In part one I discussed the four phases of a lifetime savings and investment plan and how investing during the retirement income phase is driven by the strength of your household balance sheet, not by the need to beat the market or stretch for yield. The stronger your balance sheet, the more risk capacity you have, the more market risk you can afford to take without endangering your retirement income stream.
Ironically, those with inadequate retirement savings who crave higher returns and yield in the market to make up for lost time are the least able to afford the risk, because it is difficult or impossible to replace a sizeable loss once you have stopped working. A sizeable loss then could leave you with greatly reduced income for the rest of your days.
That’s a cautionary tale for the rest of us, which brings us back to square one—reliably building and compounding savings during the first, savings phase of a lifetime savings and investing plan.
Why save and invest?
We save because in the future there will be times when we need more than we can squeeze out of the cash flow of current earnings for planned purchases or the extra cost of a life shock.
We invest so that our money is working hard to counter the effects of inflation, which even at today’s low rates can cut purchasing power in half in twenty years (don’t get me started about the ’80s!).
Retirement is the mother of all financial goals since it takes a lifetime of compounded savings, doubling and doubling again over the years to save enough to cover the possibility you may live another 30 years after you are no longer working.
So save and invest we must. The basics go almost without saying—start on the first day of your first job and don’t ever quit saving. Max your 401(k)/403(b) or IRA contributions and ensure you get any employer matching.
Hard as it is, saving can seem to be the easy part. Investing, on the other hand, can be difficult. With so much conflicting information about the market, stocks, and funds, from so many different sources, it is difficult to know what to do, where to put your savings, and how to manage it.
Much of the information swirling around us is simply speculative. No one knows the future or can predict future prices, interest rates, or what will be hot or not. And no firm can predict the future either, no matter how well established or much they spend on pastel advertising with soothing background music.
During the savings phase of your lifetime savings and investment plan, you should ignore the noise as much as you can, and focus on the four or five things you can control that will make the most difference to you in the long run:
- Save! Make regular deposits into your accounts. You can’t invest if you aren’t saving regularly. Your mileage will vary depending on your income and balance sheet, but pay yourself 10-15% first, every paycheck.
- Diversify away risk by broadly investing in the entire economy. Owning 10 or even 50 or 100 stocks and bonds is not broad diversification. And the more individual holdings you own, the more complex and the more time it takes to manage. It’s difficult if not impossible to beat the pros at this game.
- Adjust your exposure to risk (stocks) based on your income potential. If you have a solid career, or one with a pension, you can take more risk in the market than if you work in risky industry or have a variable income. As Moshe Milevsky has put it, Are You A Stock or a Bond?
- Avoid high fees. Understand what investing costs—the fees you pay to advisors, firms, reps, and funds. The money for all that advertising comes from somewhere, and the higher the fees you pay out, the less you end up with. Those small percentages compound over time as lost opportunity that costs you tens, even hundreds of thousands of dollars.
- Rebalance against the wind—trim when markets are up and buy when they are down. Stay in the market, allocated according to the strength of your balance sheet.
Diversification: Invest in the Global Economy, Not the Market
No one can predict the future, so we don’t pick stocks. A stockholders can’t control a company’s results, so when we buy a stock we are betting that the company management and good fortune will smile upon us—that’s leaving our future goals to chance! We need a better approach than that.
Fundamental (value) and technical analysis (momentum) of stocks tells us what has already happened and can make historically or statistically-based projections, but it can not tell us what will happen with certainty. In financial terms, owning individual stocks or specialized funds exposes us to specific business risk, without paying us a premium for bearing that risk—meaning that it is a losing proposition.
We can avoid that specific risk by investing in the whole economy, not in specific stocks or specialized funds. Investing in low-cost index funds that span the global economy will give us reliable market returns, less the costs of investing, year in and year out. As the global economy grows over the years, our investment will keep up with that growth, plus a point or two for the risk of being in the market.
In the next post, I’ll provide a model allocation for investing in the global economy that you can adapt to your phase and balance sheet based on where you are in your lifetime savings and investing plan.
Are You A Stock Or A Bond?
During the savings phase, if your career and income are rock-solid, you are a “bond” and your investments should be tilted towards stocks—you can afford to take the risk. On the other hand, if your income is variable, say from commissions, or if you work in an uncertain or dramatically changing industry, you are a stock, and your investments should be tilted away from risk towards bonds. If you are a “stock” and take too much risk with your investments, you could find yourself unemployed in a downturn and your savings depleted by market losses all at the same time.
As with balancing between stocks and bonds during the retirement income phase based on your balance sheet, we calculate the present value of your lifetime earnings and lifetime expenses to find the balance between stocks and bonds that works with your balance sheet during the savings phase. There’s no one allocation that is right for everyone.
Avoid High Fees: Keep More of Your Money
Specialized mutual funds have an average annual expense ratio of around 1.15% compared to .05-.15% for typical index funds. That 1% annual difference is 20% of a 5% annual return and compounds as a significant loss in your account over the years that can ultimately impact your retirement lifestyle. Specialized funds and investment advisors attempt to justify these high fees by striving to beat market returns, when most—two-thirds or more—simply do not. Picking funds is like picking stocks—the winners are not the same year after year. Your results will be uneven and usually less than broad market returns.
Save your money. Find fee-only or low-cost advisers and invest in low-cost index funds to consistently get market returns, less a lower cost of investing compared to specialized funds.
Investing is risky. Markets go down as well as up. If you balance your exposure to risky assets (stocks) based on the strength of your balance sheet—either your lifetime income potential while in the savings phase or the ratio of your savings to your expenses in the retirement income phase—then you will be better able to weather the worst market downturns. A lifetime savings and investing plan positions you to take the risk you can afford in order to realize the gains that the global economy offers.
A down market is a rebalancing (buying low) opportunity, exactly the wrong time to be selling out. Build your portfolio based on the risk capacity in your balance sheet, and you’ll sleep better at night, better able to resist panic selling.
Next time we’ll discuss the bond and stock components of a portfolio for investing in the global economy that can be easily adjusted to your household balance sheet.
In the meantime, if you have any questions or comments, please let me know!
–Mike Lonier, RMA℠