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.
Most people have money in wallets, in bank accounts, in retirement investment plans. We have a lifelong relationship — at times strong, at time strained — with little green pieces of paper.
Money tends to represent a lot of things. Reward for effort, relief from bills, wishes for our children. Security, perhaps, if we invest it well.
But here’s a fundamental way to think about money that you probably haven’t entertained: Stop thinking of money as something you earn, make more or less of, put away or spend.
Instead, think of money as your employee. Money should be working for you, rather than you working for money. Dollar bills are little green employees, ready to do your bidding.
At the most basic level, of course we work for money. We need it to live and we get it by doing work for others. That’s basic economics, right?
But that’s not how banks and investors think of money. They think of money as a tool for making money, a way of creating new realities.
Money by itself is a losing proposition. Inflation eats away at it. Temptations lead to spending. Just having money doesn’t mean much unless you spend it, or at least that’s the case for most people.
But holding money is how banks earn interest. It’s how investors turn $1 into $2 over time. Money works for them. It should work for you, too.
The initial reaction to the idea of money making money is likely, “Oh, great, but I’m no big wheel investor. I wouldn’t know where to start.”
Increasingly, you don’t have to know where to start, but you do have to start. You can start by putting money into a savings account that pays interest. It won’t earn much, but it won’t be spent, either. Big difference.
Once you reach a minor plateau, say $1,000, you can open a brokerage account and invest. You won’t know what to buy, and the temptation will be to buy company shares you think understand. Probably, you’ll buy Apple Computer or invest in your own employer.
Avoid this urge. Instead, buy an S&P 500 Index fund. It will be instantly diversified and cheap to own. You’ll get Apple and, probably, stock in your own employer, too. Just not too much of it.
Keep doing this, adding $25 or $50 increments, whatever you can spare from your paycheck, basically forever. If you can do this in a 401(k) at work, you’ll reap tax benefits. If you use a personal IRA, that’s also a tax boost.
Money and happiness
Over time, two things will happen. One, your investment will grow. Stocks over the long run beat bonds, cash, gold, everything, returning 6.6% after inflation.
The other thing that will happen is that you will collect dividends on your stock investments, currently at around 2% a year on the S&P 500. Reinvested dividends is why stocks do so well.
In time, your money will compound, doubling every 10 years or so, until you decide to retire. If you manage to hit the magical $1 million mark, you can expect about $40,000 in income from your portfolio, which by that time would include bonds, real estate and other investments.
Most importantly, money will be working for you, and you can do whatever you want with your time — even work and make more money, if that makes you happy.
We all have different approaches to money, understandably so. A lot of it has to do with who your parents are and how you are raised.
Depression-era folks are famously frugal. Their kids less so. Some people are planners in every aspect of their lives, and some throw caution to the wind.
When it comes to retirement investing, the path to peace with money can become quite convoluted. Our money personalities often are not clear even to us, and then we add to that complex personal relationships.
Your spouse, your kids, your parents, your neighbors. Everybody has an idea of what you should do with the money you earn, and while advice can be helpful, it also can be distracting.
What kind of retirement investor are you? Take a look at the four types below and see if your personality matches one or another, or perhaps a mixture of several.
You do your own taxes. You absolutely love to buy a new car, just for the chance to negotiate. You pay attention to fees and costs for everything and look for the best deals every chance you get. You also sometimes lose sight of the forest for the trees.
Action to consider: You’d probably do well as a do-it-yourself retirement investor, but first read some good retirement planning books. What you’ll find that is a low-cost portfolio approach is more effective than picking stocks, for a variety of reasons.
You attend your company 401(k) meeting and fill out the forms, but then fail to choose an investment fund. Instead, your contributions pile up as cash. You set aside a percentage of your pay into an IRA but have no idea how much is enough to achieve your goals. The stress of not knowing is hard to face.
Action to consider: Hire an hourly financial planner who is a CFP or get some help from a trusted family friend who knows what to do. A little bit more knowledge will help you bridge the “fear gap” slowing your progress toward comfort with investing.
Retirement planning is for old people. You’ll get around to it when you turn 30 or maybe 40. Besides, you like your job and can’t imagine not working. Maybe you won’t even make it 65, who knows?
Action to consider: You’ll make it to 65, maybe even 85 or older. Every month you don’t save when you are young means you’ll have to save even more when you are older. Time is a huge investment advantage. Don’t squander it.
Isn’t my spouse taking care of this? Won’t my parents leave me money? I guess my kids will take care of me when I need them, right?
Action to consider: Put the shoe on the other foot. Do your parents believe that you will take of them? Do you want your kids to worry you won’t have enough to get by in your golden years? What will they give up of their own retirement if they have to?
Found your investment profile in these four? If so, take these action steps seriously and find a way to correct your behavior while you can. Your future financial self will thank you.
We overpay for a lot of things on the presumption that price and quality are closely connected — perfumes, wine, certain restaurant experiences, travel.
While it’s true that some things are much better than others, it’s also true that just about anything can be commoditized and made more cheaply. Just recently, a $6 bottle of wine sold by Walmart in Britain won an award.
That’s right, a $6 bottle sold by a mass market retailer is considered one of the best wines in the world. You can get La Monda Reserva Malbec, a Chilean red, only at Asda stores in the U.K. Good luck with that; their website crashed with news of the award.
The larger point is that commodification is not a bad thing, especially when it brings quality into a price range that anybody can afford. The very same thing has happened with investing.
It used to be that investing was hard work. You needed a stock broker to even get access to common stocks, and commissions were high.
Even so, knowing which stocks to buy was important. Trading was slow and illiquid. It was hard to get into a company at the right price and easy to make mistakes.
Faster forward a decade or two and now millions of ordinary people invest in common stocks. The sheer demand has created a much more liquid market.
Access to the tools you need to invest safely have declined in price, too. First through mutual funds and then, soon after, through index funds and exchange-traded funds.
Now it costs very little to create a risk-adjusted portfolio that can hold its own against even highly paid professional money managers. The value of trying to “trade against” the markets virtually has been eliminated.
Not that it’s impossible to beat the market average, just that it’s very unlikely to do so consistently and the cost of trying easily overwhelms any advantage you might have accrued in the effort.
In fact, trying to trade against professionals (and plenty of amateurs still, it must be said) only increases your risk of loss.
The cheap route
Why not go the cheap route, save the trouble and have as good or better an experience as anyone out there at a fraction of the cost? Why not have that $6 bottle of wine and just enjoy it?
The reason, for many investors, is that their own egos won’t let them. They really do want to try to “win” at investing, even if that means greatly increasingly the likelihood of losing.
Retirement investing isn’t a contest with winners and losers. Your investments will grow and compound so long as you invest and avoid emotional mistakes along the way.
Will you make more than your neighbor when it comes to annualized returns? Most probably, since you are less likely to blow it all late in the process on an ill-advised gamble.
Even if you do about the same as most investors, that’s good enough to retire, then spend your golden years enjoying a few $6 bottles of really nice Malbec, and perhaps a few laughs.
The data on retirement saving is stupefying. Many of us will never retire, studies suggest. Half of Americans have no savings set aside at all and instead spend every cent they earn.
The answer, it might seem, is to start worrying. People buy loads of self-help books and follow personal finance gurus online. They clip coupons and seek better credit card deals.
In short, they do everything but the most obvious and effective thing — spend less and save more.
That’s because saving money is hard. It means having less stuff and doing less fun things, such as eating out, taking vacations and shopping.
These activities often create debt, which then feeds a cycle of spending on debt repayment and more worry. It can feel like there’s no escape.
Yet there is, and it’s actually pretty simple: Pay yourself first. Invest automatically. And stop thinking about retirement at all.
Let’s consider this step-by-step. It’s disarmingly simple, I know, but follow along:
Pay yourself first
If you have a job with a paycheck, paying yourself first means joining your company 401(k) and setting aside a significant chunk of each paycheck. Aim for 10% at a minimum. Have it diverted into your retirement plan and make sure it’s at least enough to get your company match, if you have one.
Your spending habits quickly will match your new base paycheck, minus the automatic savings you’ve just imposed on yourself. It’s important to limit access to credit cards in this phase, since you might be tempted to offset the missing income with debt.
Just put the card away, in a closet or bank deposit box, not your wallet or a desk drawer.
Many people think it’s enough to save and that they can worry about investing later. Then later comes and they’ve failed to invest at all. Cash is not an investment. Because of inflation, cash is a guaranteed money-loser.
Put your money instead into a portfolio or automated fund such as a target-date fund. If you put your money into an IRA and need to create portfolio, that also works. Just don’t sit on cash and think you have things set. You might have a savings plan, but it’s not a retirement plan.
Now, stop thinking about retirement
Here comes the easy part. Check in on your progress a few times a year. Once or twice if you want. At the most quarterly. But now that you’ve automated saving and investing, you are free to literally stop thinking about retirement.
The less you engage with your investments, the more likely you are to come out way, way ahead. Your emotional reactions to temporary downturns in the markets are now the biggest risks you run as a retirement investor, a problem solved by ignoring the issue entirely.
As you near retirement, a move toward more conservative investments is in order. But in the meantime the less you think, the less you worry. And the less you worry, the better you will do.
The one thing you can count on, besides death and taxes, is that someone somewhere will try to talk you into owning gold instead of stocks and bonds.
The reasons vary: It’s the only “real” money. It’s a hedge against inflation. It adds to your long-term returns. And so on.
But what do the numbers say about gold? J.P. Morgan publishes a helpful book of charts every quarter, called the “Guide to the Markets.” Among its 71 pages of data, there is a regular report on annualized asset class performance.
Over the past 20 years, the latest report shows, gold returned 5.9%. Compare that to bonds at 6.2% and stocks at 9.9%.
A 60/40 portfolio of stocks and bonds typical of a retirement investor returned 8.7%. Only real estate outperformed stocks, returning 11.5% over the 20 years ending in 2014.
So what happened to a retirement investor over those years? If you held only stocks, a $10,000 investment turned into a bit more than $66,000. If you owned only bonds, you came out with a little more than $33,000.
Gold? Your $10,000 turned into $31,472. Yes, you beat inflation, but stocks absolutely walloped gold and even a super-safe bond portfolio did better.
The problem with such a calm, rational analysis is that the annualized data doesn’t show volatility, that is, the up and down movement in price of any investment.
Stocks would have been plenty volatile. You only need to remember 2008 to understand how volatile. Bonds crashed in 1994, the year before the J.P. Morgan chart begins.
Of course, gold was volatile as well. It was at less than $300 an ounce until 2002. Just nine years later it topped $1,837 an ounce. It’s currently down to $1,269.
The really neat trick, if you could somehow see the future, would be to buy gold when it’s cheap and sell when it’s expensive. Just holding gold, however, is a tremendous risk because gold pays no dividends and no interest.
Most stocks pay a dividend, regardless of price. Bonds pay interest, regardless of price. Real estate pays income, regardless of what the market thinks of any given real estate investment trust (REIT).
That’s why gold does so poorly over long periods. Dividends and interest are reinvested in your stock, bond and real estate holdings.
That’s dollar cost averaging, automated. Money flows into your accounts with no effort, creating truly passive investing. The free cash buys more when prices are low and less when prices are high.
Betting or investing?
You only make money from gold by selling it, which means you have to take action all the time to make it work out, and what’s more you have to be right all the time. Guess wrong and you might sell gold high and then buy low — racking up unrecoverable losses.
It is prudent to own some gold in a portfolio, but only as a rebalancing tool. Since gold is volatile and a bit of an “anti-stock,” you cash out when speculators bid up the price, then use that cash to buy more stock while prices for equities are lower.
When others bid gold down, take some of your stock dividends and interest and rebuild your small gold position. Over time, rebalancing will smooth the volatility of your entire portfolio and add to total return.
Any other strategy toward gold, frankly, is not investing. It’s betting, plain and simple.
Surely you remember the “Dummies” series of self-help books. They had bright yellow-and-black covers and offered to explain complex ideas in simple terms. “A reference for the rest of us!” was the slogan on every book.
It’s a powerful message, one that led the series to bestseller status many times over. Planetary physics, business accounting, orchid cultivation for profit — no subject was too technical for their writers to tackle and bring down to ordinary human terms.
I mention the Dummies books because one of the principle concepts of retirement investing, diversification, is often misunderstood by the very people who need most to understand it. So let’s “dummify” diversification.
A lot of investors think diversification is owning a lot of stocks, and that’s not wrong on the face of it. But let’s start with a simpler metaphor: Don’t put all your eggs in one basket.
If you invest in a single stock, or even 20 stocks that are similar, you have put all of your eggs in one basket. For instance, owning most or all of your retirement investments in stock at the company where you work is definitely the opposite of diversification.
Selling those company shares and buying other stocks helps, but not if you just buy five or six of your company’s close competitors. You might feel better about owning stock in an industry you understand, but you’re still investing in one small, industry-focused basket.
Spreading your money out over a lot of companies from a lot of different economic sectors is starting to diversify. It’s also expensive. The way to get diversification on the cheap is to buy an index fund that tracks an entire index, say the S&P 500 Index.
Feeling pretty good about your basket? Well, you are diversified in the sense that you no longer have all of your money on one stock or even one sector, but you are in one asset class — large company stocks.
You should now add small-cap stocks and get even more diversification by owning a bond index fund, then add foreign stocks and foreign bonds, again with broad index products. Add in some real estate and now you’re getting close to a portfolio that actually is broadly diversified.
Dumb no more
Any one of those companies could collapse and your portfolio won’t founder. Any one of those thousands of bonds can default and it won’t matter. If the stock market declines, the other asset classes often rise as investors move money out of stocks.
Rebalancing allows you to passively capture such market movements at a low cost without having to get into the high-risk business of predicting the future. Indexing keeps costs low. And your eggs are definitely in a large number of very different baskets.
Feeling a little less dumb? Next time an advisor or investor friend starts talking about “diversification,” all you need to do is remember eggs and baskets. It really isn’t any more complicated than that.
Advisors like to toss around diversification math terms to build mystique about what they do (and charge you more for their work), but diversification is just lowering risk by spreading money out over a lot of different investments.
Anyone can do it, even an investing “dummy.”
Summer vacation is upon us. The pools are open and the sun is beating down. It’s the classic summer lull for stock markets, too.
It’s a predictable pattern of “sell in May and go away” that can stretch into a summer of lackluster trading. A survey from the American Association of Individual Investors finds that less than one in five small investors is bullish on stocks now.
Meanwhile, the percentage of investors who call themselves “neutral” on stocks has hit 53%, the highest in more than a decade and a half. It can feel like nobody is buying stocks.
There are any number of reasons why, besides warm weather and typical summer trading patterns. The Federal Reserve might raise the interest rate. Britons are voting on leaving (or not leaving) the European Union.
The U.S. presidential election is heating up, increasing uncertainty among investors. And so on.
What does the “smart money” do in these scenarios? Absolutely nothing, or at least nothing different from the previous six months, year or five years.
The problem is this: Past is not prologue. If you choose to get out of your stock holdings for a few months on the bet that equities will be flat all summer, you run two important risks.
First, you will miss two or more quarterly dividend payments. If you have $250,000 in a retirement fund, your dividend yield on an S&P 500 Index investment is $5,325 a year. Sit out six months and you leave $2,662.50 on the table.
Over two decades that money could compound into $10,695, but if you don’t collect, well, it isn’t yours. Do that for 10 summers and it’s $130,292 you don’t have. Starting to feel like real money yet?
The other problem is gains. Remember all that risky “bad news” from earlier in this article? Now consider this: Investors have long known the Fed would raise rates, few think Britain will leave the EU and election years often are good for stocks.
Since 1970, stocks have put on about 1% during the summer months. The up summers averaged 5.6% and the down summers averaged a negative 8%. If we have a typical, truly average summer, that’s another $2,500 you don’t collect by being in cash.
Price of patience
Feeling better? What if I told you (and you know it’s true) that how you “feel” about stocks is irrelevant to their ultimate performance? What matters is not making choices based on your feelings.
The long view is simple: Don’t buy and sell stocks. Look to own them instead, and rebalance to stay on track. Collect dividends and reinvest them steadily. Cash is a negative investment. You will not collect meaningful interest on it and inflation never stops eating away your purchasing power.
You might be slightly calmer at the beach, summer novel in hand, taking your money out of stocks and stuffing it in a low-interest but safe money market account. But you won’t be any richer, likely $5,000 poorer and maybe significantly less rich at retirement.
The price is patience and a willingness to reinvest in a go-nowhere market, buying stocks even in a flat summer market. That’s just good investing.
Retirement investing isn’t often about what you might do wrong, a sin of commission, but what you don’t do at all — the sin of omission.
What is a sin of omission? An inaction that you commit, and one that hurts really only you. After all, if you don’t save for your own retirement, who will?
The days of forced retirement investing through pensions is long gone. Social Security was always meant to be a safety net, a way to keep older Americans from falling into poverty by accident.
Neither system is perfect, but they had the very powerful feature of taking choice out of the matter. Pension plans require participation. Social Security taxes are not optional.
What can go wrong now? Consider these five mistakes, these sins of omission, that can sink a retirement plan:
Not saving at all
Seems like an obvious one, but an amazing percentage of Americans, roughly one in three, has saved literally nothing for retirement. Half of us own no retirement accounts whatsoever. Those with retirement savings accounts don’t have much, either, about $60,000 on average. Still, they’re doing better than the folks with zero.
Saving too little
We save about 5% of income as a nation. We carry debts that must be paid. Assuming normal economic growth and inflation rates, that’s a recipe for stagnation. Ten percent savings is a better target, and 15% is better still.
Starting too late
Many people put off retirement saving until they are well into their 40s. They pay for kids, for cars, they buy houses and vacations. They do anything but save and invest. But those years from the early 20s to about 40 are a huge boost to long-term returns. You need your money to be invested for decades if you expect it to grow into enough to retire.
Paying unnecessary taxes
You’ve heard it before. We’ll say it again. If you have a job with a 401(k) and don’t participate, you are paying taxes on income you could easily avoid. More than likely, you also are missing free money from your employer in the form of matching funds. If you don’t have a 401(k) but you do have a job or your own company, an IRA will achieve the same goal of paying less taxes now while saving more for retirement.
The omission here is not investigating ways to lower your investing costs. Principal among these is using index funds to own a portfolio of diversified investments. If you own mutual funds instead, you pay a high cost for management of that money, most likely. If you pay an advisor on top of that, it’s a double-whammy of costs upon costs.
You can fix these problems in about a week or two of visiting your HR department to see about your 401(k), setting up automated contributions, opening an IRA and looking into buying a small handful of index funds.
Inaction is the enemy here. Doing nothing is, in the end, the most expensive way to go.