This webpage is written for the average person who is investing for retirement. It documents lessons I have learned along the way, that I wish I had known earlier. I am not a financial advisor or expert in any way. However, most of what is here is drawn from reputable sources. In many cases, I will quote directly or give a reference. You can & should seek professional advice and check with reputable sources.
Few people seek a licensed financial advisor, but the vast majority of them are dead wrong and will not do very well on their own. I wish I had consulted one long ago. Studies show that most people are financially illiterate and make financial errors. (Of course, none of us fit that description, but that is why I'm collecting what I stumbled on here.)
Here are some of the main topics that average investors need to understand:One of my best sources of information is The Vanguard Group. Most of my money is not invested with Vanguard, but it would be if I was starting over. They are known for low fees, and they have some of the biggest funds around. The next paragraphs will discuss Vanguard.
"The Vanguard Group is an American investment management company based in Malvern, Pennsylvania, that manages approximately $2.0 trillion[1] in assets. It offers mutual funds and other financial products and services to retail and institutional investors in the United States and abroad. Founder and former chairman John C. Bogle is credited with the creation of the first index fund available to individual investors,[citation needed] the popularization of index funds generally,[citation needed] and driving costs down across the mutual fund industry." -- Wikipedia
"For his undergraduate thesis at Princeton, John C. Bogle conducted a study in which he found that around three quarters of mutual funds did not earn any more money than if they invested in the largest 500 companies simultaneously, using the S&P 500 stock market index as a benchmark.[3] In other words, three out of four of the managers could not pick better specific "winners" than someone passively holding a basket of the 500 largest public U.S. companies. The managers could pick specific stocks which would do as well as picking the 500 largest stocks (essentially doing as well as random chance would dictate), but the cost to pay their expenses, as well as the high taxes incurred through active trading, resulted in underperforming the index." -- Wikipedia
The largest ETF is the Vanguard Total Stock Market ETF (NYSE: VTI), with about $190 billion in assets. Second-largest is the Vanguard Total Bond Market ETF (NYSE: BND). [An ETF is a mutual fund that is traded on the stock market instead of sold directly - largely for convenience.]
Vanguard is a respected and proven investment manager with low fees. It is probably the most widely advocated company these days. However, I should also mention a new group of startups called "robo-advisors". These are new companies like Betterment that use a very automated approach to investing. I have not studied them extensively, but you can search on 'robo-advisors' if you are curious.
Before discussing the best plan for most investors, it is important to discuss why natural impulses just don't work. The following paragraphs will show why our intuition is not as good as the proposed plan.
The Nobel Prize in Economics was recently awarded for the following theory. "The theory basically asserted, in the words of the economist Burton Malkiel, 'that a blindfolded monkey throwing darts at a newspaper's financial pages could select a portfolio that would do just as well as one carefully selected by experts.'" -- web article
It has been repeatedly validated, sometimes in experiments involving actual monkeys. And while many market prognosticators on Wall Street still thrive in part by claiming that they can offer investments that will consistently beat the market averages, Mr. Fama's well-established theory has influenced the way millions of people now invest, contributing to the popularity of index funds that hold broad, diversified baskets of equities. -- web articleUSA TODAY markets reporter Matt Krantz answers a different reader question every weekday.
Q: How good must a stock-picker be to beat the index?
A: Jack Bogle built an entire financial empire at Vanguard on the concept beating the market is all but impossible over the long term. But that doesn't stop stock pickers and professional money managers from trying to beat the odds.
But do stock pickers have a shot? After all, it's pretty tough to beat the indexes. Investors who simply invested in the market, measured by the MSCI USA equity index, between January 1970 and December 2012 scored an average annual gain of 9.6%. That return consisted of 3.37% coming from dividends and 6.26% in capital gains, according to research from Greenline Partners.
But to keep up with the index return, stock pickers need to do much better than 9.6%. Since active traders tend to buy and sell more frequently, they have to generate a return of 11% on average a year just to achieve the same after-tax returns as the index,Greenline Partners says.
Investors who simply buy the indexes also get big discounts on fees, which are one of the biggest killers of returns. The average management fees for investors just buying the indexes is 0.05%, Greenline says, well below the average 1% annual fee of active investors and 2% annual fee charged by hedge funds. The bottom line: beating the market may be remotely possible, but it's highly unlikely.
So it is probably better to buy the entire market index. This has been proven to be a better approach than trying to pick winners.
"In finance, diversification means reducing non-systematic risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets, and often less risk than the least risky of its constituent." --Wikipedia
According to a recent report, the 61-year lifespan for the average firm in 1958 narrowed to 25 years in 1980 to 18 years in 2011. At the current churn rate, 75% of the S&P 500 will be replaced by 2027. The report was conducted by the innovation consulting firm Innosight.
In effect, diversification lowers risk. Since we generally can't beat the market anyway, it makes sense to invest in the entire market. This beats letting monkeys randomly select investments for us.
Asset Allocation carries diversification one step further by buying different classes of assets like stocks, bonds, & real estate. In particular, stocks and bonds have very different traits. They are weakly correlated & often move in opposite directions. Stocks have better growth, but bonds are less volatile.
The two most important decisions in this investment strategy are how much to contribute and how much to put in stocks, bonds or other assets. [Note that I don't discuss commodities because I think they are a mistake for most investors. This is simply because commodities don't have any growth and they are extremely volatile.]
Here is a simple introduction to asset allocation from the Motley Fool. It is just a few short pages: Introduction to Asset Allocation
Here's an excerpt from the Motley Fool article:As an extra aid in determining your mix of stocks and bonds, consider the following table, from William Bernstein's The Intelligent Asset Allocator:
Loss I can tolerate Recommended % of portfolio invested in stocks
35% 80%
30% 70%
25% 60%
20% 50%
15% 40%
10% 30%
5% 20%
0% 10%
So, according to Bernstein, if you can't stand seeing your portfolio drop 20% in value, then no more than 50% of your money should be in stocks. Sounds like a very good guideline to us. OK, you now know how much you should have in stocks. But what kind of stocks? Let's find out by playing a game in our next installment.
This web page from Vanguard shows how various asset allocations performed over 86 years, AssetAllocationModels.pdf It demonstrates the entire strategy. Pay close attention to the return and the worst year for each mix.
Stocks are a type of equity. You own a part of a company & share in the growth of that company. Stock prices rise as a company grows which results in capital gains when you sell a stock. Companies may also pay cash, called dividends, to stock holders.
Stock funds hold a group of stocks in some proportion. This web page will focus on index funds. Index funds try to hold stocks in the same proportion as an index. Vanguard has index funds which try to hold all the stocks in the US stock market in proportion to the actual size of the companies (their market capitalization). They have similar funds for international, large cap, small cap, etc.
We shall choose index funds or "funds of index funds" that are professionally designed to meet the average investor's needs. These funds will hold sensible proportions of the entire stock market - US, international, large caps, small caps, etc.
As an asset class, stocks offer about 10% growth over the long term, based on 86 years of history in the US stock market. This growth is accompanied by risk. The largest drop in those 86 years was 43.1% in 1931. Stock funds are the key to growth, but we will use other asset classes to lower the risk.
A company or government issues bonds to borrow money. When you buy a bond, the issuer pays you back with interest. Bonds can be short term (1-5 years), medium term (6-12 years), or long term (12 or more years). Longer term bonds pay more because they lock you into a fixed interest rate for a longer time - interest rate risk. Riskier bonds also pay more because of default risk. So, return is tied to risk as always.
Bond funds pay dividends, and can rise or fall in value. Bond funds offer several advantages over buying individual bonds, like diversity and the continuous replacement of bonds in the fund as they mature. Funds of medium or short duration will be affected less by changing interest rates than funds of longer average duration (longer term bonds).
The main feature of bonds for our discussion is that their price movements have a low correlation with the movement of the stock market. Stocks and bonds often move in opposite directions. Also, bonds are less volatile. Over 86 years, the worst drop in the US bond market was 8.1% in 1969. Bonds returned an average of 5.5% over that period (1926-2012).
Target date funds do asset allocation for you automatically rebalancing the portfolio as necessary and becoming more conservative as you approach or pass the target retirement date. Target date funds are also professionally constructed using asset allocation models or some variant of Modern Portfolio Theory. They are designed to maximize growth while minimizing risk.
A target date fund is usually a "fund of funds". In other words, it's a collection of index funds - usually various diversified stock and bond funds. It is an asset allocation strategy in one fund which is convenient and automatic. A few experts will quibble over the exact recipe of a particular target date fund. You must find a fund with a recipe that suits your needs. Personally, I doubt most of us could could balance all the classes of stocks and bonds (like international stocks or bonds) as well as a reputable target date fund can.
You can choose a later or earlier target date in order to make your strategy more or less aggressive. If you can't find a fund to match your needs perfectly, you can hold stocks or bonds outside it in order to increase or decrease risk. (If you hold assets outside the target date fund, you must rebalance regularly to maintain your desired stock/bond ratios.)
The reason for becoming more conservative during retirement is that retirees usually need to keep withdrawing money. If the market has a big drop, your withdrawals will become a bigger percentage of your smaller balance. During the saving phase, you can keep contributing and wait for the market to recover. During the retirement phase, it is more difficult to fully recover due to the combined effects of the drop and your withdrawals.
In addition to a target date fund, many people own an additional asset class, real estate. Many people own actual real estate like their own home or rental property. Another simple way to invest in real estate is by owning shares in a Real Estate Investment Trust (REIT). An REIT is an equity like a stock. It is a business, like commercial rental properties, that collects rent and pays at least 90% of its taxable income to shareholders as dividends.
REITs have a low correlation with stocks and bonds. However, they can fall when stocks fall and have in the past. When looking at my own portfolio, I consider REITs to be stocks. They can be even more volatile than stocks as the 2008 crisis showed. Therefore, I consider them to be a volatile class of stocks like International stocks. Having said that, they are also a different kind of asset with a fairly low correlation to stocks and bonds in many circumstances.
A lot of information already exists about real estate, so I won't try to cover everything on this web page. Basically, the average person may own a home or a rental property or both. Rental properties produce income from rents and the value of the property may appreciate. On average, we can expect appreciation to be 1.5%-2.5% above inflation. For residential rental properties, a good rough rule of thumb is that expenses take about 50% of rents, though this can vary. If you own a home, it is said to have "imputed rent". You might say that you avoid the cost of renting another house or pay the rent to yourself. In short, real estate is a third asset class in addition to stocks and bonds. It adds to the diversity of asset classes we own which should help our asset allocation strategy.
I also want to touch briefly on annuities, namely lifetime annuities. A lifetime annuity is basically insurance against outliving your savings. Terms may vary, but in the simplest case you give a lump sum to an insurance company that pays you a set payment for life based on the current interest rate and on your life expectancy (typically around age 85). If you live beyond 85, you continue to receive payments for life. If you die before 85, you normally sacrifice the remainder of your money. Personally, I believe a fairly simple lifetime annuity can be excellent insurance. However, I would avoid any complex annuities or expensive annuities. It is important to look at the interest rate in effect, the fees, and the health of the insurance company backing it. I personally don't like annuities that mix in stocks and other investments.
Exponential growth is the key to building wealth. It is the reason the rich get richer. It is convenient to think of exponential growth in terms of the doubling time. For example, a return of 8% doubles approximately every 9 years. Therefore, if you managed to accumulate $100,000 in your account and earned 8% on average (including contributions minus fees), it would progress as follows: $200K, $400K, $800k, $1.6M. Each step would take 9 years for a total of 36 years. As you can see, your investment would grow by $800K the last 9 years.
The main variables are your rate of return, contributions, and time. Time depends on when you start investing and when you retire. Keep in mind that around half of all retirements are forced (by health, layoff, or other circumstances). Your rate of return depends largely on your asset allocation which is the subject of this webpage. Contributions are more in your control provided you have the income available after essential expenses.
Contributions are the key to the whole thing once your asset allocation is decided. Most people should strive to automatically contribute 20% of their income, though 15% isn't bad. Whether or not you can contribute 20%, make it a firm goal. More is always better. Remember that investments earn money. Eventually they can earn more than you can - which is why the rich get richer.
Contributions also help more when you have less. If Sally has $60K and contributes $6K for the year, her savings grew by 10% just from contributions. (If her investments also earned 7% after fees, her savings increased by 17% to $70,200.) If she had twice as much saved (or $120K), her contribution would only be 5%. Basically, contributions have larger effects earlier and cause your money to double faster. As time passes, earnings become more important. You can divide your annual contribution by your current balance to see the percentage boost it gives you. (Total growth = contributions + return - fees; where taxes & inflation are ignored.)
Even if you are starting late, contributions are important. Contributions are really the foundation of investing. It is basic saving. The more savings you accumulate the more it pays off. Exponential growth really pays when the numbers get larger. However, you must contribute to begin the growth and start doubling your money.
Fees are an important factor in your return. (If you use an employers 401K, you may get the benefit of matching contributions which along with automatic contributions and tax deferral probably compensates for the lack of choice.) Generally, fees subtract directly from your return.
According to Vanguard: "Vanguard average expense ratio: 0.19%. Industry average expense ratio: 1.08%. Sources: Vanguard and Lipper, a Thomson Reuters Company, as of December 31, 2013"
Many people assume that Social Security (SS) will disappear. The list below shows why this is NOT the case. You should include SS estimates in all your calculations. SS is the default pension today, and can make a significant difference to your retirement. Of course, it is great if you never need it, but it may be a huge help.
Here are some facts from the Social Security Administration:Social Security, a pension, and other incomes form an important part of most people's retirement. Don't forget to include those in your planning.
This page represents the basics of current retirement planning. It also covers everything that I wish I had known at the start. If I had known these things, I would have contributed more. I also would have owned more stocks when I was young only tapering as I approached retirement.
Some experts recommend that your percentage of stocks be (100 - your age); some use 120. Really, I recommend developing a spreadsheet for your portfolio and adjusting the growth rate, contributions, etc. This way you can see what is achievable and follow your progress. [If you aren't familiar with spreadsheets, try this one: Retirement-1.xlsx (Excel) Retirement-1.ods (Libre Office)] You can also use the calculator below this section.
You can earn money from labor or capital (money). Labor seems to be less valuable these days than capital. Investing allows you to rely less on labor. Labor is actually just as risky or even more risky than capital, especially as you age. It also doesn't have that potential for exponential doubling - which becomes huge when you accumulate enough wealth. The poor specialize in labor while the rich specialize in capital or business.
Tax strategies were not covered in this web page. Plenty information exists concerning various ways to minimize the impact of taxes. Personally, I do not obsess over taxes. It is important to have a retirement strategy first. However, taxes should be considered. It is important to understand your tax rates: your overall tax rate (100*tax/AGI), your marginal or top tax rate (top tax bracket), and your long term capital gains tax rate (currently 15% for many people).
You must hold stocks one year to qualify for your long term capital gains tax rate. Understanding your tax rates is the beginning of having a tax strategy. However, don't obsess about taxes at the expense of your investment strategy. If you have no retirement money, you pay zero taxes. That is not really a victory for you. It is better to have too much money and pay plenty of taxes.
It is a good viewpoint to see the world as a dream. When you have something like
a nightmare, you will wake up and tell yourself that it was only a dream. It is
said that the world we live in is not a bit different from this.
-- Hagakure: The Book of the Samurai by Yamamoto Tsunetomo