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.
Tuesday, August 30, 2011
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.
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.
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.
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.
Saturday, July 30, 2011
You and the Debt Crisis
By and large, I have told readers that it's important to avoid paying too much attention to the headlines and instead employ a long-term approach when looking at investments and the financial markets. Our collective will in executing that has been shaken lately by dire news reports ticking down the hours and minutes to when the United States may potentially miss its first debt payment and in effect, will be considered in default on its financial obligations to its creditors.
While this news is indeed scary, it's not something that should shake your confidence too much for two reasons. First, if the market was taking such a prospect as seriously as the media makes it out to be, then the major market indices would have shed much more of their value in the weeks leading up to the August 2nd deadline. I look at it this way: based on the efficient market theory, everything that can be known about an investment or the market in general is already priced into it because of the speed and efficiency of information flow. Even the bond market, while under plenty of pressure given the uncertainty, has not seen the types of wholesale declines that would indicate a default was imminent.
Secondly, we must not kid ourselves. Lawmakers in Washington know how much is on the line and how disastrous a default would be, and while there has been much political grandstanding and theatre throughout the process, at the end of the day, a deal will be cut, especially if it means preserving re-election chances for many of the incumbents. Unfortunately, this is how Washington works and the media likes to capitalize on the uncertainty. Don't fall victim to the circumstances which don't seem that dire after all.
While this news is indeed scary, it's not something that should shake your confidence too much for two reasons. First, if the market was taking such a prospect as seriously as the media makes it out to be, then the major market indices would have shed much more of their value in the weeks leading up to the August 2nd deadline. I look at it this way: based on the efficient market theory, everything that can be known about an investment or the market in general is already priced into it because of the speed and efficiency of information flow. Even the bond market, while under plenty of pressure given the uncertainty, has not seen the types of wholesale declines that would indicate a default was imminent.
Secondly, we must not kid ourselves. Lawmakers in Washington know how much is on the line and how disastrous a default would be, and while there has been much political grandstanding and theatre throughout the process, at the end of the day, a deal will be cut, especially if it means preserving re-election chances for many of the incumbents. Unfortunately, this is how Washington works and the media likes to capitalize on the uncertainty. Don't fall victim to the circumstances which don't seem that dire after all.
Saturday, July 16, 2011
Weekend Reading: Gen Y's Conundrum
A July 11th blog post at the WSJ's "Real Time Economics" blog caught my eye as it noted that most of the income growth in the United States from 1975-2009 was achieved not through wage increases, but through overtime (i.e. working longer). This conclusion was reached by the Brookings Institution's Hamilton Project which noted the following:
"Although median wages for two-parent families have increased 23 percent since 1975, the evidence suggests that this is not the result of higher wages. Rather, these families are just working more. In 2009, for instance, the typical two-parent family worked 26 percent longer than the typical family in 1975."
This news is especially sobering for Generation Y for two reasons. First, since the data was taken from 1975-2009, it does not include the last year and a half of dismal unemployment data which further suggests that a recovery might take awhile to form. Since an extra year and a half of work data was not included, the results are likely even slightly worse than the 1975-2009 data indicates. Secondly, Michael Greenstone, the MIT economist who runs the Hamilton Project notes that, "The long-run decline in wage opportunities has put lots of pressure on families. People are adjusting, but they’re adjusting in ways that we might not like very much. All of that points away from a vision of the American dream where each generation is doing better than the last."
Unfortunately, that last line should serve as a wakeup call to Generation Y. While it's common to see each successive generation better off financially than the last - this new data suggests that such progress may skip our generation entirely.
As scary as that sounds, it simply means that as a generation, we need to alter our expectations, especially from an investing perspective. On this front, my number one recommendation to Gen Y investors is to use a 7% long-term average rate of a return in all investment calculations so as to avoid any type of unreasonable optimism and to build a cushion into all assumptions. The worst feeling in the world is building an investment plan that assumes a rate of return that is much higher than what actually happens. A 7% return is reasonable since the 10-11% long-term average rates of return that we used to see seem to be a thing of the past; now, more than ever, it's better to be safe than sorry!
"Although median wages for two-parent families have increased 23 percent since 1975, the evidence suggests that this is not the result of higher wages. Rather, these families are just working more. In 2009, for instance, the typical two-parent family worked 26 percent longer than the typical family in 1975."
This news is especially sobering for Generation Y for two reasons. First, since the data was taken from 1975-2009, it does not include the last year and a half of dismal unemployment data which further suggests that a recovery might take awhile to form. Since an extra year and a half of work data was not included, the results are likely even slightly worse than the 1975-2009 data indicates. Secondly, Michael Greenstone, the MIT economist who runs the Hamilton Project notes that, "The long-run decline in wage opportunities has put lots of pressure on families. People are adjusting, but they’re adjusting in ways that we might not like very much. All of that points away from a vision of the American dream where each generation is doing better than the last."
Unfortunately, that last line should serve as a wakeup call to Generation Y. While it's common to see each successive generation better off financially than the last - this new data suggests that such progress may skip our generation entirely.
As scary as that sounds, it simply means that as a generation, we need to alter our expectations, especially from an investing perspective. On this front, my number one recommendation to Gen Y investors is to use a 7% long-term average rate of a return in all investment calculations so as to avoid any type of unreasonable optimism and to build a cushion into all assumptions. The worst feeling in the world is building an investment plan that assumes a rate of return that is much higher than what actually happens. A 7% return is reasonable since the 10-11% long-term average rates of return that we used to see seem to be a thing of the past; now, more than ever, it's better to be safe than sorry!
Friday, July 8, 2011
Building Wealth Can Be a Slow Process
One of the toughest things for many Gen Y investors to accept is that building wealth is exactly what its name implies: a process, sometimes slow, that starts with something small and ultimately grows to something much bigger. Much of the time, we're put out of a touch with reality when we hear stories of instant wealth being "made" either by investors, company founders or the like.
This all highlights an important principle: it's easier to make money when you already have it. However, do not fret! Just because you're not starting off with a billion dollars does not mean that it's impossible to become wealth; just the opposite, in fact. Just because building wealth can be a slow process does not mean it's the wrong process. Being cautious but at the same time well-calculated, meaning you have an asset allocation that fits your tolerance for risk but also allows you enough flexibility to enjoy the here and now, will ultimately make you a better person and investor.
Many readers know that I like to use examples to illustrate why even though building wealth may seem "slow" it ultimately pays off. Consider an investor who begins with $5,000 at at age 22 and is able to earn a 7% return without adding any additional capital. Of course, 99.9% of investors reading this blog will actively add to their nest egg over time, but this example proves that even if our investor doesn't, the magic of compounding still works. After 40 years, our investor would have $74,872. Now, some people might ask what the point of investing and saving is if we can't enjoy today. My response is simple: give yourself enough flexibility to enjoy today - set aside a comfortable amount of discretionary income per month so you can go away on a trip, buy a new TV or do whatever else you'd like to do - and by investing the rest today, you'll ultimately ensure a much earlier retirement than age 62.
This all highlights an important principle: it's easier to make money when you already have it. However, do not fret! Just because you're not starting off with a billion dollars does not mean that it's impossible to become wealth; just the opposite, in fact. Just because building wealth can be a slow process does not mean it's the wrong process. Being cautious but at the same time well-calculated, meaning you have an asset allocation that fits your tolerance for risk but also allows you enough flexibility to enjoy the here and now, will ultimately make you a better person and investor.
Many readers know that I like to use examples to illustrate why even though building wealth may seem "slow" it ultimately pays off. Consider an investor who begins with $5,000 at at age 22 and is able to earn a 7% return without adding any additional capital. Of course, 99.9% of investors reading this blog will actively add to their nest egg over time, but this example proves that even if our investor doesn't, the magic of compounding still works. After 40 years, our investor would have $74,872. Now, some people might ask what the point of investing and saving is if we can't enjoy today. My response is simple: give yourself enough flexibility to enjoy today - set aside a comfortable amount of discretionary income per month so you can go away on a trip, buy a new TV or do whatever else you'd like to do - and by investing the rest today, you'll ultimately ensure a much earlier retirement than age 62.
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