A new study points out a pretty scary statistic: Of middle-class kids who go to college, just 40% finish with a degree. If you’re a parent with young kids and saving for your own retirement, the reason why this happens matters to you.
Think about it for a minute. Ten capable high-school graduates from middle-class backgrounds enter college and just four walk out six years later.
Not even in four years, the traditional calendar for a BA. They had 50% more time (and more money spent) and still don’t finish.
The reasons vary. Financial problems crop up. Some realize they were never ready for the rigors of higher ed. Some cite “personal reasons” with no real explanation. Maybe they all got great jobs and moved on, but almost certainly not.
The really interesting part is how the kids who finish managed it. Being from a wealthy family helps, of course. But so does being a full-time student. A strong majority (63%) of middle-class students carrying a full load of classes got degrees on time.
There is one key thing to learn here in regard to lifelong success: Start early and commit to a goal. This relates very specifically to retirement saving and investing, too, and I’ll explain why.
You can think of motivated college students a number of ways, but the bottom line is the same. Something or someone lit a fire under them at an early age. Finishing college became a priority to them personally.
Maybe they got excited about their coursework. Maybe a fascinating job offer on the other side wouldn’t happen without a diploma.
More likely, they had strong role models at home, achieving parents who set the bar high and simply didn’t present an alternative, like dropping out or combining work and school to the point of taking 10 years to graduate.
A very similar dynamic happens with investing and retirement. Parents who are savers set an example for kids to become savers. Parents who spend wildly and go into debt do the opposite.
Saving early is a lot like getting an associate’s degree while still in high school. Yes, it’s hard to do. But you get to start off the next stage well ahead of the game. It means you are much more likely to make your goal.
Likewise, saving enough is like going to class full-time. Yes, saving adequately costs you in the here and now. But building up savings buys you freedoms later on that your peers cannot access.
Freedom to choose between jobs. Freedom to retire on time, or even early. Freedom to make interesting life choices.
Here’s your homework assignment. If you have kids going to college some day, sit down and share with them these stats on graduation. Set a hard line on finishing on time and help them find the resources to make it work, such as living at home and summer jobs.
Then immediately link those achievements to retirement saving and investing, starting young. Show them how you are doing it and share the real numbers of your own experience. The time for these conversations is now, while you can still mold a young mind by example.
Otherwise, you find yourself later throwing thousands of dollars at yet another kid with no clear path to graduation, a job and the firm, secure future you want them to have.
Investment advisors often talk to their clients about “asset allocation” without much explanation. Too bad, because it’s worth your while as a retirement investor to understand what asset allocation is — and what it is not.
Business owners understand allocation well. They have a limited amount of incoming cash to spend on growing their business, so you have to pay attention to where it goes. A restaurant owner must pay his employees, suppliers, taxes and the like. Then, if there’s any profit, make a choice: Take a profit or put it back into the business.
Assuming our restaurant owner already draws a salary, the best choice is to reinvest. But in what? Expanding? More efficient equipment? A new hire? It’s a tough problem.
The long-term retirement investor faces the same fundamental question, but what is asset allocation for an investor? It’s putting money to work in the best possible place.
Some advisors may interpret this to mean market timing, that is, trying to get in and out of an investment at specific moments. Or buying certain asset classes based on the business cycle, the interest rate or some other factor in the economy.
The more accurate definition of asset allocation, however, is not investment vs. cash (cash is by definition not investing) but what collection of investments you own. Remember, a huge part of the gains we find in stocks happen over a small number of market days. Sit in cash and you miss those gains entirely.
So how do you limit your risk of down periods? By rebalancing. A powerful portfolio will own a selection of investment types, called asset classes, and rotate among them periodically.
Rather than attempt to move in and out of those asset classes, the smart portfolio sets a specific goal of owning, say, 60% U.S. stocks. If the U.S. stock market rises in value, that slice of the total pie becomes larger.
So if stocks rise to become 70% of the portfolio in value, you rebalance, selling off the extra gains and using the resulting cash to buy more of the rest of your portfolio.
That’s what finance researchers mean when they say that asset allocation is responsible for 90% of observed returns. It’s not what you own, it’s the fact that you own investments (rather than cash) and take gains when they appear (by rebalancing) along the way.
Over time, you can reduce your risk by adjusting the asset allocation to become more conservative. At or near retirement, a risk-adjusted portfolio will be far less volatile than in previous years, helping you to hold on to your compounding gains.
There’s nothing tricky about this approach. Pension funds and endowments have used it for years, with great results. The important thing for retirement investors to understand how the rules of asset allocation apply to their long-term picture, and how adopting a sound strategy leads to a comfortable retirement.
If you’re reading these words, I’d wager it’s because the headline piqued your interest. From that, it seems clear that you already know what an IRA is and think you might need one.
Mostly probably, though, you don’t have one. But you should, and you probably should have two. Let me explain why.
If you have a job with a salary, you are very likely to have access to a 401(k), 403(b) or a 457 plan. The differences in these plans are minor; they all do the same thing roughly the same way, that is, they help you save for retirement.
The reason you want a workplace plan is because it helps you lower your taxes today and helps you to save more. Your contributions grow tax-free until retirement and, in many jobs, your employer will match your contributions in part. Both of these facts mean free money for you.
So why bother with an individual retirement account (IRA)? Well, if you know for fact that you will work at the same job for 40 years, you might not need one. However, if you expect to change jobs in the future, have an unemployed spouse or any need for tax-free income in retirement, well, that’s what an IRA does.
You can open one at any bank or brokerage house you like. Your ability to put money into an IRA has some limits. If you already maximize your workplace plan, it’s hard to put away more in an IRA and still get a deduction for it. Contributing to a non-working spouse’s plan is the exception.
If you’re not going to get a current year deduction for a traditional IRA, consider opening a Roth IRA instead. That money will grow tax-free and can be withdrawn later tax-free, too. Plus, the rules around required distributions and withdrawals are far more forgiving.
This can get complicated quick, so it’s worthwhile to consult a tax preparer and to become a student of the IRA game. Nevertheless, one last point is important to remember: Remember to open an IRA once you leave your current job.
The reason why is rollovers. You have the right to roll money out of your 401(k) plan and into an IRA once you leave a job. Over the course of a career this might happen several times.
Now, you could leave the money in your old company plan, that’s true. However, the fees in corporate 401(k) plans are often extraordinarily high. Brightscope, a firm that analyzes workplace plans, found that only when a plan is managing well over $100 million do fees become reasonably low.
Since they are smaller, most small company plans charge more. Nevertheless, you can remove money from old 401(k) plans and manage it yourself in an IRA using ETFs at a fraction of the cost.
Bottom line: Use your 401(k) to the hilt while you’re there, or at least enough to capture the tax breaks and matching money. Maximize your tax-free income for later with a Roth. And never leave money stranded in a pricey workplace plan once you move on.
You might recently have seen headlines about the NASDAQ. The tech-centric stock market has broken through its previous all-time high, set back in the dot-com days.
It soon fell right back under the record, of course, but it is likely to advance more than retreat over the coming weeks, and the headlines will fade. The same thing happened with the Dow and the S&P 500 not long ago.
We pay a lot of attention to false positives in the financial media, events that supposedly prove that assets are overvalued or undervalued. It can be very easy to forget that behind all the certainty of the news headlines is 100% conjecture — plain old guessing.
Yes, if enough people pile on during up years, stocks can correct lower. It’s just human behavior to want more of a good thing.
But it’s also human behavior to fear losses, what behavioral science researchers call “loss aversion.” They do complex psychological experiments to test these ideas, but the bottom line is easy to understand: We make irrational, costly choices when presented with the risk of losing money.
So fundamental is that urge that some studies show that our fear of losing money is twice as strong as our desire to make it. The result often shows up as selling perfectly good investments on the mere hint that something might go wrong.
We feel better staying out, and we discount the obvious and concurrent risk: That markets could instead go up — as they did in 2013, for instance — and you miss the gains by sitting on the sidelines in cash.
Staying invested is a big deal. The only way to compound your money is to realize gains and to reinvest those gains.
For most investors, that means steadily reinvesting dividends and gains made from rebalancing, that is, from programmatically selling off some of the “winners” in a portfolio and dedicating those gains to the relative “losers” in the same portfolio.
Stocks too high fix
Rebalancing tests your loss-aversion brain circuitry in a major way. You are being asked to get rid of a portion of a stock that has treated you well and to give those resources to a stock or other investment that has not — at least on paper.
Take a step back. By rebalancing, what you’re really doing is selling high and buying low. Ask any 10-year-old how to make money and the logical conclusion will come back to you as “buy low and sell high.” Rebalancing flips the order, but it’s the same transaction.
If you truly fear a major market meltdown is in the near future, well, that’s a sign that you are invested in ways that are too risky for your own mental well-being. The solution there is to revamp your portfolio to have a more conservative tilt.
That move alone will change your life in terms of your relationship with money. You’ll sleep better for sure. Playing chicken with the markets will change your life too, but not in the way you would hope.
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.