Tuesday, August 30, 2011

Debunking Financial Myths

I came across an interesting and informative article the other day - "10 Financial Myths Debunked". An especially relevant myth is assuming long-term average stock market rates of return of 8 percent as are certain rules of thumb when planning for retirement. 

Point 4 is relevant because most people are way too optimistic when it comes to calculating potential rates of return during retirement planning. From a young age, it pays to err on the side of caution and assume anywhere from a 5-7% long-term rate of return on your portfolio. If you have the time, use a financial calculator to plug in your current investments, time horizon and potential rates of return from 5-7% and see where you end up during the year you plan to retire. By assuming a smaller potential return, you will be able to set up the best possible plan to reach your goals and ensure that your investments don't overpromise and underdeliver.

It's also worth noting that "rules of thumb" in the investment world are rarely worth the paper they're printed on because each person is different and the world is not static. Since the world we live in today will be drastically different than the world we will live in 40 years from now, it's not worth prescribing to certain rules that simply can't change with the times. For example, it's impossible to tell what type of health we will be in, what our family situation will be like and how the world will really be so far into the future. Thus, we should plan our investments out based on our own goals and risk tolerances, while avoiding "catch all" rules of thumb that don't accomplish much.

Saturday, August 20, 2011

Navigating Your 401(k)

As a new entrant into the working world, I was recently faced with the task of figuring out what my 401(k) options were and deciding on an asset allocation appropriate for my age. Asset allocation decisions are such that if you ask 50 different experts for opinions on what an appropriate asset allocation is for a 22 year old, you are going to receive 50 different answers. The key in deciding on an appropriate allocation in your 401(k) is to take advantage of the opportunities you have as a young investor. 

First and foremost, I cannot stress enough the importance of maxing out your 401(k) contributions each paycheck while you are young. While preparing a monthly budget, you should decide on a pre-tax contribution percentage that will enable you to achieve maximum savings while at the same time ensuring you are not cash poor when all is said and done. For example, if you earn roughly $2,000 a paycheck and contribute 10% of your pre-tax pay to your 401(k) then that's an automatic $200 investment every paycheck. If you get paid twice a month, this adds up to $4,800 a year. The beauty of this is that the percentage is taken from your pre-tax pay so that you achieve maximum savings benefit and as a result, pay less taxes because you are no longer taxed on the $2,000 you would have earned, but on $1,800 instead. I encourage you to calculate what percentage you can afford to contribute and then maximize that - the benefits of the long-term time horizon you have are many.

Now comes the part where you need to decide what to invest in. While your plan sponsor may encourage you to invest in an target retirement fund, I would first check the total expense ratio of such a fund and its holdings. If the fund is actively managed, it is likely to have higher costs and may tend to drift away from its stated objectives as the underlying funds ebb and flow with the markets. Your best options are index funds and I would recommend an asset allocation along the lines of: 60% total stock market index fund, 30% total international index fund and 10% total bond market (or high yield) index fund. This asset allocation, while only a suggestion, will give you a broad exposure to the U.S. stock market, international stock markets and provide some bond exposure which you are likely to increase over time.

Saturday, August 13, 2011

The "Experts" Can Be Wrong

I came across an article in the Wall Street Journal earlier in the week detailing the performance of some key hedge funds as they deal with the bumpy ride the stock market has offered up lately. Amidst all of the volatility, some funds have scored impressive gains by having investments in traditional safe havens like gold and Treasuries. 

Meanwhile, John Paulson's firm, Paulson & Co. has dealt with the opposite - severe underperformance to the tune of -31% at his Advantage Plus fund and -21.5% at his Advantage Fund. This serves to demonstrate how difficult it is to beat the markets, even for the experts. After all, Paulson was the fund manager who racked up very impressive gains during the mortgage market meltdown that lead to a person windfall upwards of $5 billion + dollars. 

Thus, this news should give individual investors some comfort because many successful professionals who manage money for a living are having a very difficult time outperforming in such a weak environment. If the experts can't consistently outperform, why should you try to and even more importantly, why even try to pick managers who try to beat the market? Sometimes it takes a volatile market and large gyrations in stock prices to help reinforce key investing principles. 

Sunday, August 7, 2011

Change is Constant

If one thing is certain about the financial markets, it's that change is constant. We are likely to see many changes and new developments over the next few weeks, especially in light of S&P's downgrade of the United States' credit rating from AAA, the safest possible rating, to AA+, one notch below. 

While we can't know of any of the changes that are likely to take place, it helps to have some perspective and take solace in the fact that in 2008, when things were much worse, we were able to recover from many major firms failing, or coming dangerously close to it including: Bear Stearns, Lehman Brothers, AIG, Washington Mutual, Wachovia, Merrill Lynch, Fannie Mae & Freddie Mac and many more. While much of the current crisis is centered on the shortcomings of policymakers in Washington, much of the blame can also be passed along to the Eurozone, whose financially secure members are forced to bear the burden - including potential bailouts - of those nations facing insolvency. 

Going forward, it helps to look back on the 2008 financial crisis and realize that things are much better today than they were then. Ultimately, the United States rebounded strongly and was able to prosper in the wake of such difficulties; hopefully we are able to do much the same now.