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.
Over the long run, stocks rise in value. That’s why investors own them. But what about those years when they just meander along?
That’s what has been going on so far this year, so much so that the Dow Jones Industrial Average just broke a record of sorts. It swung to a negative year-to-date return for the 21st time, beating the 20 times that happened in 1934 and 1994.
Uninspiring, I know. But that’s why we invest in a portfolio that includes stocks, bonds, real estate, foreign equities and bonds and commodities. Sometimes stocks wander.
We still want to own them. The data is very clear on U.S. equities. Over decades, research shows, stocks returned 6.6% compared to 3.5% from bonds.
That 6.6% return is the reason a portfolio is able to compound and outpace inflation. According to data from Wharton’s Jeremy Siegel, $1 invested in 1802 would be worth $802,326.
The same dollar in bonds is worth just $1,552. Pretty big difference!
The price we pay for that ride is an emotional one. Some years, such as 2013, stocks absolutely rocket higher. Some years, they go as flat as an open can of soda.
Some years, they go negative. We certainly saw that in 2008. But your retirement portfolio is not going to benefit from trying to time the market and pick which years to be in and which years to be out.
In fact, investors tend to get that kind of bet wrong pretty consistently. They ride stocks down and sell out when things are at their worst. They sit in cash and wait, then miss the updraft years.
The effect of that kind of investing approach is real damage. So, the moral of the story is, stay invested. A flat year is not a “bad” year. It’s just a year you didn’t lose money.
If you are young and just starting out, a down year is a great year. It’s a chance to buy into the market while it’s temporarily cheaper.
If you are older and nearing retirement, a down year can be a pretty serious test of your resolve. But that’s why your portfolio will, by design, be lighter on stocks and have less-volatile investments instead.
All along the way, of course, you will collect dividend payments just for holding stocks. Those reinvested dividends are the reason stocks end up with such a great track record.
In a “slack” year, your stocks are paying dividends and you get that money to reinvest while prices are flat or even lower than average. It’s a great boost once those up years come back into play, and they help you retire with more.
Every few years, Forbes magazine does what is possibly their most entertaining annual list: Most overpaid actors.
Simply enough, they compare the estimated earnings of the people on their Top 100 Celebrities list to box office results to find a ratio. The math is the operating income of each actor’s last three films vs. their compensation.
The result is a very simple number. For every dollar this actor was paid, how much did he bring in? Topping the “worst” list last year was comedian Adam Sandler, who by Forbes’ calculation was paid $1 and brought in $3.20.
Compare that to, say Shia LaBeouf. He starred in some big-budget action flicks but commanded a relatively paltry $5 million for the robot movie Transformers. That’s a lot of cash, but a fraction of what a big-name actor might demand.
Accordingly, LaBeouf is (or at least was) a great deal for Hollywood, turning over $81 for every $1 he earned filming.
Let’s compare that to your financial advisor. He certainly needs to carry his weight, right? Otherwise you might not retire at all.
If you have $250,000 in a retirement account, the typical advisory fee is going to be 1% of your total assets. Chances are, your advisor will farm out the actual stock picking to a selection of mutual fund managers.
Combined, they will charge you another 1.5%, although that money is coming out of return so you aren’t likely to notice it leaving your account. Added up, though, the impact is real: 2.5% of your money, each and every year.
That’s $6,250 in cash leaving your retirement fund. But wait a minute, doesn’t your advisor “earn” his or her pay?
Consider that the goal of your retirement savings is to compound, that is, to double every certain number of years without any headaches. You might reasonably expect to earn 7% in your portfolio. That means $17,500 in cash coming.
And $6,250 in cash leaving. The managers and advisors are keeping a whopping 36% of your return! Each and every year! Startled yet?
It gets worse. The impact of that loss is just starting to be be felt. Over the long run of an investing life, financial advisors keep half and up to 80% of your earnings from invested money.
Yet they took no risk at all. It’s your investment that’s in the market, not theirs. All they do is slice off their take and hope you don’t notice.
Okay, they do more than that. They disconnect you from the work of picking your investments. And in theory they help you manage risk.
But the fact is, you could buy index funds and build a portfolio that does the same thing for pennies on the dollar compared to their fees, and risk is not that hard to manage if you build a solid, diversified portfolio and rebalance it periodically.
Next time you’re standing in line to buy tickets to a Hollywood blockbuster or some Adam Sandler family comedy, consider just how much you pay for investment advice and if it’s worthwhile.
Chances are, the answer will be “Yes, but not 36% of money!” And you’ll reconsider your approach to retirement.
A lot of financial advisors like to talk about “insurance” for their clients’ investments. Often, however, this takes the unlikely form of highly risky counter-investments.
For instance, an advisor might choose a broad selection of blue-chip stocks. They pay a nice dividend and, assuming they are not too tightly concentrated, are pretty safe from causing a major loss.
After all, quality companies are quality companies. If the market is challenged, typically, buyers rush in to snap up bargains and the good companies rebound.
But a declining portfolio can be hard news for the client, even if the advisor knows stocks are very likely to rebound and head to new highs. So, to comfort the nervous client, he or she will buy an investment expected to move in the opposite direction.
That might be a leveraged fund, something designed to short the whole market.
While there are some narrow instances where that kind of approach might be logical, say, in a taxable account full of low-basis stocks, in a retirement account it’s just asking for trouble.
What happens if the stock market keeps going up instead? The leveraged short position loses money, that’s what!
Owning a diversified portfolio helps you avoid the problems of a reversal in the stock market by mitigating the decline.
Wide diversification is a form of portfolio shock absorber. Yes, your portfolio will decline in face value during a challenging time for stocks. But, it won’t decline by nearly as much as the market itself.
If you’re in a long-term retirement plan, in fact, a decline in stocks is a chance to buy more, while stocks are temporarily “on sale.”
By owning a multitude of asset classes, you are very likely to see other parts of your portfolio appreciate while stocks are temporarily knocked down. In those moments, you sell off some of those temporary gainers and use the cash to buy stocks.
When stocks recover, you steadily sell off the gains to buy the parts of your portfolio that are dragging relative to equities.
And so it goes, selling high and buying low, but never liquidating anything entirely.
In a broadly diversified portfolio there’s just no need to have “portfolio insurance” against a decline. Rather, as you near retirement age, the portfolio becomes less and less volatile by design.
That’s the way college endowments and pension plans manage risk, and it should be the way retirements are managed too. Thanks to low-cost index funds and portfolio science, it’s possible for just about anybody to get that kind of assurance at minimal cost and trouble.
The great thing about index funds is that they are “set it and forget it” investments. But does that make sense for a retirement plan?
Absolutely, and for a number of reasons. First, though, you should understand what an index fund really does.
An index fund owns a selection of investments, much like a typical mutual fund. The difference is, nobody is picking and choosing those investments. There is no money manager in the background trying to pick winners out of a heap of stocks.
Rather, in an index fund you own the whole market, whatever market that fund is tracking. If it’s an S&P 500 index fund, you own the entire S&P 500 — all 500 stocks.
If the S&P 500 Index goes up, so does your fund. If it goes down, your fund falls too.
Likewise, you can buy an index fund that tracks the broad bond market, or foreign developed companies, or emerging markets stocks. Even foreign bonds and commodities.
The upside is cost. You get exposure to an entire asset class with no intermediary in the form of an active manager, so they are cheap and easy to hold. Since there’s little turnover in the fund, there’s almost no drag from buying and selling, no commissions and no real reason to sell it.
Unless you need to rebalance. That’s the “secret sauce” that helps you get an edge on just holding stocks alone. As some asset classes are challenged, usually other investments go up.
Rebalancing is simply programmatic selling of a portion of the winners you have in order to buy the relative “losers” in your portfolio. By taking gains automatically, you are able to bank those winning investments and get ahead of the general market curve.
That’s why index funds are so powerful in a long-term retirement plan. Automatic reinvesting and rebalancing, low cost management and minimized tax impacts keep money in your portfolio.
Index fund to win
More money in your portfolio allows you to compound more effectively and, in time, leads to a great return. It’s not about buying a stock fund and trying to sell it before a market decline.
Rather, index fund investing is about owning an asset class and prudently buying and selling parts of investments in a broader portfolio strategy at the lowest possible cost.
That’s risk management, and it’s something ordinary, everyday investors can do for themselves. The opposite — buying a small selection and stocks and sweating the ups and downs of the market — isn’t retirement investing at all.
In fact, that’s just speculation, the end result of which might be glory and might be pain. But it won’t be a retirement, that’s for sure.
You hear a lot of obscure terms in the investing business, too many of them math-related for sure. But one key idea that far too many gloss over is “portfolio.”
It sounds pretty complicated, but it’s not that hard to grasp. A portfolio is just a collection of investments. They are typically chosen at the same time with the purpose of providing the investor a range of asset classes.
This is not the same thing as diversification, which is owning a lot of investments in each asset class. An index fund with 500 stocks inside of it could be said to be diversified, but it’s not a portfolio.
After all, the entire fund is made up of one investment type — stocks. Now, stocks are great. You need them in your retirement plan to give you enough of a return to overcome inflation.
The problem with stocks is that sometimes they go down. That’s not a bad thing, generally. You get to buy more of them while they are “on sale.” But the ideal is to invest in a portfolio to balance out the ups and downs of the stock portion.
Traditionally, that means owning bonds. But a well-designed portfolio holds real estate, too, and commodities and foreign stocks and bonds.
As the market see-saws up and down, many times these other asset classes move in the opposite direction. That is, stocks go down but bonds go up. As U.S. equities dip, foreign shares enjoy a moment in the sun.
Often, different asset classes move contrary to one another. That’s a golden opportunity to rebalance. You don’t sell all of your stocks just because they are down. In fact, you don’t sell any.
Instead, you look for the asset class that has gone up and sell off a portion of that. Then you use that incoming cash to buy stocks while they are cheap.
A year later or so, you might find that the opposite is going on. Now bonds have slipped but stocks are riding high.
That’s right, you sell off some of the stocks and buy bonds. They’re on sale, after all.
In the end, the ultimate goal is to have a collection of stocks, bonds and other investments that gives you a stock-like performance without the stock-like volatility. Your portfolio return should even out to a regular, clockwork gain.
That way, the compounding effect kicks in and you get the best of both worlds: A strong, secure retirement from solid investments without the nail-biting stress of watching a collection of stocks get whipped around in a market downturn.
You probably have run into a few retirement books over the years. One of the more interesting of them was one entitled The Number.
That really puts a fine point on things, doesn’t it? How much do you need to retire, exactly? What’s your “number” for retirement?
Often, we assume a large round figure and let it go at that. Like $1 million.
But it’s more than a little unrealistic to pick a number from the air without knowing two important things: How do we get there, and do we even need that much money anyway?
Last things first. You should not target a number you need to retire but instead get a real sense of how much cash you need to live well and care for yourself. That’s what retirement is, after all — not having a job anymore.
Go through your monthly spending now. Look at your bills, your bank account, any credit card spending and come up with that number first. Work with a year’s worth, so you don’t miss any one-off costs like insurance bills or vacationing.
Now, subtract the costs that will go away. Probably, that will be your mortgage. You’ll replace cars less often, so halve your automobile spending.
Add back some money for healthcare costs, since those will creep up for sure. And make sure you assume a certain amount of “splurge spending” on travel or new hobbies.
Now you have your really important number, your cost of living in retirement. The only issue is how to pay for it.
Chances are, you haven’t really run your own Social Security estimates. Do it now. It’s free at the Social Security Administration.
Let’s say you came up with a figure like $25,000 a year in Social Security income. You know your post-work life is going to cost you about $50,000 to pull off.
Yes, you can retire
That means you need $25,000 in regular income. Assuming a 4% withdrawal rate, you now know you need $625,000 to retire. That’s a lot less than $1 million.
If you’ve been saving into a 401(k) plan for a few decades, even modestly, you might be closing in on your retirement number early! But let’s assume you are short.
No need to panic. Just amp up your savings rate and aim to work a few years more. The important thing to remember is that money compounds. If you can take Social Security and work part-time, your private savings plan has time to grow.
A retirement plan with $300,000 in it could double in value in 10 years if properly invested, and faster if you make larger contributions along the way. Making your retirement number appear is just willpower and planning.