorry.
Owen Li, founder of Canarsie Capital, wrote to his clients to say he had run their accounts down from $100 million less than a year ago to just $200,000. Reportedly, he got into a hole and took on a string of high-risk bests to try to save his firm.
It didn’t work out. “My only hope is that you understand that I acted in an attempt — however misguided — to generate higher returns for the fund and its investors. But even so, I acted overzealously, causing you devastating losses for which there is no excuse,” he wrote.
Here’s the thing, though. Hedge funds are not supposed to be running extremely high-risk strategies. They’re supposed to “hedge” risk by investing in ways that protect wealthy investors from dramatic losses.
You might not get an amazing return from a hedge fund (and it’s interesting that people think that’s the goal) but instead get a reasonable return with minimal risk of big losses. That’s why rich people use them.
A hedge fund, if correctly operated, is in fact just one slice of a larger asset pie, one which includes stocks, bonds, real estate and commodities. There has been a lot of research over decades to support the idea that again, properly run, a limited hedge fund allocation can lower overall volatility in a very large portfolio.
That’s why universities and endowments use them. Of course, as with any hot investing trend, demand outstrips supply. CalPERS, the big California state pension fund, famously gave up on hedge funds in 2013, precisely because their high fees were unjustifiable in the face of shoddy performance.
Hedge fund alternative
For ordinary retirement investors, the risk is far, far too high and the hedge effect can be purchased much more cheaply in other ways. By simply owning a well-designed, well-allocated portfolio of index funds you get a lot of risk management at a very low price.
Rebalancing with discipline allows you to book gains as they occur, selling high and buying low in a timely fashion. All that’s left is to make sure that your exposure to higher volatility asset classes — chiefly stocks — is slowly lowered over time as you near retirement.
Sometimes, you don’t get what you pay for in an actively managed fund, and sometimes you get something you never bargained for — high risk and poor oversight from the managers themselves.
The billionaire investor Warren Buffett is a highly quotable figure, but perhaps the most revealing of his many statements on money management is also his funniest: “You only find out who is swimming naked when the tide goes out.”
That gem appeared in his 2001 letter to investors in his holding company, Berkshire Hathaway. Buffett’s point is that good times can cover up a lot of risk, yet markets have a way of balancing out that eventually reveals who is taking those risks.
It all ties back to the fundamental observation of Buffett’s mentor, Ben Graham, who likened the stock market in the short term to a voting machine but, over the long run, a weighing machine.
More simply, a lot of investments might seem like real winners in the space of a month or a year, but which ones will grow steadily and safely for long periods? That’s the question retirement investors should be asking, not who’s beating the market now.
What most people want, of course, is to “beat the market.” A lot of ink is spilled, digital and otherwise, explaining the millions of ways to do so.
Sadly, virtually none of those methods are replicable. They are what finance researchers call “form-fitting” arguments. That something happened a certain way over the recent past is absolutely no assurance that the pattern will continue. Past performance is no guarantee of future results.
In fact, often the opposite. A stock or other investment that has risen dramatically rarely has anywhere to go but down. Likewise, an investment that has fallen sharply could easily find itself moving back toward the middle ground in the near future.
There are exceptions. Some stocks fall and never recover. But the experiences of investors over long periods is more likely to be reversion to the mean — a return of an investment’s value toward a long-running average price, plus some.
Investors who strive to “beat the market” are often doing so at great risk. They are much more likely to get caught up in the story of a company or its CEO, much more likely to follow the crowd, lemming-like, over a cliff.
And, in time, they are much more likely to experience a total return that is below the market’s long-term average. At some point, the tide will go out and it will be plain who is swimming naked.
What’s the solution? There are two paths to consider. Either you know exactly which stocks will rise and which will fall, or you don’t. If you don’t, the logical path is to own them own in an index fund and trust that the market itself will give you a steady performance.
The long-term data suggests exactly that. Over decades, the market has returned roughly 6.6%, or double the rate of economic growth. Owning a portfolio of stocks, bonds and other asset classes and rebalancing can add a point or two to that.
Most importantly, diversification and low-cost investing protects you from the ultimate disaster: Getting caught naked in a low market tide.
Few things are more entertaining than when a presumptive sports superstar gets promoted to the big leagues and then unceremoniously handed his hat.
You know this guy, the great college quarterback who flounders in the NFL. The supposed savior of the NBA who can’t score anywhere near what his salary implies. The loudmouth skier who fails to medal at all.
Money managers can be like that. It is, after all, a sport known for its testosterone and braggadocio. Yet the data isn’t there to back up even a fraction of the trading bravado.
Mark Hulbert, the newsletter tracker, figures just 15.6% of active managers beat the broad market in 2014, using the Wilshire 5000 Index as a benchmark. That’s down from 33.1% just a few years ago.
Before you assume it’s because more people are using index funds, Hulbert points out that just under 20% of equity mutual fund assets were in index funds as of this past year — not anywhere near enough to matter, yet.
No, he concludes, it’s just getting harder to do. This is the natural and expected result of the vast amounts of information that’s available to the markets now in real time. Consider how automated and how very rapid trading is these days between major institutional investors, how deep and liquid most markets have become.
It’s startling, really, than anyone beats the market at all. But did they “beat” the market, or just get handed an accidental edge on their way in and out of their trades? The jury is out, since the only real measure that counts is turning in outperformance for many consecutive years. Increasingly, that doesn’t happen, even among superstar managers.
Modern portfolio theory is widely misunderstood in this regard. It is often simplified to mean that stock prices are accurate all the time. That’s clearly not the case if 15% of advisors can “beat” a benchmark.
Or is it? After all, all of the managers were trying to beat their benchmarks. Most did not, and a few did. What we don’t know is how much risk those managers took on in the attempt to “win” during the 12-month period of 2014.
Double the normal portfolio risk? Triple? And how much risk did the the “losing” portfolios assume on their way to a lower performance? Perhaps even more.
Modern portfolio theory doesn’t concern itself with this year or next. Rather, it concerns itself with adjusting the risk in a portfolio to gain the maximum return possible at an agreed acceptable risk level for the investor.
Why beat the market?
In that sense, a balanced, risk-adjusted portfolio might not exceed the broad stock index either, especially if it is designed for a near-retiree with five years left until leaving work. That portfolio would earn a reasonable return at a very reasonable level of risk — but do so repeatedly.
Likewise, a 25-year-old might not beat the market with a portfolio designed for the long-term. However, over time, that higher-risk portfolio will have higher, more-marketlike gains and, importantly, take only enough risk to help that saver reach his or her goals over decades of saving.
You don’t need to beat the market to retire with more. You just need a solid, repeatable game plan that doesn’t choke when the pressure’s on.
Now that the year is behind us and we have some nice round numbers, it’s a good time to look back and understand how building an ETF portfolio really works.
For this experiment, let’s use some widely held ETFs that track the major market benchmarks. The bottom line is simple: Taken in 12-month cycles, asset classes always surprise us. Things go in and out of fashion at different paces, but the big winner in any given year is never what we expect.
1. U.S. stocks
As a proxy, consider the SPDR S&P 500 ETF (SPY), which tracks the benchmark of the same name. It closed 2014 up 11.8%, well above the long-run performance of stocks. It was a bit of surprise result, considering that most pundits felt that stocks were due to slip after such a big run in 2013.
2. U.S. bonds
Here we’re looking at the iShares Barclays Aggregate Bond Fund (AGG), which is often used as a benchmark for bond fund managers. As a “total market” fund, it is meant to reflect not Treasuries but the entire investment grade U.S. bond market. It finished up 3.47%. Not bad at all, considering that many traders were signing the death warrant for bonds 12 months back.
3. Foreign stocks
Here’s where things fell apart, in theory. As a proxy, consider the iShares MSCI EAFE Index Fund (EFA), which follows a broad array of globalized companies based in Europe, Australia and the Far East. This is Nestle, Novartis, Toyota and Bayer, among other major foreign industrials. It closed down 8.6% for the year.
4. Foreign bonds
On the flip side, government debt in foreign lands was a winner in 2014. Consider the Vanguard Total International Bond ETF (BNDX). It holds investment grade bonds not denominated in dollars. This fund returned 8.76% for the period.
At this point, I could drill down into a half-dozen alternative choices to these funds, all of them inexpensive index funds trading as ETFs. And a typical money manager might begin to talk about where to “overweight” next.
There’s the rub. He or she really has no idea where to invest next, any more than they could guess the number of beans in a jar or the weight of a calf at a county fair. It takes a market of millions to determine these outcomes, and nobody gets a peek in advance.
Will foreign stocks roar back, or sink further? Is the performance of U.S. bonds a sign of capital markets strength or a signal that the bond market has topped? Nobody knows.
I do know this: U.S. stocks have a way of grinding higher and higher over the decades. Demand for U.S. debt, while not bottomless, is far less volatile than demand for corporate debt or foreign debt.
Owning a portfolio means holding those assets in a broadly diversified way and letting the outcomes dictate your next move. If the market bids up one asset class, you sell your gains and redistribute the money into the relative “losers” you hold.
That’s selling high and buying low. Along with keeping costs down and staying focused, that’s how you build a retirement for the long run.
Saving for retirement is hard work, especially starting out. It’s no picnic to sock money away you might spend instead.
But you have to do it, and the earlier the better. Getting started with retirement saving and investing is common sense, but the really important part is starting early.
Why? Because time is money. You have to save and you should increase your saving levels as your income level rises over the years. But it’s that early money that gives your retirement plan a real boost.
In time, money makes money. People don’t realize this early on, when their savings balances are low. But those early years of saving begin to multiply in a variety of ways later on.
Here’s five ways your retirement money makes money as the years pass:
1. Interest earned
Money you set aside in a savings account, CD, money market or a bond fund is going to earn interest payments. The only questions there are the terms and the risk. A savings account or CD are lower risk and, usually, lower interest. A money market might earn you more with relatively little added risk, while a bond fund would likely pay the most but also expose you to the highest relative risk.
2. Dividend payments
A little further up the risk scale is owning dividend-paying stocks. If you buy a broad index fund of the stock market you are likely to earn dividend payments commensurate with inflation, more or less. An individual dividend stock will pay more while increasing your concentration risk. A diversified, dividend-focused fund can lower that specific risk but likely pays a bit less. In any case, as a stock holding the risks are greater than with bonds, CDs and savings accounts.
3. Tax deferral
This is a detail many people fail to consider, but any time you can defer taxes your money grows faster as a result. Using an IRA or 401(k) at work can allow you to earn more interest and dividend payments on money you would otherwise have paid in taxes while simultaneously avoiding those taxes until retirement, when your tax rate is likely to be lower.
Investors like to say they buy low and sell high. But do they do so regularly? One way to automate this best practice is to rebalance. By setting as specific weight of say, stocks to bonds, you can reset you portfolio periodically to regain the right mix as a percentage. That way, you automatically sell gainers and use the proceeds to buy the relative “losers” in your portfolio. That adds up to real gains over time.
Finally, the power of compounding takes small dollars and makes them ever larger with the years. A market rate of return is likely to double your money in 10 years or less as those dividend and interest payments are reinvested, and there’s price appreciation, too. Compounding simply means that the new total doubles again, that is, two becomes four, the four becomes eight, and eight turns into 16, etc. It’s how long-term investors retire, by saving early and letting compounding create real wealth.