Investing

This section offers basic information to get you started investing. If you are unsure of some of the financial terms, reviewing the financial definitions section may help give you a better understanding.

Section One – Before You Start Investing.

Section Two – Why Invest?

Section Three – How to Invest?

Section Four – What to Invest In?

Section Five – Taxes and Your Investments.

Section Six – Personal Freedom 

Section Seven – Social Security

Section Eight – Wealth in America

Section One: Before You Start Investing

Are your personal finances in order? Only after your finances are in order can you start to think about investing.  To make sure you are ready, here are the following things to review:

  • Budget
  • Emergency Fund
  • Debt
  • Saving

Create a budget by listing your known income and expenses and then start tracking your spending.  Although many people find a budget constricting, I find it liberating.  It allows you to spend money guilt free if you have additional money left over after achieving your goals. It also allows you to see if your spending habits match your values; you might be surprised.

Once your budget is in place the next step is to create an emergency fund if you don’t already have one. Most financial experts recommend that you save enough money for 3 to 6 months of expenses, although there is nothing wrong with having an emergency fund up to 12 months.  By keeping a larger emergency fund, it can help alleviate stress.  Invest your emergency fund in a stable account such as a savings or money market account.    

Clean up any debt you may have.  Paying off debt is an automatic guaranteed investment return.  To many of us, we look at the payment amount rather than the total cost of the loan.  The interest paid over and beyond the original loan amount can be substantial and is money in excess of the purchase price.  When you borrow money, I like to think of it as reverse investing.  There are examples later in this section that show how large amounts of interest are earned, but in this scenario you are paying that.  Why do you think there are so many people anxious to lend you money?  Don’t pay interest, collect it.

This may seem obvious, but you can’t invest if you don’t save. Once you have your emergency fund, the easiest way to save is to set up automatic savings deductions each month from your checking account to go directly to your investment account.

Personal Financial Questions to Consider BEFORE Investing

How much money do you have and where is it invested?  This should include everything from your retirement accounts, local banks & credit unions, investment accounts, cash in your sock drawer, etc.  This includes any shared accounts you may have with a spouse or partner- everything!  This is your net worth excluding any real estate or other non-investable assets.  If you are unclear on how your money is invested, find your last statement from those accounts. There will be information regarding the funds that you’re invested in, any contributions made, etc.

What is your income?  This includes everything from your primary occupation to any side jobs you may have or anything that is providing you income. It could include disability payments, social security or investment income.  A paystub is helpful to figure out your take home pay and any taxes or deductions that are being taken out.

Do you have debt?  What type of debt?  How much are the payments?  What are the interest rates on the debt?  How long before each debt is paid off?   What is the total amount of all debt owed? If your expenses are more than your income there is literally no chance to invest.  This is why a budget is critical to help you achieve financial independence.  If you’re not operating from a clear complete picture it is difficult to succeed.

Do you have an emergency fund?  This is readily accessible cash for short-term emergencies. How long will it cover you and your dependents? 

Are you saving for retirement?  Does your employer provide a retirement savings match program and how much is it? Could you be saving more? Where is the money being contributed or saved to?  Is it pre-tax or after-tax investments?  A paystub is helpful to figure out what is being contributed by you and your employer regarding retirement plans.

Will you be making any large purchases such as a vehicle? This will need to be accounted for within your budget.

Do you have life insurance?  What type of insurance is it?  How much?  Do you need it?  You may need a significant amount, or you may not need any, depending on your situation.  Once you have saved enough money to cover your life expenses (or that of any loved ones you are supporting), you may no longer need life insurance.

Do you have a will or trust? A will or trust can make sure your assets go where you want them to go after you’re gone.

Life Questions

What life do you want?  What are your goals?  Where do you want to be in 1 year, 5 years, or 10 years?  Most people have a difficult time answering these questions, but consideration of this is valuable.  Take a look at your life including family members to think this through.  These are big questions and it’s important to know what you are saving for.  Do you want to retire early, leave an inheritance, give to charity, travel, etc.?    Money is simply a tool to achieve the life you wish for in the future.  It’s easier to succeed if you have a goal you are excited about attaining.

Are you satisfied where you are at both personally and professionally?  This can affect how you plan your future financially.  If you dislike your job, are you willing to leave it for perhaps a lower paying job that you enjoy?  Do you enjoy where you live, or want to move to somewhere more appealing?

Are others dependent on you?  This could be children, elderly parents, other family members, friends, etc.  Will you be paying for your children to attend college?  Will you be contributing to your parents for their care?  If you are subsidizing anyone else for any reason, it is important to take that into consideration.  This should take into account the ages of dependents and how their needs will change over time.

Investing Questions

What is your knowledge of investing?  Do you know what asset allocation is and what yours is?  Do you know what fees and expenses are being charged on your account? 

What is my tolerance for risk?  Can I handle the volatility of the investments that I choose? 

What is your time horizon for investing?  How and what you invest in will change over your life along with why you are investing but keep in mind that your horizon may be substantially longer than you think.

When do you plan to cease working for pay?  This affects how much you need to save, where to invest, etc. 

When do you plan on receiving social security payments?  How much will you be receiving? 

Do you have beneficiaries on all of your financial accounts?  Make sure the money goes where you want it to go when you pass.  You can have primary beneficiaries (such as a spouse) and contingent beneficiaries (next in line if primary passes such as children).  Your beneficiaries can be anyone not limited to family.  Also, remember to update them as your life changes.  This is often forgotten.

This information is absolutely vital to investing properly.  If you don’t know the answers to these questions, continue reading through this section to get a basic understanding.  Then continue your investing education through independent sources that have nothing to gain by your investing or the advice they give.  A list of books, podcasts, websites, documentaries, YouTube channels, etc. that can help you, is in the recommended resources section of the website.

Section Two: Why invest?

You have “bought” personal freedom when you invest. The play on words is intentional.  You can “buy” a lot of things, but in the end your most valuable “thing” is your life and the freedom to choose how you spend your time.  It allows you to choose your occupation, your hours worked, your hours doing what you love to do.  Allocate your money to “you” first.

Don’t “buy” into the myth you can’t become wealthy. Contrary to what you may have heard, almost anyone can become wealthy due to compound returns.  It doesn’t take a lot of money; it just takes some discipline each month to save a little and it’s not that hard.  By investing early, you have more money to spend during your life and you will have to save far less, therefore allowing you more money to spend today!  For example the table below shows the power of compound returns by saving just $100.00 per month over different time periods.

Account BalanceAccount BalanceAccount Balance
Time InvestedTotal Contributions3% return5% return10% return
5 years$6,000$6,481$6,829$7,808
10 years$12,000$14,009$15,593$20,655
15 years$18,000$22,754$26,840$41,792
25 years$30,000$44,712$59,799$133,789
30 years$36,000$58,419$83,573$227,933
35 years$42,000$74,342$114,083$382,828
40 years$48,000$92,837$153,238$637,678

Another example would be investing $500.00/month for 40 years starting at age 25 and you will have saved $240,000.00 of your own money by age 65.  Based on an average stock market return, you would end up with $2,438,465. You end up with ten times more than you saved!

If you wait 10 years (age 35) you will need to save $1,200.00/month totaling $432,000.00 of your own money. Based on an average stock market return you would end up with $2,260,834.89.

By waiting 10 years you will have to save an additional $192,000.00 and still end up with less for retirement. With the first example, you save less and end up with more, a win-win. Think about what you could do with an additional $192,000.00 over the course of your working life. This gives you a chance to live well today and tomorrow. The information provided isn’t meant to encourage you to save less, it is simply showing the power of compound returns over time.  Start saving early! 

Another name for the above example is passive income.  It’s like having a second paycheck with no work involved.  Example:

Work 40 years at an annual salary of $60,000.00 and you will have earned $2,400,000.00, or approximately $1,800,000.00 after taxes.  Save $400.00/month in a total stock market index at an average annual market return of 10% and the total would be $2,551,112.10.  If this was invested in a Roth IRA there would be no taxes on the gains.  Keep it all.  With passive income you can make as much money as working your entire lifetime. 

Even if you get started late your saving and investing time horizon is probably longer than you think.  At age 55 you may well live another 30 to 40 years.  This would allow your savings to compound almost as long as your working career.

Section Three: How to invest?

Fees

“After costs, only the top 3% of managers produce a return that indicates they have sufficient skill to just cover their costs, which means that going forward, and despite extraordinary past returns, even the top performers are expected to be only as good as a low-cost passive index fund.  The other 97% can be expected to do worse.” – Eugene Fama, Nobel Prize in Economics

By taking charge of your own investing, you can easily avoid hundreds of thousands of dollars in fees.  Yes, you read that correctly, hundreds of thousands of dollars.  For example:

If you invest $500.00 per month for 40 years and pay 1% in fund or advisor fees, you will forfeit $600,000.00 in returns due to that 1% fee (based on 9.53% historical average stock market return).

If you pay 3% in fund or advisor fees on the same investment, you forfeit over $1,300,000.00 in returns due to that 3% fee (based on 9.53% historical average stock market return).

High fees and expenses are unnecessary-they don’t increase your return. You should be able to own a diversified portfolio of stock and bond index funds for around .08% expense fees.  By controlling expenses, you keep the returns versus the fund company or financial advisor keeping it.  This is how to achieve above average returns.

Many mutual funds can have additional fees (loads or commissions) above their standard operating expenses attached to them as well.  These mutual funds are sometimes referenced as Class A, B or C which is an indicator that there are loads attached to them.  These can be both front end and back end loads as high as 5.75%.  Front end loads means the fund takes 5.75% (or whatever the fee is listed at) of your money before they even invest it.  This means you would need to earn over a 6% return the first year just to break even.  Back end loads are taken out when you sell shares in the fund.  There is no reason to ever invest in funds with loads or any fee for purchase or sale.  There are many other options available to you that are better.

Financial Advisors

“There are two kinds of investors, be they large or small; Those who don’t know where the market is headed, and those who don’t know that they don’t know.  Then again, there is a third type of investor-the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends upon appearing to know.”- William Bernstein, author of The Intelligent Asset Allocator

Most financial advisors work for a financial company that is selling a product.  Most of their products are designed to make them money, not necessarily make you money. I can’t stress enough how important it is to know how your advisor is compensated.

Most advisors do not have a “fiduciary” responsibility. A fiduciary is required to put your interests ahead of theirs.  They should only be paid by you. If they receive compensation from anyone else regarding the advice or investments they recommend they have a conflict of interest.  Also, just because a fiduciary has a requirement to act in your interests first doesn’t necessarily mean their advice is right for you.  Ultimately only you can decide what is right and in your own best interest.  You can look up fiduciaries in your area at http://www.napfa.org.

There are fee only and fee-based advisors.  Fee only advisors are a better choice than fee based.  They charge by the hour or by the job, so you know exactly what you are paying for.  Fee only advisors can be helpful for occasional advice and questions you may have.  A CPA (Certified Public Accountant) who specializes in taxes is a good example of an advisor that can be useful.  Fee based advisors take a percentage of your overall investments and this can be incredibly expensive as shown previously.

A Certified Financial Planner (CFP) is an advisor who is trained in all aspects of personal finance.  They can be located at http://www.letsmakeaplan.org.  Unfortunately, many are fee based, but the website shows how they are compensated, and some are fee only.  If you use a CFP they can formulate an entire plan including taxes, education, estate, retirement, etc.  If you do use an advisor, it is important to ask them to disclose any conflicts of interest they may have and select fee only advisors.

There are companies now that offer advisor services online called robo advisors.  These companies typically have lower fees than a local advisor.  A couple of examples are Betterment and Wealthfront.  Vanguard also offers personal service for .3% and you are assigned an advisor available over the phone or online.  If you are comfortable working online and need help these might be right for you. Just remember they all charge fees and you still need to understand your investments and what service they are providing. Links for these companies are in the recommended resources section.

If you choose to hire an advisor you need to be comfortable enough with them to share all of your financial information.  They can’t do their job appropriately without knowing your total personal financial situation.  Unfortunately, I have reviewed many portfolios of investments for people and most of the time their advisors asked for little or no information.  There is no way to appropriately manage your finances without knowing the entire picture and if they don’t ask all of the questions listed above, find another advisor.  Lastly, an advisor needs to be thoroughly vetted before any information is given to them.  Check online, check references and make sure you are 100% comfortable with who you are dealing with. You can check your advisors history at http://www.finra.org. (Financial Industry Regulatory Authority)

All of your investing accounts should be in your name or spouse/partner only.  NEVER put your money into an account with someone else’s name on it, such as an advisor or financial firm.  NEVER!

Don’t just blindly take advice from an advisor, be it a financial advisor, lawyer, CPA, etc.  Speaking from my own experience of having used many different professionals over the years, they don’t always get it right.  I have received incomplete, incorrect and conflicting information.  You need to do some of your own research.  The best option is to take control of your money by investing time to educate yourself.  If you decide to hire an advisor, you still need to thoroughly understand your investments.  It’s just too important to close your eyes and hope everything turns out well. 

Common myths on investing or what not to do!

Buying individual stocks or bonds is the wrong approach in most cases.  The depth of knowledge to understand buying securities is beyond most people. When you make a stock purchase you are in effect, buying a business. This requires a business valuation. Who among us has even a basic understanding of placing a value on a large multi-national publicly traded company.   Information within this section will show that nearly 90% of professional money managers fail to beat a simple market benchmark for returns. In other words, even the most qualified individuals fail to buy the right stocks to achieve a superior return.

Furthermore, all stock market trades in aggregate break even.  In other words, there is a buyer for every seller and they both think they know what they’re doing.  The only discrepancy is the expenses paid to execute the trade. Paying less expenses is the important thing to remember.  The financial industry is able to charge a fee on every transaction and by not trading stocks you will be paying less expenses and this will put your return well ahead of a large group of investors.

In Chris Hogan’s book Everyday Millionaires, of the 10,000 millionaires surveyed, none of them mentioned buying individual stocks as a contributor to becoming wealthy.

Mutual funds or Exchange Traded Funds (ETF) are the best way to invest. They offer low cost and broad diversification through low cost broad based market index funds. There is more information ahead on the value of index investing.

Trading assets or market timing is also not a good strategy.  Trying to guess when to buy or sell is a fool’s game; even Warren Buffett has stated he knows of no one who can time the market.  To quote Nobel Prize winner in Economics Eugene Fama, “Money is like soap.  The more you handle it, the less of it you have.”

The financial media is biased, inaccurate and typically wrong.  This includes tv, magazines, and newsletters.  Go to the best sources in the world for your investing information like Warren Buffett, John Bogle, and the authors listed in the recommended reading section, not your uncle, co-worker or friend.  Use sources that aren’t selling anything along with sources that show academic peer reviewed studies to back up their investing information. 

Life insurance is NOT an investment.  It is for insurance purposes only to protect your dependents if you would die.  If you need life insurance, buy term life which is for a death benefit only and inexpensive to purchase.  Avoid most annuities, cash value life insurance, whole life insurance, universal life insurance, etc.  These products are sold as investments with a death benefit, but the return is poor due to high commissions and fees built into the product.  You are better off separating your investing and insurance needs. After your debts are paid and your retirement is fully funded to cover you, your partner or any dependents, it is unlikely you need life insurance.

The Value of Index Investing

A common example of an index would be the Standard & Poor’s 500 (S & P 500). This is a group of the 500 largest publicly traded companies within the U.S. This could also be used as a benchmark to compare investment results. There are many types of mutual funds available and they all have a benchmark that they are compared to. This is how an investor decides if the fund they own is providing superior returns.

The table below shows how many actively managed funds have failed to outperform their respective benchmark or index over three different time horizons; very few have.  For instance, 70% of actively managed domestic funds failed to beat their corresponding index after 1 year and by 10 years it was 89%.  The statistics are even worse if you hold multiple managed funds which is generally the case for most investors.

These funds are managed by professional money managers with large research teams and extensive knowledge of the financial industry.  If they can’t figure it out, what makes anyone think they can trade stocks or time the market?  What’s more incredible is if you own actively managed mutual funds you are typically paying higher fees for lower return.  Passively managed index funds outperform most managed funds.

This report is called the SPIVA (Standard & Poor’s Index vs. Active) U.S. Scorecard Year-End 2019. It is updated several times a year and is available online.

Percentage of U.S. Equity Funds Outperformed by Benchmarks

Fund CategoryComparison Index1yr (%)3yr (%)5yr (%)10yr (%)15yr (%)
All Domestic FundsS&P Composite 150070.0171.9283.2789.3389.10
All Large-Cap FundsS&P 50070.9871.1380.6088.9990.46
All Mid-Cap FundsS&P Mid-Cap 40031.6745.9764.4184.2288.27
All Small-Cap FundsS&P Small-Cap 60038.5061.0277.3788.6189.08
All Multi-Cap FundsS&P Composite 150069.2568.1782.3189.0290.21
Large-Cap Growth FundsS&P 500 Growth33.3342.2860.0089.4692.72
Large-Cap Core FundsS&P 50069.5383.5793.8397.3891.95
Large-Cap Value FundsS&P 500 Value97.2382.2188.9291.8981.41
Mid-Cap Growth FundsS&P Mid-Cap 400 Growth9.3019.2351.2278.2885.71
Mid-Cap Core FundsS&P Mid-Cap 40040.5459.8382.4692.0995.24
Mid-Cap Value FundsS&P Mid-Cap 400 Value65.0078.4388.7188.3093.67
Small-Cap Growth FundsS&P Small-Cap 600 Growth 13.7921.7967.7182.3593.37
Small-Cap Core FundsS&P Small-Cap 60041.3574.7191.3696.7292.35
Small-Cap Value FundsS&P Small-Cap 600 Value80.0082.5792.0496.7792.77
Multi-Cap Growth FundsS&P Composite 1500 Growth45.2459.6075.8187.8091.28
Multi-Cap Core FundsS&P Composite 150074.4588.3894.0193.1291.11
Multi-Cap Values FundsS&P Composite 1500 Value91.8092.1796.0496.3886.96
Real Estate FundsS&P United States REIT26.5854.7663.4181.6183.10
Source: S&P Dow Jones Indices LLC Data as of Dec. 31, 2019

University Endowments

The table below shows the average returns of university endowments (a large pool of donated money that is invested for income to fund university expenses) versus the Bogle model.  The Bogle model is simply a portfolio of 60% stocks owned in a total stock market index fund and 40% bonds owned in a total bond market index fund.  There is no management involved.  The colleges employ sophisticated money managers and teams.  They search for alternative investments and try to maximize their returns.  These people are some of the best and brightest among us.  As you can see, they primarily fail to beat an unmanaged index.  After 10 years the colleges that have the top 10% of performance still fail to outperform this simple portfolio.  The funds used in the Bogle model are available to anyone through Vanguard.  You can outperform these colleges with just two funds.  It’s very simple.  

Bogle ModelAverage Endow.Top Qtr. EndowTop Decile
3 yr6.4%5.2%6.3%6.6%
5 yr6.5%5.4%6.2%6.6%
10 yr6.0%5.0%5.3%5.4%
Source: http://www.marketwatch.com from the blog “A Wealth of Common Sense” by Ben Carlson Data from NACUBO-Commonfund Study of Endowments

Mutual Fund Rankings

The information below shows how the top six managed mutual funds of 2000 fared in 2001.  Many people think they can just find the best performing managed mutual funds and that they will continue to perform, they don’t.  This shows that picking mutual funds is as futile as trying to pick stocks.  When you read a prospectus detailing a mutual funds objectives, all funds use this disclaimer: past performance is not a guarantee of future results.

Top Ranked Mutual Funds 2000Same Mutual Funds Rank 2001
12042
2309
34013
42459
54225
62810

Most Investors Earn Below Average Returns

Over a 20-year period ending 12/31/15, the S&P 500 Index averaged 9.85% a year while the average equity fund investor earned 5.19% according to an annual study called the Quantitative Analysis of Investor Behavior by Dalbar, Inc. The study attempts to measure the impact of investor decisions to buy, sell, and switch into and out of mutual funds.  The poor return is due largely to trying to time the market.  The study shows that many investors would sell when the market was low out of fear and then buy after the market had reached new highs. This is sort of like buying something at regular price and then returning it when it goes on sale; not very profitable.  To be successful, one needs to stay the course and stick to your long-term plan even when the market drastically declines periodically. 

Listed below are some financial terms that describe common investor mistakes.

Recency Bias – People tend to put too much emphasis on recent history.  You have to think long-term and avoid paying attention to short-term market fluctuations.

When advertising the mutual fund industry often fails to track funds that simply closed their doors and transferred their assets to another fund within their company.  This is called “survivorship bias” and it makes their overall returns appear higher than they were.  These funds performance is effectively buried, never to be seen again. According to Mark Hulbert (editor of the Hulbert Financial Digest) in a 2017 article on MarketWatch, only 1 in 20 actively managed mutual funds beats the index when survivorship bias is accounted for. According to an article on Yahoo Finance from a S & P Dow Jones report, of 563 actively managed mutual funds that were in the top quartile of performance in September 2015, only 6.3% of those remained in the top quartile in September of 2017.   Index investing is simpler than trying to pick managed funds and more importantly, it’s more profitable.

The Efficient Market Hypothesis – This is for people who think they can evaluate and pick stocks.  The Efficient Market Hypothesis states that all known information is already priced into the stock, meaning any information you may have to purchase or sell the stock is already known by others in the market and reflected in the price. This theory was developed by Nobel Prize winner in economics, Eugene Fama.

Modern Portfolio Theory – This theory spreads your money around different asset classes (stocks, bonds, international stocks, real estate, and cash) to fit your investment profile while maximizing return and minimizing risk.  How each individual asset class acts at a given time is less important than how the entire portfolio performs as a group.  The average investor doesn’t put much thought into their asset allocation, although it may be the most important decision you make. This theory was developed by Harry Markowitz who won the Nobel Prize in economics for his work.

Chasing performance – Some fund companies advertise they have funds that have beat their market index.  This can look very appealing to investors but when you look a little closer, you will see things aren’t always as they appear.  They use what is called data mining to come up with what appear to be winners.  Let’s say a large mutual fund company has 200 different types of funds that it offers.  In any given year some will surely beat their benchmark index.  The company will then advertise they have a half dozen actively managed funds that outperform.  Historical data suggests they will fail miserably the next year, but only after many investors have piled money into the fund.  As stated in every prospectus, past performance is no guarantee of future results.

Reversion to the mean – Investors tend to buy when stock prices are high and unfortunately sell when prices are low.  If the market is increasing at 20% a year for five consecutive years and the historical return is half of that, at some point the returns are not going to be so good.  Unfortunately, we don’t know when the market will adjust but we can protect ourselves by rebalancing our assets (stocks and bonds, etc.) when appropriate.  What goes up, must come down and vice versa.

Loss aversion – As explained in the book Your Money & Your Brain by Jason Zweig, humans have a tremendous aversion to losing money.  One needs to fight the urge to sell during market volatility.

It is important to thoroughly understand your investments and yourself.  If you sell at the wrong time in a panic, you have destroyed years of investment returns.  The book Your Money & Your Brain explains how we are hardwired in many ways to be bad investors and how to overcome some of those tendencies.

Become a saver and an investor

In order to become financially independent, it is best to do both.  Listed below are 3 scenarios of how each affects the other based on a person or family with an annual income of $60,000.00.

Example #1 – Investor saves 5% ($250.00/month) of their salary and invests in a stock index fund earning 10%.

After 30 years the great investor has $515,728.28.

Example #2 – Saver saves 20% ($1,000.00/month) of their salary and invests it at their local bank and earns 3%.

After 30 years the great saver has $578,715.46.

Example #3 – Saver & investor Saves 20% ($1,000.00/month) of their salary and invests in a stock index fund earning 10%.

After 30 years the saver and investor has $2,062,860.76.

You will notice that the saver (example #2) doesn’t fare much better than the investor (example #1).  The saver (example #2) has to save over four times as much of their own money throughout the 30 years to keep up with the investor (example #1).  The saver and investor (example #3) show that a combination of both saving and investing can provide substantially better returns than just one or the other option.

Dollar Cost Averaging

The above example of the great saver and investor is also a good example of what is called dollar cost averaging. You may be doing this already through your employer retirement plan.  This is saving a fixed amount of money each month and investing it regardless of the share price.  This approach will consistently buy more shares of mutual funds over time when prices are low.  It forces you to buy shares at discounted prices when stocks are low and helps take emotion out of your investing. Here is an example of how it can help.

PurchasePriceShares Bought
Month 1$100.00$15.006.67
Month 2$100.00$5.0020.00
Month 3$100.00$10.0010.00
Total$300.0036.67
Average Share Price $8.18

You will notice that you are saving $100.00 per month but that the share price fluctuates.  Since more shares were bought at the low price of $5.00, the average price paid at $8.18 is lower than the average price of $10.00 for the three months. So, for your $300.00 investment you now have $366.70 which is 36.67 shares X $10.00 per share at the current share price.  This is a simple example, but it shows how your returns may increase over time.                                                                                          

Section Four: What to invest in?

Retirement Plans

The IRS has classifications for retirement plans that are tax advantaged. They are not investments but are simply how your investments are classified by the IRS.  They are assigned to different groups based on the type of work or institution one works for:

  • 401(k) is for private companies employees
  • 403(b) is for non-profits employees
  • 457(b) is for city and state employees
  • TSP is for federal employees
  • SEP is for the self-employed 

Investing in these types of accounts creates a significant advantage in building wealth by either deferring taxes until retirement or by the gains not being taxed. These accounts should be fully funded if possible.

Types of retirement accounts that are tax advantaged

Traditional Individual Retirement Account (IRA)-this is a tax deferred account on your contributions and any earnings while accumulating.  Taxes are paid upon withdraw in retirement.

Roth Individual Retirement Account (IRA)-this is a tax-free account on all gains.  You pay taxes up front on your contributions but pay no further taxes on earnings forever.

Both the Traditional IRA and Roth IRA can be established through an employer (if offered) through one of the classifications listed above like a 401(k). They could also be established on your own, or both, depending on how your personal situation fits into current IRS guidelines.

Types of accounts outside retirement plans

Non-Retirement Accounts-this could be a brokerage account that is set up at Vanguard or one of the other companies mentioned.  This account gives you the option to invest in stocks, bonds and real estate through mutual funds rather than just having a bank savings account. This type of an account may provide some tax advantages as well, Depending on your current tax rate. This is detailed in the tax section.

Investments within these accounts

Mutual funds would be the best choice for most investors. A mutual fund is simply a pool of money from many investors that is invested into different asset classes like stocks, bonds, or real estate. This allows individual investors access to a broad range of investments they many not have access to otherwise. A more detailed definition is within the financial definitions section.

Evaluating your options

When selecting among these options, there are many variables.  If you invest in a company retirement program, do they offer an additional contribution of money?  This is something you want to know and consider.  It is free money.  Typically, they require you to invest the same amount of money they contribute. This is called a match.  Another consideration is to know what your company offers for investments.  Depending on whether your employer offers quality investment choices will affect where and how much money you invest.  If they have poor investment choices you may still want to get the match, so try to find the least expensive, broadest based fund that is offered or possibly a target date retirement fund.  If the choices are poor (high expense fees or front/end load fees) limit your investing within your company plan to the match and consider opening your own IRA outside of your company. If they don’t offer a match and the investment choices are poor you may want to skip the plan altogether and invest outside their plan.  Another consideration is how long you will be with your employer.  Some companies have vesting periods on their retirement matches. A vesting period is a defined amount of time one needs to be with a company in order to get all of the company’s match over that time period. This means if you leave the company before the vesting period, they may reclaim all or part of the money they contributed. This is important information to be aware of.

When deciding whether to invest in a Traditional IRA or Roth IRA, you should consider your tax bracket as well.  Each individual needs to weigh their own situation.  Conventional wisdom suggests that if you are in a low tax bracket, the Roth IRA is a better choice and if you are in a higher tax bracket the Traditional IRA is a better choice.  If you are paying low taxes there is less reason to defer them until later which is why a Roth IRA may be appropriate whereas if you are paying higher taxes the deferral of a Traditional IRA may help more now.  Because we don’t know what future tax rates will be, it’s a guessing game and either choice is better than doing nothing.

If you max out your retirement accounts, and still have the ability to save, you could open a non-retirement account for long-term investing.  In your non-retirement account, you can own the same index funds as within your retirement account.  There is no tax-deferral or tax-free gain on this account, but if you invest long-term (classified by the IRS as over one year) your gains are taxed as capital gains which is typically lower than your personal income tax rate.  Currently, depending on your tax bracket, this could be zero. There is more information on this in the next section.

Your bank or credit union is an option for short-term expenses in your daily life.  Other options for short-term money needs could include money market accounts or short-term bond index funds.  Money market accounts invest in very short-term securities such as government treasury bills.  Short-term Bond Index Funds invest in short-term bonds but can have some minor volatility which means your fund could lose value.   These typically pay above average rates over a local financial institution.  You can easily set up electronic funds transfer online to shift money back and forth as needed. They are not insured like a bank or credit union checking or savings account.  Banks and credit unions also offer money market accounts that are not insured, so when making your deposits it is important to understand what type of account it is if deposit insurance is important to you.

Asset Classes to Invest In – Stocks, Bonds, & Real Estate

Stocks, bonds, and real estate produce income and are the easiest to invest in for a small investor through a low-cost index fund.  They can be purchased with minimal expenses and are easiest to understand.  Good examples would be a Total Stock Market Index Fund, a Total Bond Market Index Fund and a Total Real Estate Index Fund.  By investing this way, you are in effect, buying each of these sectors of the U.S. economy- the ultimate in diversification.

Please keep in mind that these investments are not insured like a bank savings or checking account and there is no guarantee of return.

Stocks

A stock (also known as “shares” or “equity”) is a type of security that signifies proportionate ownership in the issuing corporation. This entitles the stockholder to that proportion of the corporation’s assets and earnings. Source: http://www.investopedia.com In other words you own part of a business.

The best way to invest in stocks is through a total stock market index fund. As mentioned earlier, purchasing individual shares of stocks is risky and those who do it for a living generally underperform those owning an index fund.

Stocks have several advantages over other investments including the highest historical returns when investing long-term and historically returning more than inflation even in periods of high inflation.

Stocks can also have extreme short-term volatility and long periods of sub-par returns. Stocks are not guaranteed or insured whether you own them in an index mutual fund or individually.

Bonds

A bond is a fixed income instrument that represents a loan made by an investor (typically corporate or governmental) to a borrower. A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments. Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations. Owners of bonds are debtholders, or creditors, of the issuer. Bond details include the end date, when the principal of the loan is due to be paid to the bond owner and usually includes the terms for variable or fixed interest payments made by the borrower. Source: http://www.investopedia.com Put simply, you are loaning money in exchange for interest payments.

The best way to invest in bonds is through a total bond market index fund. Investing in this method has historically outperformed cash and is less volatile than stocks helping to reduce volatility in your portfolio (accounts). U. S. government treasury bills and notes are backed by the U.S. government which makes them a safer investment. They would be an exception that could be purchased individually but are also available in funds such as a short-term bond index fund that may invest heavily with them. Money market accounts that are typically thought of as cash may also invest heavily in them.

Purchasing individual bonds much like stocks is not recommended other than U.S. government backed bills or bonds in certain situations. They can be complicated and risky particularly junk, high-yield or long-term bonds whereas the Total Bond Market Index Fund offered through Vanguard only invests in investment-grade intermediate duration bonds. Put simply, they hold bonds within their fund that are less likely to default and be subject to wild valuation swings.

Bond funds work inversely to interest rates so when rates are rising they lose value but when rates are declining the fund will increase in value. Bonds can struggle to keep up with inflation and accounts are not insured or guaranteed.

Real Estate

Real estate is property made up of land and the buildings on it, as well as the natural resources of the land including uncultivated flora and fauna, farmed crops and livestock, water, and any additional mineral deposits. Source: http://www.investopedia.com

A total real estate market index is a good option for people wanting to invest in real estate. This gives the investor broad diversity in residential, commercial and industrial real estate. It also may invest in other real estate related industries such as builders, mortgage companies and home store retailers. Real estate when purchased through an index should be considered part of your stock allocation. Currently the real estate sector is only 4% of the S & P 500 index (largest 500 companies in the U.S.) while the overall real estate market in the U.S. is much larger. This is why many advisors recommend roughly a 10% portion of your stock allocation be devoted to the real estate index. This reflects a closer percentage of the value of real estate assets in the U.S. and adds another layer of diversification to your portfolio (accounts). By owning the index fund you again have broad diversification through every sector of the real estate market. Since 1970 the total real estate market index has returned roughly the same as the total stock market index.

Being a small-time real estate investor can work for some people, but realize it is a business and can be difficult and risky. Real estate is also sold in the form of Real Estate Investment Trusts (REIT). REITs have different formats, investment objectives, and some can be more complicated and illiquid compared to the total real estate market index and not as broadly diversified. Real estate can be volatile as well. A good example is the 2007-2009 housing bubble. As with stocks and bonds these accounts are not insured or guaranteed.

A common misconception in my view is that a personal residence is often described as a real estate investment.  Your home is a place to live, not a great investment. Conventional wisdom describes it as an appreciating asset, but if you track all the expenses attached to it, it probably is more like a depreciating asset.  There are many scenarios where renting may be better financially than owning a home.  There are many considerations when owning a home that are positive such as your quality of life but don’t make the assumption that it’s an automatic winning “financial investment”.  Many times, it’s not. Having said that it does hold financial value that typically increases at the rate of inflation and this could be unlocked if sold. For example, when you have reached an age where you no longer wish to maintain a property, the cash from the sale could be used to pay for future housing whether it be an apartment, condo or senior living center. Another advantage of home ownership under current tax law is that many people when they sell their home will not be taxed on their gains. There are limitations but this is a good deal for those that qualify. There will always be a cost regardless of what housing you choose. Choose what is right for you.

Don’t take my word for it. Here are excerpts from interviews with Robert Shiller. Mr. Shiller is a professor of economics at Yale, along with co-founding the Case-Shiller Housing Index that measures housing prices monthly. He also is a Nobel Prize winner in Economics. He may be the foremost expert on real estate prices in the United States.

Robert Shiller on Bloomberg: Housing is traditionally not viewed as a great investment. It takes maintenance, it depreciates, it goes out of style. All of these are problems. And there’s technical progress in housing. So, the new ones are better…So, why was it considered and investment? That was a fad. That was an idea that took hold in the early 2000’s. And I don’t expect it to come back. Not with the same force. So people might just decide, “yeah, I’ll diversify my portfolio. I’ll live in a rental.” That is a very sensible thing for many people to do. From 1890 to 1990 the appreciation in US housing was just about zero. That amazes people, but it shouldn’t be so amazing because the cost of construction and labor has been going down.

Robert Shiller on Motley Fool: There’s no guarantee that home prices are going to go up. I think we’ve gotten into an illusion about that. We got into an illusion and created this spectacular bubble. We have to reflect now that we had a kind of crazy mind-set in the last couple of decades, and we have to get back to thinking like people used to think. Housing is a depreciating asset, goes out of style; it’s going to end up in the wrong place. People will want to live somewhere else, so it’s not any automatic capital gain.

Cash

Cash is legal tender—currency or coins—that can be used to exchange goods, debt, or services. Cash is also known as money, in physical form. Cash, in a corporate setting, usually includes bank accounts and marketable securities, such as government bonds and banker’s acceptances. Although cash typically refers to money in hand, the term can also be used to indicate money in banking accounts, checks, or any other form of currency that is easily accessible and can be quickly turned into physical cash. Source: http://www.investopedia.com

Cash is generally not thought of as an investment regarding your asset allocation. It should be available for daily transactions and as a buffer for emergencies. By having extra cash on hand, it can keep you from liquidating an investment before you are ready and also avoiding taxes by doing so. Although your cash is not invested one should try to earn as much interest as possible. There are many institutions that offer accounts including your local bank and credit union, online banks, brokerage houses (the same place you hold other investments) as well as different types of accounts including a standard savings account or a money market account. It is important to understand the differences before making your decision.

Cash is 100% stable with no loss of principal when deposited at your local bank or credit union in a savings or checking account by the Federal Deposit Insurance Corporation (FDIC). These types of accounts are insured at a minimum of $250,000.00 and depending on your account structure and family size, your accounts could be insured for substantially more. Money market accounts typically pay a higher rate of interest but are not insured even when sold through a bank or credit union. Another option one can do is to purchase certificates of deposit (CD) that generally have a higher rate of interest for your promise of keeping the money within that institution for a fixed amount of time. Unfortunately, if you need the money before the due date you will be penalized.

Deciding on how much cash to have on hand is an individual decision based on circumstances within your own life. If your cash is not earning the current inflation rate or above, you are in effect losing money. Also, if you do consider cash as an investment, from historical rates of return, you will need to save far more money over your life due to lower returns versus stock or bond investments.

Bottom line, each individual needs to have enough cash on hand to sleep comfortably at night.

Asset classes NOT to invest in

Avoid commodities like gold, oil, bitcoin, etc.  These don’t produce income and are pure speculation. Producing income is important to increasing the value of your assets. If your asset retains its original price, and continues to pay dividends or interest, or appreciates along with the income produced it is a win-win situation. A couple of examples would be dividends paid by stocks, interest payments on bonds or rent paid on real estate. Whereas commodities don’t produce income and you are at the whim of the market (how much someone will pay you at any given point in time) which can be highly speculative. You are guessing that the price will rise but with income producing assets there is less risk over time due to the ongoing income stream.  Warren Buffett in a CNBC interview used a humorous way to describe bitcoin, “Last I checked if I owned bitcoin, no little additional bitcoins would come out.”  This emphasizes he purchases investments that produce an income stream like the investments described earlier.

Historical Returns of Asset Classes 

Value of $1.00 invested in 1802 through 2001 in the United States financial markets before inflation and after inflation:

Before InflationAfter Inflation
Stocks$8.80 million$599,605
Bonds$13,975$952
Cash-Treasury Bill$4,455$304
CPI-Consumer Price Index$14.67$0.07
Gold$14.38$0.98
Source: Stocks for the Long Run by Jeremy J. Siegel Professor of Finance the Wharton School University of Pennsylvania

Stocks are without question the best long-term investment throughout the history of the United States; nothing else compares.  This return is through incredible times of volatility including the Civil War, World Wars, nuclear bombs, presidential assassinations, etc.  The returns have been equal throughout entirely different times in US history including the agricultural era, the industrial era and now the service and tech era. Also note the dramatic effect inflation has on your money. Inflation is discussed in greater detail later in this section.

Why do stocks return more than bonds and bonds more than cash over the long-term?  It’s what’s called the risk premium.  Investors are rewarded due to the risk of each asset class.  For example, if you own stocks you are the owner of a business.  If that business were to fail, any debt is paid first (bonds) and the shareholders (owners) are the last to be paid with any liquidation.  Therefore, shareholders are generally rewarded with a higher return for their investment.

Choosing appropriate investments

Historical returns are approximately 10% for stocks, 5% for bonds and 3.5% for cash.  Investing in the right assets and the right mix (asset allocation) of those assets is important. Based on these historical returns, if you saved and invested $100.00 per month in stocks over 40 years, you would have:

  • $400,000.00 more than if you invested in cash at a bank.
  • $350,000.00 more than if you invested in bonds.

Stocks produced almost 5 times as much as cash. Understanding the risk and reward of each asset class is important.

TimeframeTotal ReturnAnnual ReturnEvent
9/1929-6/1932-81.75%-46.14%Great Depression
9/1929-6/194517.55%1.03%Great Depression & WW II
1/1966-1/1982135.93%5.51%Subpar return for 16 years
1/1982-12/19992027.37%18.61%Amazing return for 18 years
1/1983-3/20173654.34%11.20%My investing lifetime
10/21/1987-20.40%Black Monday 1-day loss
3/2000-3/2003-38.73%-15.07%Internet bubble
3/2000-3/2009-38.55%-5.27%Internet & housing bubble
3/2000-3/2017126.84%4.94%Subpar return for 17 years
3/2009-3/2017269.11%17.73% After housing bubble
9/1929-3/2017208,693.43%9.13%Return since Depression

These time periods show the incredible volatility of the stock market.  There can be long periods of subpar returns as well as long periods of superior returns.  The key is to invest for the long-term and ride out the peaks and valleys.  A good example of long-term investing is my personal investing lifetime from Jan. 1983 – Mar. 2017.  The annual return is 11.20%.  There was an amazing up market followed by two bubbles and the market still provided an excellent overall return.  Also, important to note is after Black Monday in 1987 the market was still up for the year.

Year ending3 Mo T BillUS T BondS&P Return (including dividends)S&P S&P PE Ratio
19283.08%0.84%43.81%24.8617.77
19293.16%4.20%(-8.30%)21.7113.94
19304.55%4.54%(-25.12%)15.9817.00
19312.31%(-2.56%)(-43.84%)8.3013.99
19321.07%8.79%(-8.64%)7.0917.19
19330.96%1.86%49.98%10.5423.73
19340.28%7.96%(-1.19%)9.2616.25
19350.17%4.47%46.74%13.7617.87
19360.17%5.02%31.94%17.5916.75
19370.28%1.38%(-35.34%)11.3110.50
19380.07%4.21%29.28%12.5018.84
19390.05%4.41%(-1.10%)12.3013.23
19400.04%5.40%(-10.67%)10.5510.02
19410.13%(-2.02%)(-12.77%)8.937.97
19420.34%2.29%19.17%10.099.67
19430.38%2.49%25.06%11.8512.65
19440.38%2.58%19.03%13.4914.35
19450.38%3.80%35.82%18.0219.17
19460.38%3.13%(-8.43%)15.2113.46
19470.60%0.92%5.20%14.839.02
19481.05%1.95%5.70%15.366.62
19491.12%4.66%18.30%16.887.22
19501.20%0.43%30.81%21.217.48
19511.52%(-0.30%)23.68%24.199.97
19521.72%2.27%18.15%26.1810.86
19531.89%4.14%(-1.21%)25.4610.09
19540.94%3.29%52.56%35.6012.56
19551.73%(-1.34%)32.60%44.1512.12
19562.63%(-2.26%)7.44%45.4313.34
19573.23%6.80%(-10.46%)41.1212.49
19581.77%(-2.10%)43.72%55.6218.77
19593.39%(-2.65%)12.06%58.0317.12
19602.88%11.64%0.34%59.7218.60
19612.35%2.06%26.64%69.0721.25
19622.77%5.69%(-8.81%)65.0617.66
19633.16%1.68%22.61%76.4518.77
19643.55%3.73%16.42%86.1218.75
19653.95%0.72%12.40%93.3217.81
19664.86%2.91%(-9.97%)84.4515.31
19674.31%(-1.58%)23.80%95.0417.71
19685.34%3.27%10.81%102.0017.65
19696.67%(-5.01%)(-8.24%)90.3115.76
19706.39%16.75%3.56%93.4918.12
19714.33%9.79%14.22%103.3018.01
19724.07%2.82%18.76%118.4018.09
19737.03%3.66%(-14.31%)96.1111.68
19747.83%1.99%(-25.90%)72.568.30
19755.78%3.61%37.00%96.8611.82
19764.97%15.98%23.83%103.8010.41
19775.27%1.29%(-6.98%)90.258.28
19787.19%(-0.78%)6.51%99.717.88
197910.07%0.67%18.52%110.907.39
198011.43%(-2.99%)31.74%133.009.02
198114.03%8.20%(-4.70%)117.307.73
198210.61%32.81%20.42%144.3011.48
19838.61%3.20%22.34%166.4011.52
19849.52%13.73%6.15%171.6010.36
19857.48%25.71%31.24%208.2014.28
19865.98%24.28%18.49%264.5018.01
19875.78%(-4.96%)5.81%250.5014.02
19886.67%8.22%16.54%285.4011.82
19898.11%17.69%31.48%339.9715.13
19907.49%6.24%(-3.06%)325.4915.35
19915.38%15.00%30.23%416.0825.93
19923.43%9.36%7.49%435.2322.50
19933.00%14.21%9.97%472.9921.34
19944.25%(-8.04%)1.33%465.2514.89
19955.49%23.48%37.20%614.4218.08
19965.01%1.43%22.68%766.2219.53
19975.06%9.94%33.10%963.3624.29
19984.78%14.92%28.34%1,248.7732.92
19994.64%(-8.25%)20.89%1,425.5929.04
20005.82%16.66%(-9.03%)1,335.6327.55
20013.39%5.57%(-11.85%)1,140.2146.17
20021.60%15.12%(-21.97%)895.8431.43
20031.01%0.38%28.36%1,132.5222.73
20041.37%4.49%10.74%1,181.4119.99
20053.15%2.87%4.83%1,278.7318.07
20064.73%1.96%15.61%1,424.1617.36
20074.35%10.21%5.48%1,378.7621.46
20081.37%20.10%(-36.55%)865.5870.91
20090.15%(-11.12%)25.94%1,123.5820.70
20100.14%8.46%14.82%1,282.6216.30
20110.05%16.04%2.10%1,300.5814.87
20120.09%2.97%15.89%1,480.4017.03
20130.06%(-9.10%)32.15%1,822.3618.15
20140.03%10.75%13.52%2,028.1820.02
20150.05%1.28%1.38%1,918.6022.18
20160.32%0.69%11.77%2,275.1223.59
20170.93%2.80%21.61%2,789.8024.97
20181.94%(-0.02%)(-4.23%)2,607.3919.60
20191.55%9.64%31.223,278.2023.50 est.
2020
Sources: Annual returns by Aswath Damodaran NYU Stern School of Business, S & P statistics from http://www.multpl.com

Asset Class Volatility

Listed below are the best and worst annual compound returns over each time period listed.  This covers all time periods between 1802-2001.

Holding PeriodStocksBondsCash (T-Bills)
1 year gain66.6%35.1%23.7%
1 year loss-38.6%-21.9%-15.6%
2 year gain41.0%24.7%21.6%
2 year loss-31.6%-15.9%-15.1%
5 year gain26.7%17.7%14.9%
5 year loss-11.0%-10.1%-8.2%
10 year gain16.9%12.4%11.6%
10 year loss-4.1%-5.4%-5.1%
20 year gain12.6%8.8%8.3%
20 year loss1.0%-3.1%-3.0%
30 year gain10.6%7.4%7.6%
30 year loss2.6%-2.0%-1.8%
Source: Stocks for the Long Run by Jeremy J. Siegel Professor of Finance the Wharton School University of Pennsylvania

This is a remarkable table.  After only 5 years, the volatility (loss) between asset classes is almost the same and after 10 years, stocks are less volatile than cash or bonds.  This is contrary to most conventional wisdom.  And as you can see, the returns for stocks are significantly higher on the upside. Over time, volatility (speculation) is washed out of the stock price and it simply reflects the actual earnings of the underlying businesses.

Asset Allocation

Your asset allocation is simply the amount of your investments that is invested into each category such as stocks, bonds, real estate, and cash. This is important in many respects including what return you can expect, overall volatility, amount or risk, etc. This should be evaluated carefully depending on your personal situation. There is more information ahead to help you understand some things to consider.

Asset Allocation Historical Chart

This section will help you decide what percentage of your funds should be in each asset classification based on your goals and risk tolerance.  The returns listed are based on a historical risk return from years 1926-2015. (90 years) They are broken down into three categories used by the financial industry of Income, Balanced, and Growth. Source: http://www.vanguard.com

Income-An income-oriented investor seeks current income with minimal risk to principal, is comfortable with only modest long-term growth of principal, and has a short- to mid-range investment time horizon.                                                                                     

ReturnBestWorstYrs w/loss
100% Bonds5.4%1982-32.6%1969-(-8.1%)14
20% Stocks/80% Bonds6.7%1982-29.8%1931-(-10.1%)12
30% Stocks/70% Bonds7.2%1982-28.4%1931-(-14.2%)14

Balanced-A balanced oriented investor seeks to reduce potential volatility by including income-generating investments in his or her portfolio and accepting moderate growth of principal, is willing to tolerate short-term price fluctuations, and has a mid- to long-range investment time horizon.

ReturnBestWorstYrs w/loss
40% Stocks/60% Bonds7.8%1933-27.9%1931-(-18.4%)16
50% Stocks/50% Bonds8.3%1933-32.3%1931-(-22.5%)17
60% Stocks/40% Bonds8.7%1933-36.7%1931-(-26.6%)21

Growth-A growth-oriented investor seeks to maximize the long-term potential for growth of principal, is willing to tolerate potentially large short-term price fluctuations, and has a long-term time horizon.  Generating income is not a primary goal.

ReturnBestWorstYrs w/loss
70% Stocks/30% Bonds9.1%1933-41.1%1931-(-30.7%)22
80% Stocks/20% Bonds9.5%1933-45.4%1931-(-34.9%)23
100% Stocks10.1%1933-54.2%1931-(-43.1%)25

There is nothing surprising here; the more stocks you own-the higher the return along with higher volatility and more losing years.  By looking at these data, it can help you decide how much volatility you can handle.  You will notice that 1931 and 1933 were the best and worst years as you add more stocks to your portfolio. Many investors probably sold after 1931 because they were afraid of further losses. The market had declined 89% from its peak. I doubt that very many of us could handle that kind of decline.  This is a typical reaction, but the long-term investor that stayed the course had a large rebound in 1933. Unfortunately, the stock market continued to underperform for many years thereafter and although this was easily the worst time to own stocks, this is how to maximize long-term returns by staying the course along with diversification and not locking in permanent losses.  If you sell and try to time the market you will most likely end up with much smaller returns over the long-term.  This is what you must decide.  Can you handle the wild swings in the market?  Making an honest assessment of your personality and your risk tolerance is how you decide to allocate your assets.  It is perfectly fine to invest in less volatile assets but keep in mind your expenses will most likely increase over time and your standard of living may drop.  Your goal with your investments at a base level would be to keep up with inflation (cost of living).

Non-correlated assets can increase return and reduce risk because they don’t typically go up or down at the same time.  This would include stocks, bonds and real estate investment trusts (REITs).  For instance, the bond performance does not correlate highly with the performance of stocks.  This means that bond prices don’t always move in tandem with stock prices.  Real estate in the form of a REIT index can add another layer, along with an international index fund which is explained below.  All of these can be non-correlating assets producing a seesaw affect, which reduces volatility and can increase your returns by rebalancing when one asset class goes up and another goes down. 

An example of rebalancing would be when one asset class grows beyond your preferred percentage of allocation.  Say you wanted stocks at 60% and bonds at 40% of your investments. Your stocks then grow to 70%.  You would then sell 10% of your stock fund and buy 10% more in your bond fund.  This in effect helps you to buy low and sell high and maintains your preferred allocation.  Rebalancing could be done once a year or at a certain percentage of change in your assets like the 10% example listed above.  Rebalancing within retirement accounts doesn’t trigger any tax liability.  After-tax accounts outside of retirement can, so you should always try to work within your retirement accounts when rebalancing.

By owning an international stock index fund you diversify even further which can help lower your overall risk. The United States used to hold a large percentage of the world market, but now owns less than half.  Finance theorists now recommend what is called the “efficient frontier” to calculate the current best mix of markets.  Put simply, the efficient frontier is the sweet spot of risk and reward.  This currently would be approximately a 70% US and 30% International stock allocation of your assets.  This can be achieved easily having just two index funds.  Under current U.S. tax law, any foreign tax paid on a non-retirement account can be used as a tax credit on your overall tax liability.  Retirement accounts however are not eligible for this credit.  You may want to consult a tax advisor for help in deciding which account to place your international fund.  When investing in an International Stock Market Index Fund, read how the index is constructed within the prospectus.  They do vary some depending on the benchmark that they follow.  For instance, Vanguard offers a more diversified index than Schwab or TIAA, so you end up with broader diversification and potentially higher returns.  Vanguard invests in both developed and emerging markets whereas the others listed invest in only developed markets.  This is important information to know regarding your diversification and estimated return as emerging markets have outperformed developed markets historically in spite of being more volatile.  Another option would be to invest in a developed markets index and an emerging markets index separately. From 1970-2001 the International Index achieved a return of 10.86% versus the United States achieving a return of 11.59%.  These returns are before inflation.

When formulating your asset allocation, take into account all of your financial assets.  Write down every investable asset you own including bank accounts, certificates of deposit, stocks, bonds, savings bonds, mutual funds, cash in your mattress; literally all of the money to your name.  This includes retirement accounts in and out of work along with any non-retirement accounts. This doesn’t include non-investable assets like home equity, however. To get an accurate picture you need everything.  This could be time to transfer old work retirement accounts into a personal IRA and condense and consolidate after you have made your allocation decisions. Keep in mind there is no tax liability when rolling over a retirement account, but it has to be done according to IRS rules.  Contact your fund company or a tax advisor if you are unsure how to do this.

Each person has their own unique situation before deciding what asset allocation is right for them and is based on   your age, risk aversion, size of your portfolio (how much money you have) as well as what your personal investing objectives are. Are you barely getting by, do you have far more than you need, are you investing for future generations or charity or do you just want a steady stream of income that is stable? Each person has to make that decision based on what fits their life.  Over time your needs may change, and you should adjust your allocation as necessary. For example, you may want to lower the volatility of your investments.

Inflation 

You can see below there are long periods of time where prices rise faster than cash or bonds perform on average.  This of course is an average and every person will vary within their own purchasing decisions.  Depending on your age, just keep in mind what an item may have cost years ago and what it would cost today.  Take for example an automobile.  An average new car is probably five times as much today as when I was in high school in the 1970s.  Other examples would be the cost of health care, health insurance and a college education.  These have increased at a much higher level than the Consumer Price Index, which is also known as the CPI. The CPI is a measure of the prices of goods and services.

In understanding inflation, it is important to note that our Federal Reserve (the nation’s central bank) has several mandates regarding their operations. One is to keep the inflation rate at 2%. This is tracked by the Consumer Price Index. What this means to you and me is that our government purposely devalues our currency by 2% each year so our money buys less goods and services. The chart below shows that the inflation rate is typically higher than their stated goal. If you invest 100% in cash or bonds, you will struggle to keep pace with the ever-increasing costs in your life. This is why understanding and factoring inflation into your returns is so important.

Why does the Federal Reserve aim for 2% inflation over time?

Low and stable inflation helps the economy operate efficiently. The Federal Open Market Committee (FOMC) judges that an annual increase in inflation of 2 percent is most consistent over the longer run with the Federal Reserve’s mandate for price stability and maximum employment.

When inflation is low and stable, individu­als can hold money without having to worry that high inflation will rapidly erode their purchasing power. Moreover, households and busi­nesses can make more accurate longer-run financial decisions about borrowing and lending and about saving and investment. Longer-term interest rates are also more likely to be moderate when inflation is low and stable.

Over time, a higher inflation rate would reduce the public’s ability to make accurate longer-term economic and financial decisions. However, a lower inflation rate would be associated with an elevated probability of falling into deflation, which means prices and perhaps wages, on average, are falling—a phenomenon associated with very weak economic conditions. Having at least a small level of inflation makes it less likely that the economy will experience harmful deflation if economic conditions weaken. The FOMC implements monetary policy to help maintain an inflation rate of 2 percent over the medium term.

The inflation rate is measured by the annual change in the price index for personal consumption expenditures, an important price measure for consumer spending on goods and services.

Source: http://www.federalreserve.gov

U.S. Inflation Rates by Decade

1913-19199.80%
1920-19290.38%
1930-1939-2.08%
1940-19494.86%
1950-19591.82%
1960-19692.45%
1970-19797.25%
1980-19895.82%
1990-19993.08%
2000-20092.54%
2010-20151.86%
1913-20153.18% long-term average

Investment returns before factoring inflation are called nominal returns whereas returns after inflation are called real returns.  For example, in the 1990s inflation was 3.08%.  If your return was 10% on your investments during the decade that would be your nominal return whereas your real return would be 6.92% by subtracting the inflation rate.  This would reflect the true value of your investments or put another way, what goods and services you could purchase in 1999 like you were able to in 1990.

Index Funds to Own

As noted earlier, the best way to invest is through broad-based low-cost index funds or ETFs.  These can be found through Vanguard, Schwab, Fidelity and TIAA-CREF (University of Iowa Retirement Accounts only) as well as others. Listed below are some good options.

Vanguard

Vanguard is a popular choice among many investors.  They were the company that started the low-cost revolution.  They are investor owned and have no equity shareholders to answer to.  You the customer are the owner of the company.  They have always had low costs across the board.  Several other companies listed below are very competitive and could be used instead of Vanguard depending on your personal situation. 

The Vanguard mutual funds listed below all have $3,000.00 minimums to open an account.  There are no contribution minimums once the account is set up.

  • Total Stock Market Index Fund Admiral Shares (VTSAX) .04% expense
  • Total Bond Market Index Fund Admiral Shares (VBTLX) .05% expense
  • Total Intl. Stock Market Index Fund Admiral Shares (VTIAX) .11% expense
  • Real Estate Index Fund Admiral Shares (VGSLX) .12% expense
  • Short-Term Bond Index Fund Admiral Shares (VBIRX) .07% expense
  • Prime Money Market Fund Investor Shares (VMMXX) .16% expense

Schwab

Schwab offers other index fund options and they have no minimum investment. Here are three examples:

  • Total Stock Market Index Fund (SWTSX) .03 expense; no minimum
  • Total Intl. Stock Market Index Fund (SWISX) .06% expense; no minimum
  • U.S. Aggregate Bond Index Fund (SWAGX) .04% expense; no minimum

Fidelity

Fidelity has lowered prices across the board with many index fund options that have no minimums. Here are a couple:

  • Zero Total Market Index Fund (FZROX) .00% expense; no minimum
  • Zero Intl. Index Fund (FZILX) .00% expense; no minimum

TIAA-CREF (Option for University of Iowa employees)

TIAA also offers many Vanguard Funds through the University of Iowa Retirement Plan.  It is easy to construct a low-cost index investment plan.  If you are not in the University of Iowa Retirement Plan the expenses on their index funds are much higher and they are not the best option to invest with.

The funds and their expenses listed below are within the University of Iowa retirement plan.  Any of these fund choices below would be satisfactory.  The funds all have low fees and the differences are negligible.

  • Total Stock Market Index Institutional Fund (TIEIX) .05% expense
  • Total Intl. Stock Market Index Fund Institutional (TCIEX) .06% expense

Lazy Portfolios

Lazy portfolios are investment plans devised by some of the smartest financial authors, planners, and managers who are advocates of index investing.  They vary from using two funds to as many as eight funds, but they all have one thing in common- they are invested in low-cost index funds and are simple and easy to manage.  These portfolios give you a great example of how easy investing can be with examples by experts in the field.  The creators of the lazy portfolios along with their credentials are listed below. There is also a link to the actual portfolios on the Boglehead’s webpage- https://www.bogleheads.org/wiki/Lazy_portfolios .  This website is a sharing website on personal finance and investing and is a great source for information.

Rick Ferri – creator of Two Fund, Three Fund and Core Four Portfolio

  • Master of Science in Finance
  • CFA (Chartered Financial Analyst)
  • Authored 6 books on investing- Including All About Index Funds, All About Asset Allocation, Bogleheads Guide to Retirement Planning, The Power of Passive Investing, etc.
  • Forbes.com and Wall Street Journal columnist

Taylor Larimore – creator of Three Fund Portfolio

  • Authored 3 books on investing-Including the Boglehead’s Guide to Investing, The Boglehead’s Guide to Retirement Planning, and The Boglehead’s Guide to the Three-Fund Portfolio.
  • Honored by Money Magazine as Champion for the Small Investor

Scott Burns – creator of Couch Potato Portfolio

  • Graduate of Massachusetts Institute of Technology
  • Nationally syndicated financial columnist
  • Co-Founder of the website Asset Builder which advocates using index funds over stock picking through his “Couch Potato Portfolio.”
  • Author of many books including Reinventing Retirement Income in America, The Coming Generational Storm, and Spend ’til the End

Andrew Tobias – creator of Three Fund Portfolio

  • Graduate of Harvard University
  • Authored the Only Investment Guide You’ll Ever Need, Money Angles, and The Funny Money Game among others.

Bill Schultheis – creator of the Coffeehouse Portfolio

  • Fee-Only Financial Advisor
  • Wrote a syndicated investment column for 8 years
  • NPR contributor on personal finance
  • Author of The Coffeehouse Investor: How to Build Wealth, Ignore Wall Street, and Get On With Your Life.

William Bernstein – creator of the Coward’s Portfolio

  • Neurologist, Professor and Financial Theorist
  • Founder of the Coward’s Portfolio which argues against anyone’s ability to pick stocks or time the market, showing that asset allocation is more important.
  • Author of The Intelligent Asset Allocator, The Four Pillars of Investing, The Investor’s Manifesto and Rational Expectations among others.

Frank Armstrong III – creator of the Ideal Index Portfolio

  • Certified Financial Planner, Accredited Investment Fiduciary Analyst
  • Contributor to The New York Times, CNN, Wall Street Journal, The New Yorker
  • Author of The Informed Investor, Investment Strategies for the 21st Century, The Retirement Challenge, Will you Sink or Swim?, and Save Your Retirement.

David Swenson – creator of the Lazy Portfolio

  • PhD in Economics from Yale University
  • Chief Investment Officer of the Yale University Endowment since 1985
  • Author of Unconventional Success which is an investment guide for the individual investor.

I listed their credentials to show you that some really smart people believe in index investing.  They don’t try to beat the market but simply to match it with the lowest cost expenses. Just doing this with as few as two funds puts you well ahead of the majority of investors including professional money managers.

If that’s not enough, listed below are quotes from Nobel Prize winning economists regarding index investing:

Eugene Fama: “Whether you decide to tilt toward value depends on whether you are willing to bear the associated risk…The market portfolio is always efficient…For most people, the market portfolio is the most sensible decision.”

Harry Markowitz: “A foolish attempt to beat the market and get rich quickly will make one’s broker rich and oneself much less so.”

Paul Samuelson: “The most efficient way to diversify a stock portfolio is with a low-fee index fund. Statistically, a broadly based stock index fund will outperform most actively managed equity portfolios.”

William Sharpe: “You may think your opinion is superior, but it pays to be humble, investing in the market rather than trying to beat it.”

Robert Shiller: “A portfolio approximating the market may be the most important portfolio.”
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If you look at the lazy portfolios listed above you will notice the different indexes that are used. The table below shows the annualized returns of various indexes. They include stocks and bonds that are broken down between domestic and international along with small-cap, large-cap, value, growth, developed markets, emerging markets, etc. The Total Market Index is in bold print as a reference to compare returns. The 90 year return (last column) is in descending order of highest to lowest return long-term. It is possible to enhance your overall return by adding small amounts of these indexes like the lazy portfolios.

Over the last decade large company and growth stocks have been in favor but you will notice historically that small company and value stocks have outperformed. This is counterintuitive to most people. You will also notice regarding the international part of your portfolio that emerging markets have outperformed and when you combine small and value with emerging markets the return is even higher. Just 1% of additional return to the 90 year market return of 9.71% making it 10.71%, you would increase your return from $4,189,472.61 to $9,480,179.69 based on a $1,000.00 investment with no additional contributions. Unfortunately, when adding more concentrated indexes your risk is increased as well. Emerging markets and small cap stocks can be volatile with extreme downswings. Before considering adding a small percentage of these indexes to your portfolio realize the risk involved. Of the lazy portfolios that use these various indexes, it is a small percentage of their portfolio and part of a larger diversification plan.

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Indexes2017 (1 yr)2013-2017 (5 yr)2008-2017 (10 yr)1998-2017(20 yr)1968-2017 (50 yr)1928-2017 (90 yr)
ES IFA Emerging Markets Small35.26%6.83%4.71%12.16%15.89%13.94%
EV IFA Emerging Markets Value33.76%3.67%1.40%11.34%15.85%13.89%
ISV IFA International Small Value27.98%12.57%5.77%10.86%14.53%13.16%
SV IFA U.S. Small Value9.59%14.05%9.28%10.64%13.59%12.64%
EM IFA Emerging Markets36.57%4.18%2.53%9.06%14.52%12.64%
IS IFA International Small Company30.24%11.75%5.64%9.88%13.27%12.50%
SC IFA U.S. Small Cap11.52%14.63%9.97%9.49%11.16%11.33%
IV IFA International Value26.09%7.96%1.64%7.18%11.38%10.89%
IFA Real Estate9.20%7.92%6.19%8.49%10.27%10.85%
IFA U.S. Large Value18.97%16.09%8.73%8.80%12.38%10.68%
N Nasdaq32.99%20.71%11.30%8.30%8.83%9.71%
TM IFA Total Market Index21.18%15.56%8.73%7.54%10.13%9.71%
LC U.S. Large Company21.77%15.72%8.49%7.13%9.96%9.50%
SG IFA Small Growth Index21.91%13.59%9.40%9.20%7.88%9.11%
IC IFA International Large Company25.37%7.52%2.18%5.35%8.50%8.67%
LG IFA Large Growth Index27.82%16.08%9.53%7.37%8.94%8.36%
CB Long-Term Corporate Bonds12.25%5.26%7.83%7.26%8.22%6.03%
GB Long-Term Government Bonds6.24%3.16%6.12%6.69%7.85%5.48%
5F IFA Five Year Global1.97%1.53%3.04%4.08%6.49%4.76%
3G IFA Five Year Government0.51%0.66%2.23%3.61%6.30%4.66%
2F IFA Two Year Global0.93%0.61%1.27%2.77%5.84%4.43%
1F IFA One Year Fixed0.94%0.54%1.13%2.62%5.68%3.79%
1T One-Month Treasury Bills0.80%0.21%0.30%1.91%4.80%3.36%
CPI U.S. Consumer Price Index2.11%1.43%1.61%2.14%4.05%3.00%
Source: http://www.ifabt.com Index Fund Advisors

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There are other good options as well that require even less work.  All major fund companies offer Target Date Retirement Funds.  These funds are set up by your estimated retirement date, i.e.  2030, 2035, 2040, 2045.  The further you are from retirement or the younger you are, the higher percentage of stocks would exist in the fund.  As you age, the fund automatically rebalances its assets from stocks to bonds. The fund company does the work for you.  If you choose to purchase Target Date Funds, please remember that the fund company should be investing in total market index funds within the Target Date Fund and that low fees are important. Evaluate these funds like any other fund you would review. 

Keep in mind you can invest yourself with a minimal amount of time spent (lazy portfolios) and is generally cheaper. Also, you can adjust your asset allocation to fit with all of your investments including non-retirement accounts rather easily.  Either option is satisfactory.

Create a Long-Term Plan  

Decide what you are investing for.  Every individual has a different situation regarding what they are investing for.  There are many variables including age, income, net worth, etc.  Investing for a person with limited resources and no heirs would be entirely different than a high net worth individual who has many resources and is in effect investing for their heirs.

Take into account your time horizon- it may be longer than you think.  If you are investing at age 25 and live to be 90, you time horizon is 65 years.  Your asset allocation may change as you age, but it is a long time period.  Even if you are 65, you are still looking at potentially a 30 year or longer investing timeframe.  Taking it a step further, if you have far more money than you need to live on, you may be investing for your grandchildren and that timeframe could be 60 years or longer.  This is important to think about when deciding on your asset allocation.

When creating your long-term plan keep in mind that money needed within 5 to 10 years should be invested in some form of cash, such as a bank or credit union, money market account or short-term bond index fund.

Investment Policy Statement

Once you have decided on your investing plan and asset allocation you might consider writing an Investment Policy Statement.  This is a simple written account of what your intentions are.  This can help keep you on track and also help your spouse or family understand exactly how you are invested and why.  Become an investor, not a trader or speculator.  Think long-term.

Section Five: Taxes and Your Investments

John Bogle conducted a study that illustrated how devastating the tax bite can be for actively managed funds.  Over a 16-year period, Bogle concluded that investors kept only 47% of the cumulative return of the average actively managed stock fund.  Indexes kept 87%.  Source:  Daniel R. Solin, The Smartest Retirement Book You’ll Ever Read

According to Kent Smetters, a finance professor at the University of Pennsylvania, 97% of actively managed taxable funds fail to beat their benchmark index.  If they are one of the fortunate 3% to accomplish that goal, they have less than a 20% chance of doing it again.  Source:  University of Pennsylvania Wharton School Radio podcast www.kentonmoney.com

Taxes and Retirement Accounts

The most important thing you can do for long-term investing returns is to max out your tax advantaged retirement accounts.  By deferring taxes now in a Traditional IRA or eliminating all future taxes on gains with a Roth IRA you will increase your returns dramatically.  Depending on your employment situation and income, you may be able to invest in your employment retirement plan and an outside Roth IRA.  When you start to withdraw your retirement account investments, you will be taxed at your ordinary income tax rate for that year with traditional IRAs and you are not taxed on any Roth IRA gains.

Taxes and Non-Retirement Accounts

If you are able to max out your retirement accounts and have the ability to save more, one option is to invest in index funds similar to your retirement account.  Unfortunately, there will be no tax deferral or tax-free gains, but there are some potential tax advantages for stock funds.  If your investments are held for over 1 year, your gains currently are taxed as long-term capital gains rather than investments held for less than 1 year that are taxed as short-term capital gains.  Depending on your tax bracket you could pay as little as 0% federal taxes when you withdraw funds held for at least 1 year.  Short-term capital gains (funds withdrawn in less than a year of purchase) are taxed at your ordinary income tax rate.

Index funds do minimal trading which is called low turnover in the financial industry. Therefore, they incur very few short-term gains each year. Index funds can have some gains that are taxed but it is generally small and is due to companies either leaving or being added to the index. In fact, most of your appreciation over time ends up being tax deferred as you are only taxed when you sell shares.  This is an important point to remember when you look at returns of mutual funds. 

If an actively managed fund is trading investments constantly in attempts to beat the market index, the tax liability could be substantial as shown above by John Bogle’s study. So, the return that they advertise isn’t necessarily your real return. This again makes the case for investing in market based low cost index funds.

Non-Stock Investments

It is best to hold your bond and real estate funds in your retirement accounts.  They both produce dividends that are currently taxed as ordinary income.  Stocks are taxed at the typically lower capital gains tax rate.  They can be a better option for your non-retirement account. This can be accomplished by dividing your overall asset allocation between retirement and non-retirement accounts.

Interest earned on your cash is taxed at your ordinary income tax rate.  This is historically the lowest returning asset class along with potentially being at the highest tax rate of your investments.

Summary

Depending on your personal situation a CPA (Certified Public Accountant) may be advisable.

Be aware of federal and state taxes.  Taxes may well be the biggest expense in your life.  Know your rates and work to take advantage of all existing tax laws. Be aware of your options to decrease them.

Be in the right types of accounts as you acquire wealth.  Wealthy people tend to have more capital gains and less ordinary income due to their investments.  You have the same options- take advantage of it and pay less in taxes.

Section Six: Personal Freedom

There are many things in life to save for including marriage, children, college, housing, travel, etc. I believe first and foremost your personal freedom/retirement should be funded as soon as you have paid off debt and established an emergency fund.  You may have health issues as you age or difficulty working for a variety of reasons, which may leave you only with Social Security income and potentially a diminished standard of living.  Taking control of your financial life will help you live “your life” on “your terms”.  This section shows you a simple way to calculate how much you need to save for personal freedom/retirement.

How much of my gross income do I need to save?  

The short answer is a minimum 15% of your gross income.  This percentage is based on historical norms, should achieve the equivalent of your current income in 40 years (a typical career length). This means it is inflation adjusted and your living standard could remain the same.  Here is an example using $60,000.00 gross income which is the average family income in America today:

  • Save $750.00/month for 40 years at 6.7% return. Your total would be $1,713,982.00

  • Your yearly income in 40 years is $68,559.00 (4% annual withdrawal rate of $1,713,982.00)

The example above uses the assumption of a 6.7% return, which is the inflation adjusted historical Total Stock Market Index Return.  The before inflation return is closer to 10% but by using the inflation adjusted return, it shows the totals in today’s dollars, meaning a more accurate portrayal of what your money may be worth in the future. 

Your return will differ depending on your asset allocation. Say, if you were invested in a Total Stock Market Index at 60% of your assets and 40% in a Total Bond Market Index.  This allocation would most likely generate a lower return which would require a higher savings rate to come up with same numbers as above.

The 4% withdraw rate is based on numerous studies that have shown if at least 50% of your assets are invested in a Total Stock Market Index Fund at a low cost in retirement, you have a high probability of your assets lasting at least 30 years in retirement.  This is with a couple of important things to remember:

  • it has to be a low-cost index fund
  • you have to have at least 50% of your assets invested in the Total Stock Market Index at a low cost. 

If these two guidelines are not followed, it changes dramatically.  The study also includes an inflation adjustment of approximately 3% each year to build into your calculations.  In other words, you give yourself a raise to keep your standard of living the same.  Source:  Trinity University Study 1998 updated 2009 

Your withdraw rate should be flexible.  You may be able to withdraw more if your investment returns are favorable, but the opposite is also true.  If the markets are down for an extended period, you may need to lower your withdraw percentage.  Noted financial expert William Bernstein prefers a maximum withdrawal of 3% whereas J. L. Collins sees higher rates as possible when markets are up.  Just remember- it’s not about spending every dollar before you die.  It’s about living a comfortable stress-free life while you are here.  

An example of needing to be flexible on withdrawal rates can be explained by looking at two portfolios with the same return rate but in different time periods.  They both start with $1,000,000.00 and plan on withdrawing $75,000.00 annually. The first portfolio is from 1954-1983, the second from 1973-2002.  During both 30-year time periods the market returned approximately 12% but there are vastly different results.  The first portfolio ended up with over $7,000,000.00 at the end of 30 years.  The second portfolio ran out of money after 16 years.  The difference is in the first two years.  The first portfolio was up 52.6% and 31.6%, the second portfolio was down -14.66% and -26.47% respectively each of the first two years.  On the surface it would seem withdrawing 7% annually when the market is returning 12% over a set time period would be no problem, but returns aren’t even.   It is important to keep your expenses low and your income flexible to avoid withdrawing money if possible during down markets.  It helps to keep a couple of years of living expenses in non-volatile investments to ride out market downturns.  Source: The Simple Path to Wealth by J. L. Collins

There are many online calculators for estimating your withdrawal rate.  This calculation is called a Monte Carlo simulation.  These calculators estimate 5000 different market scenarios.  These include up and down markets of various lengths, intensities, and combinations.  It then tells you what your odds are of having enough money for a defined amount of time, say 30 years.  One online calculate is available at https://retirementplans.vanguard.com/VGApp/pe/pubeducation/calculators/RetirementNestEggCalc.jsf

Keep in mind if you are paying an advisor 1% a year to manage your investments and you are withdrawing 4% of your assets, they are taking 25% of your income during retirement.  Let that sink in a minute!  This is another reason to know exactly what fees are being paid on your investments. 

Defined Benefit and Defined Contribution Plans

These are names of retirement plans and it is important to understand the difference as it pertains to your investing.  

Defined Benefit Plan – this is a plan that is quickly disappearing.  It is a plan where your employer guarantees you an income for life after retirement through a pension that they manage for you.  At their peak, these plans covered almost 50% of private sector workers but today it is less than 10%.  

Defined Contribution Plan – this is the plan you are most likely in today with your employer.  The responsibility for managing the account along with making contributions has shifted to you.  This would be your 401(k) or for non-profits the 403(b). 

You may long for the “good old days” but they are not coming back, and I prefer to look at this as an opportunity.  Having shown that most money managers fail to perform at an average market level and charge excessive fees, you will probably end up with more money doing it yourself.  If that hasn’t convinced you, take a look at some recent headlines from the past few years below.  Do you want them managing your money?

Pension Newspaper Headlines:

  • America’s Pension Bomb:  Illinois Is Just the Start
  • IPERS’ Unfunded Liability Nears $5.6 Billion
  • UPS to Freeze Pensions for 70,000 Nonunion Workers
  • Expert Warns of IPERS Future
  • IPERS:  Pension Thefts May Be Linked to Database

“The typical pension plan is invested in the market, with the belief that those stocks and bonds will produce a certain return over time.  The plan issuers-say, state or local governments or corporations-have the responsibility to make good on their obligation to you.  But you always have to worry indirectly, because you don’t know for sure if those promises will be kept. – Jack Bogle, founder of Vanguard in AARP interview with Jack Otter

“Our employer-based savings system is a mess.  Everywhere you look, you see mismanagement, malfeasance, and meltdown…This situation didn’t happen by accident.  The federal government, with its own $11 trillion unfunded Social Security liability, has condoned the underfunding of private pensions for decades.” – Laurence J. Kotlikoff, professor of economics at Boston University

The above quotes aren’t meant to instill fear but to show that even if someone else is investing for you, they are investing in similar investments as you would be on your own, only charging more and returning less.  Understanding where the money is coming from, going to, how and where it is invested, and how much you are being charged is a much better situation for you.  

The information above doesn’t include your estimated social security payment which of course can and should be used to plan your future.  This is the focus of the next segment.

Section Seven: Social Security

This is a very important program to many people, but I believe isn’t completely understood.  It isn’t just a retirement pension, it’s more like an insurance program to protect you and your family in different ways.  It can be complicated, and it is important to review it thoroughly before taking any benefits.  

Many people believe that Social Security won’t exist when they are eligible for benefits but in my view that is highly unlikely.  Currently, if Congress doesn’t act, sometime in the 2030’s the system will only be able to pay out 77% of benefits.  This program is too important for many citizens and I would be surprised if no action was taken to keep it solvent.  This may be an increase in retirement age, increase in taxes, decrease in benefits or a combination of all of the above.

Social Security is funded through a payroll deduction for every working citizen. Currently, your contribution is 6.2% along with another 6.2% from your employer. If you are self-employed you contribute 12.4%. This deduction currently applies to income up to $137,700.00.  One way to think of this is a 6.2% match from your employer towards a lifetime pension to protect you in old age. This could be higher than the match you’re receiving with your current employer retirement program.

Social Security Website

http://www.ssa.gov – If you haven’t already done so, open up your personal account at this website.  It will show your estimated benefits, work earnings history and provide calculators for estimating different payout scenarios.  Make sure you check your work earnings history for accuracy and notify Social Security of any correction.  Your benefit could be negatively affected with incorrect or incomplete information.

Social Security Benefits

Social Security provides retirement benefits, disability benefits, death benefits, and survivor benefits.  These are provided in a myriad of ways.  Married spouses with no work history, divorced spouses, spouses and children of the deceased may be eligible for your benefits, depending on the scenario.  The rules can be quite complex, and it is important to review your options thoroughly before taking any benefits.  Some benefits can be taken and then changed to a different benefit later while others can’t be changed.  If you make the wrong decision it could cost you thousands of dollars in missed benefits.  Review all benefits offered to make sure you aren’t missing out on any that you are eligible for.

Here is an example of benefits that are listed on a Social Security Statement.  Your personal benefits will vary depending on your work history and income.

  • $2484/month:  at full retirement age (FRA)   
  • $3225/month: at age 70  
  • $1905/month: at age 62
  • $2472/month: if disabled

Family benefits– If you receive retirement or disability benefits, your spouse and children may also qualify for benefits:

  • Survivors – Your child $1856 a month

  • Survivors – Your spouse who is caring for a child $1856 a month
  • Survivors – Your spouse, if benefits start at full retirement age $2475 a month
  • Survivors – total family benefits cannot be more than $4332 a month

When you contact Social Security for information, be very careful with the information that is given to you.  To quote Social Security: “They don’t give advice, they provide information.”  Unfortunately, due to the complexity of the program you may receive incorrect information from Social Security’s own personnel according to the book Get What’s Yours for Social Security.  Before, applying for any benefit, it is important to get multiple opinions and thoroughly research what you are doing.  Social Security has many rules which aren’t necessarily clear. These include paying retroactively back six months when you file for benefits which could lower your benefits permanently due to a reduced age at application.  They may also automatically deem (this is social security lingo for permanently deciding your benefits) you into your highest current benefit when in fact that may not be the best situation for you.  Another potential pitfall is collecting your benefit at age 62 or any time before your full retirement age (FRA) and continuing to work.  You may be penalized if your income is above certain social security thresholds.  Making the wrong decision could cost you thousands of dollars in benefits and possible leave your spouse or family with lower benefits.  

If you turned 62 before January 1st, 2016 you are eligible for some benefits that have been eliminated by an update in the Social Security regulations.  Understanding this can substantially add to your benefits in certain situations.

The book Get What’s Yours for Social Security is the most detailed book on Social Security that I have seen.  It would be worth reading the latest edition before filing for any benefits.  One of the authors, Laurence J. Kotlikoff, has a website called maximize my social security.  There is a link in the recommended resources section.  This website will help you decide when to take benefits and which benefits to take.  There is a charge for the service, but Professor Kotlikoff is one of the foremost experts on Social Security in our country and if you are unsure it is a small price to pay for what could be millions of dollars in benefits for you and your family. 

Social Security Retirement Benefits

This is the benefit that most citizens become eligible for at age 62.  It is critical to understand how the system works regarding payouts as you age.  There are hundreds of thousands of dollars at stake.  Waiting for your FRA (currently between 65 and 67 depending on the year you were born) will increase your payout 6-7% annually plus an inflation adjustment.  From your FRA until age 70, your payout increases by 8% annually plus the inflation adjustment.  Put simply, if you wait until age 70 you will receive benefits worth 76% more than age 62.  The investment return generated is excellent.  Yes, I called it an investment return and it’s guaranteed.  Many people reason that taking the money as soon as possible is their best scenario for them but there are a number of things to consider.  If you are unable to work and have limited resources or if you have a family medical history of a short lifespan might be reasons to consider taking your benefits immediately. For most individuals, waiting to take benefits for as long as possible is the best course of action.  There is no additional benefit for waiting past age 70, so it is important to file then so no Social Security benefits will be missed.

Listed below is a table showing a real-life example of some different ways to examine your benefits.  I have said there are thousands of dollars at stake and this table shows that.  Spouse #1 would be 66 years 4 months at FRA and Spouse #2 would be 67 years at full retirement age (FRA).  Spouse #1 is 6 years older than Spouse #2.  This table shows their social security payouts at combinations of ages 62, FRA, and 70 for starting their benefits.  It shows the monthly and annual payouts along with totals when this couple reaches age 90 and 84 along with 95 and 89.  According to Social Security shown on their actuarial tables the average 65-year-old male in 2016 will live to be 83 and the average female will live to be 85.  According to the Society of Actuaries the average is higher at 87 and 89 respectively.  These are just averages, there is a chance you may live longer.

MonthlyAnnual90/8495/89
Spouse #1 Age 62$1,874$22,488$629,664$742,104
Spouse #2 Age 62$1,657$19,884$437,448$536,868
Total$3,531$42,372$1,067,112$1,278,972
Spouse #1 FRA$2,484$29,808$700,488$849,528
Spouse #2 Age 62$1,657$19,884$437,448$536,868
Total$4,141$49,692$1,137,896$1,386,396
Spouse #1 Age 70$3,225$38,700$774,000$967,500
Spouse #2 Age 62$1,657$19,884$437,448$536,868
Total$4,882$58,584$1,211,448$1,504,368
Spouse #1 FRA$2,484$29,808$700,488$849,528
Spouse #2 FRA$2,353$28,236$480,012$621,192
Total$4,837$58,044$1,180,500$1,470,720
Spouse #1 Age 70$3,225$38,700$774,000$967,500
Spouse #2 FRA$2,353$28,236$480,012$621,192
Total$5,578$66,936$1,254,012$1,588,692
Spouse #1 Age 70$3,225$38,700$774,000$967,500
Spouse #2 Age 70$2,918$35,016$490,224$665,304
Total$6,143$73,716$1,264,224$1,632,804
Spouse #1 Age 62$1,874$22,488$629,664$742,104
Spouse #2 FRA$2,353$28,236$480,012$621,192
Total$4,227$50,724$1,109,676$1,363,296
Spouse #1 Age 62$1,874$22,488$629,664$742,104
Spouse #2 Age 70$2,918$35,016$490,224$665,304
Total$4,792$57,504$1,119,888$1,407,408

Let’s assume that this couple is in good health and has no known family medical history that may shorten their lifespan.  If they live to be 95 and 89 and hold off taking their benefits until they are both 70 rather than both taking them immediately at age 62, they will receive an additional $353,832 in benefits.  If they live to be 90 and 84 they will still receive an additional $197,112 in benefits.  This is significant for most people.  Another example is Spouse #1 waiting until 70 and Spouse #2 taking their benefit at age 62.  They still end up with $225,396 in additional benefits then if they both started at age 62 and by doing this if Spouse #1 passes away prematurely, the Social Security Administration then allows Spouse #2 to take over the larger benefit and is protected long term. 

Previously, I mentioned that Social Security could be viewed as an investment.  A good way to look at this is based on the 4% withdrawal rule mentioned in the Personal Freedom Section.  If both spouses wait until 70 to claim their benefits the total annual benefit is $73,716.  Using the 4% rule, that would be the equivalent of another $1,842,900 in savings.  In other words, $73,716 is 4% of the $1,842,900.  Also, the 6 to 8% return plus inflation by waiting each additional year is an outstanding return that you may not achieve with your own investment accounts.  It may seem counterintuitive, but it could be wise depending on your own situation to spend down some of your savings instead of claiming benefits early.  

These are just a couple of examples and there are many variables to look at before taking benefits.

Section Eight: Wealth in America

It’s not what you think.  A book entitled Stop Acting Rich! by William J. Stanley (author of The Millionaire Next Door) influenced me to add this section.  It is important to debunk commonly held assumptions about wealth in America.  These assumptions are what keep most people from achieving their financial goals.  By exposing these “myths” you will realize that you can achieve some wealth. 

When you follow the “actual” behaviors of millionaires you will notice two things:

  • They didn’t start out much different than you
  • They are frugal with their money regarding material possessions.  

Another book just released titled Everyday Millionaires by Chris Hogan reinforces these ideas even more with a sampling of over 10,000 millionaires surveyed.

How does your wealth measure up to others: 

Wealth Percentile          Net Worth

  • 90%                                    $1,182,390.36
  • 50%                                    $97,225.55
  • 20%                                    $4,798.06
  • 10%                                   (-$962.66)

This table shows how few people are wealthy in spite of the fact it’s not that hard.  If you have managed to scrape together $5,000.00, you are ahead of 20% of the population.  It appears that as a country, we spend everything we make and then some.  Don’t buy into the culture, buy your freedom.

Taxes paid by the wealthy

In 2012, the top 50% of all taxpayers (69.2m filers) paid 97.2% of all income taxes while the bottom 90% (124.5m filers) paid the remaining 2.8%.

The top 1% (1.3m filers) paid a greater share of income taxes (37.8%) than the bottom 90% (124.5m filers) combined (30.2%).

The top 1% of taxpayers paid a higher effective income tax rate than any other group, at 27.1%, which is over 8 times higher than taxpayers in the bottom 50% (3.3%).  

Source:  http://www.irs.gov

This information may surprise you, but it would appear the high-income earners in this country do in fact pay a substantial amount of income tax.  One tax law they take advantage of is paying less tax on their long-term investments by holding them for over a year and not trading or selling.  This same advantage is available to you and may even be lower rates than the wealthy can receive.  Currently if you are in the lowest two income tax brackets you would pay no taxes on your gains!

Habits of the Wealthy

  • They live well below their means.
  • They allocate their time, energy, and money efficiently.
  • The believe that financial independence is more important than displaying high social status.
  • Their parents didn’t provide economic outpatient care.
  • Their adult children are economically self-sufficient.

Source:  The Millionaire Next Door by Thomas Stanley& William Danko

Again, probably surprising information to some people.  The images that we see of “rich” people does not match up with reality.  According to most of the, you wouldn’t even have any idea who they are by appearance.  Chances are, the people you assume are wealthy through their use of material items such as clothes, cars, jewelry, large homes, expensive vacations, etc. are not.  

You might say that millionaires practice “simple living.”