Financial Literacy

I recently reviewed an IRA account for someone who opened it with two $2,000 deposits that is now worth $100,000 today. The deposits were made 28 years ago into four large company stocks: Coca-Cola, American Express, Clorox, and Merck. A quick calculation reveals that this is just over a 12% annual return for that time period. This is an excellent return rate that any investor would be happy to earn. But I happen to know that the timing of this investment started right at a market bottom, 1984, just before both bull markets of the ‘80s and ‘90s.

I wanted to know what this portfolio would have done it had been opened at an inopportune time, such as the stock market peak of the year 2000 and been held until today. Excluding dividends, the portfolio would only be worth $5,800 for an average annual return of only 2.8%.

This example helps highlight that the difference between an opportune or inopportune time that you make a stock purchase can have a difference in your account balance by +1,000%. This is a very big deal; a return gap on your portfolio this big can create the difference between being able to retire early and never being able to retire at all. In my study of market cycles, I have determined that any lump-sum investment into stocks should be made over a 2 year period, made quarterly. For example, you just received a $5,000 bonus that you want to place into stocks. Divide the lump sum amount by 16, and these portions are used to make quarterly purchases into your stocks over the next two years. This way you are scaling in to minimize your exposure to buying everything at the peak without delaying too long to take advantage of future bull markets in stocks.

Unless your employer offers a 100-200% match to your 401(k) plan contributions, I highly recommend that you put your retirement money anywhere else but a 401(k), 403(b), or similar plans.

This is not standard financial planning advice, what are some of the problems?

1. Your money is locked in prison. Your 401(k) plan administrator normally offers 10-20 poorly performing mutual funds with very high fees. You can confirm this with websites like BriteScope.com or other companies that analyze retirement plans showing the +$150,000 you are losing to these plans over your career. Every plan portfolio I have reviewed is also highly correlated, meaning they all move up and down together, there is no opportunity to hedge or truly diversify your portfolio. Yes, a few 401(k) plan programs allow you to invest in anything (called a “brokerage option”), but they make it difficult to do this, charge you an extra annual fee, and the trend is moving away from permitting this type of investing.

2. Your 401(k) plan administrator is the metaphorical prison warden. Normally, it is someone in Human Resources with zero financial background. Unfortunately, they are frequently in meetings with attorneys to minimize their risk exposure to lawsuits from you – what is not on the agenda in these meetings is providing you the best financial options for a prosperous retirement. In the past, I have tried to assist many people trying to remove a minor shackle of their 401(k) plan. I have been about as successful as a convict complaining to the prison warden about something trivial.

3. What are your options when money is trapped in a 401(k) with poor performing funds? Try to time the ups and downs with newsletters or technical analysis. Not so fast Skippy – this activity is a slight extra expense for the mutual fund managers so they have several defenses to prevent this. First, they forbid frequent trading, impose extra fees for moderate traders, and impose trading bans for large groups of people making the same trade from a newsletter or advisory service.

4. I have gone through detailed retirement forecasting for many people and I have never found a 401(k) plan that is a successful location to put your retirement money. Even with a 50% employer match up to 6% of your contribution. This is because the extra fees and poor performance subsume the tax-deferral benefit. A Roth IRA or other retirement vehicles are far better at providing investments for a prosperous retirement.

5. Lastly, 401(k) plans are a political invention that is subject to the whims of both state and federal politicians. It seems that every year there is some politician trying to pass new 401(k) legislation at the expense of employees who invest in them. A few recent attempts include: forcing plans to buy U.S. government debt, making contributions mandatory for all employees, putting further caps on loans, adding more restrictions, and frequently, of course, adding more taxes on them.

Even if you are currently contributing the maximum to your 401(k) plan, you can stop contributing and divert your money toward far more friendlier locations for investors.

Interest rates have been falling for over 30 years. As interest rates fall, bond prices increase as previously issued rates become more valuable. There is an inverse relationship between interest rates and bond prices.

This 30-year up trend in bond prices has lulled some investors into thinking that bond prices are only stable or go up, not remembering that they can also drop a lot if interest rates rise.

In order to protect your portfolio from a sharp drop in bond prices, it is safer to own short-term bond funds, 5-years or less. Blackrock just issued a new fund last week where the bonds will mature in only a year or less, and 80% of them are investment grade. You may want to evaluate this fund for your portfolio; it is an ETF with the ticker symbol, “NEAR.”

Will interest rates rise? Someday, but before that time arrives you should have some kind of plan to protect yourself from rising interest rates on your longer-term bonds.

A neighbor asked me about $11,000 in a single stock that he just inherited from an aunt. He doesn’t know much about investing but he wanted to hold the stock since his aunt was successful at stock investing. However, his wife wanted him to sell it to put that money into a different stock that she thought had far more growth potential. I had the impression that he was looking to get some argument pointers from me to win this debate with his wife.

I asked a few questions, “Do you know exactly why your aunt bought the stock?”

He replied, “No idea.”

I asked, “So she may have bought this stock as a loser to create a tax loss against other gains?”

He replied, “Possibly, but I don’t even know what that means.”

I asked, “Do you have any idea what her criteria were for selling this particular stock?”

He replied, “I have no idea.”

I asked, “What exactly are your criteria for selling this particular stock going forward?”

He replied, “I really don’t have any.”

I then said, “Ok, it is clear to me now. What your aunt bequeathed to you was the $11,000 of value; not the particular stock that it randomly happened to be in the moment she passed away. Each investment vehicle needs to be managed and you just told me that you do not know how to manage this one. Don’t be like a lottery winner that loses all their winnings from poor money management. It is my recommendation that you sell the stock immediately and place the money into something that you are knowledgeable about and capable of managing in order to conserve and benefit from your aunt’s generous gift.”

When you want to protect and conserve your investment money, then you place it in secure vehicles like FDIC insured accounts and AAA credit rating instruments like bonds. The return on your money will be low on these investments but its purpose is not high growth but protecting what you have. These are also easy investments to find and totally passive to manage, there is nothing for you to do and they require no financial education.

However, to acquire and buildup any meaningful amount of money it cannot occur in places like those. Compound interest at safe but low rates cannot add up to much on small amounts of money. It is physically impossible unless you have many, many decades. In order to earn a sizeable amount of money you must earn a 20% return on your money, or more. Money that earns 20% or more will compound into a very meaningful amount of money each year that you allow the gains to continue to grow.

The problem is that there are no easy, off-the-shelf investments that will hand you a return this high. It will take more education, time, and effort to find, acquire, manage, and exit investments with this level of return. Here are some investing examples that I have done to reach this target return: rental real estate, raising livestock, stock trading, and selling home-made items.  I’m sure everyone will have a different list of investing candidates of what may be appropriate for their talent and capability. I met someone that earns well over 20% on weekends by buying and selling used motorcycle parts; any interest you may have will likely have some avenue for you to earn a meaningful return.

When you are in the “accumulation phase” of your investing life, you must find 20% returns to build your portfolio into a meaningful amount of money. Once you are retired and are in the “distribution phase” of your investing life, then you want to have more of your money in locations where it is conserved and protected; but unfortunately earnings will be significantly lower. But that’s OK because what is most important during the distribution phase is to actually have some money to withdraw and spend when you are least able to earn more.

The U.S. federal government’s fiscal year-end is September 30^th plus the federal debt limit is expected to be reached around the last week in October or the first week in November.

The White House has been in talks for weeks with a few moderate republicans in the senate to find a compromise on these fiscal issues. President Obama is looking for a replacement spending deal for his sequester cuts that took effect earlier this year.

Yesterday, Senator Bob Corker of Tennessee said, “It is very evident that there isn’t any common ground and we’ve all agreed there is no reason for these talks to continue.”

Congress returns to work on September 9th and will have to quickly figure out how to fund the government beyond September 30th. Meanwhile, Tea Party groups and dozens of House republicans are urging Speaker Boehner to block any spending deal that doesn’t eliminate funding for Obamacare.

No matter what your political opinion may be about these issues, the financially literate always adjust and align their finances with reality.

Remember that each time there was a debt ceiling showdown in Washington that interest rates went up temporarily and the stock market declined. So you may want to adjust your balance sheet accordingly:

• Avoid or scale out of long-term bonds and medium-term bonds
• Lock-in low-rate mortgages
• If you like CD’s, have cash ready for any up-tick in CD rates
• Postpone additional stock market purchases until the decline

However Washington’s debt showdown may play out, like every financial event, be sure that you are aligned to both defend your assets and hopefully profit from their decisions and market gyrations.

Newly minted financial advisers eagerly talk about earning 10-12% or more on your money. Many of these claims are made using stock market bottoms and tops to skew the results. For example, these unusually high returns they reference will be either start around 1932 (after the crash) or 1984 (just before the stock market soared).

If you want some realistic numbers, look at the bar chart. Sure, the stock market has earned 8% over the last 20 years, however, during this same period the average investor earned only a measly 1-4%. There has been much research over why actual individual investors earn so little (emotional buying and selling, trying to time the market cycles, paying high fees to mutual funds and 401(k) plans, high tax rates, etc.), but for whatever reason, this is the reality. So you cannot rely on 8% returns unless you are capable enough to actually earn 8% returns. Do you track how well you are earning each quarter or year? Many of your investment goals are depending on this number, like buying a home, funding a degree, or retiring early. Make sure your plans are based on reality and not rainbows & unicorns sold by financial advisers.