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Investing Retirement

Personal Finance Foundation – Part 4 – Invest, Invest, Invest

Having examined how you can grow net worth by reducing spending and growing income, we now come to the most powerful tool for growing net worth: Investing. Reducing spending produces quick wins in growing net worth, but there’s only so much cost cutting you can do until you are living on a bare bones budget. Increasing earned income is a great way to increase your net worth that, theoretically, has no ceiling, but we all know that raises don’t come easily. Also, even if you do get that raise, you’re still trading time for money.

What if there was a path for you to augment employment income by having your assets work for you and earn money for you?

The Miracle of Compounding Interest

I started investing when I got my first full-time job out of college. I put 5% of my salary into a 401(k) and, following my older brother’s advice, I maxed out a Roth IRA. For better or for worse, I socked money away in both accounts and didn’t spend much time looking at them except to rebalance occasionally. I say this was “for better” because shortly after I started working full time, the subprime mortgage crisis contributed to the stock market crashing and, as a result, my 401(k) and IRA accounts lost almost half their value. Had I been more attentive to my retirement accounts, I would have seen them hemorrhaging value which likely would have caused me grief. While I’m very committed to leaving my retirement accounts alone until retirement, I’d rather not test my resolve.

You may be thinking, “you’re not much of a personal finance person if you only put 5% of your salary into your 401(k).” If I remember correctly, I received a 3% match on this contribution but, you’re right that 5% is less than I’d recommend anyone invest. Over time I gradually increased my contributions so that now I contribute over 20% of my gross income to my 401(k) and also max out IRA contributions. Now I have well over a decade’s worth of compounding interest rewarding me for my efforts.

What is compounding interest? A plain English example: You start off with $1,000 and earn 10% interest annually. The first year you earn $100 in interest, which leaves you with $1,100 total. The second year you earn $110 (10% of $1,100) in interest, which leaves you with a total of $1,210. Keep repeating this math (or, even better, use this great compounding interest calculator: http://www.moneychimp.com/calculator/compound_interest_calculator.htm) and you’ll have $1,610.51 at the end of five years.

The beauty of this $610.51 growth (the difference between the red line and the blue line in the picture above) is that you didn’t trade time for money to gain the $610.51. Instead, your money sitting in an investment account worked for you to earn more on your behalf. Extend your timeline to 15 years and your initial $1,000 turns into $4,177.25. Mind you this growth is happening without you adding a penny extra. Change the initial $1,000 to $5,000 with the same 15 year timeline and 10% interest rate? You wind up with $20,886.24.

If you use your imagination a bit, you’ll see how you can leverage compounding interest in a very powerful way. It’s not very likely that you’d make contributions to your retirement accounts only in your first year of employment but never again, right? If you make the first year contribution of $5,000 then add $5,000 every year for 15 years at a 10% interest rate, at the end of 15 years you end with $179,748.65. Not bad, huh? Key takeaway: $29,748.65 in growth that occurred (your $150,000 of deposits subtracted from the $179,748.65) didn’t require your time, sweat, energy, or tears. Instead, your money worked for you.

One of the most powerful variables in growing wealth via compounding interest is time. If you extend the previous example from 15 years to 30 years, you witness astounding growth.

“Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” – Albert Einstein

The Basics: How to Invest in the Stock Market

You may be thinking, “OK, great buddy. I want some of this stock market action and having my money work for me. Where do I start?” A common place to start, and where I started, is in an employer-provided 401(k) retirement plan. Think of the 401(k) retirement plan as a wrapper for investments, and stocks as an investment you can put inside this wrapper.

A significant benefit of the 401(k) retirement plan is the tax advantages that come along with it. When you invest in the 401(k), your annual taxable gross income is reduced by the amount you invest, and the invested money is not taxed until you withdraw it. If your employer, for example, uses Fidelity to manage their 401(k) plan, you would create an account on Fidelity’s web site or use the account created for you by your employer. Once you log into the account, you’ll be able to select from likely a variety of investment choices.

One very common selection to make in 401(k) plans is a target date retirement mutual fund, which automatically adjusts the mutual funds holdings (think stocks, bonds, and cash) as you approach your targeted retirement date. In general, it’s a good idea to move gradually from riskier investments (think stocks) to less risky investments (think bonds and cash) as you approach retirement.

The volatility of stocks could cause the loss of a significant amount of your nest egg as you enter retirement, so it’s best to have some protection against this volatility. A great example: Retirement portfolios immediately after the sub prime mortgage crisis lost almost 50% of their value. It took roughly three years (until 2012) for the stock market to recover the lost value. How would you feel if you planned on retiring in a given year and then observed almost half your nest egg evaporate?

I’ve just described investing in the stock (often referred to as the equities) market, but there are many, many other types of investments. An alternative investing technique I’ll discuss next is real estate, specifically rental property, investing.

A Second Investment Vehicle: Real Estate

A brutal reality I observed during the subprime mortgage crisis were retirees needing income from their 401(k) accounts while seeing almost 50% of their balances evaporate. Hindsight tells us that the stock market recovered these losses within a few years, and then entered a very long bull market, but I could empathize with the fear and anxiety experienced by retirees who depended on their 401(k) to navigate retirement.

About the same time, I learned of a concept I found fascinating: The multi-legged retirement stool. In short, what if your retirement income didn’t solely depend on a 401(k), with its commensurate stock market volatility, but was also funded by another source of income? A three-legged stool has stability not by relying on one or two legs but on three legs. Similarly, your retirement income could have more stability if it didn’t only rely on income from the equities market.

While I love the simplicity of investing in index funds within a 401(k) and and a Roth IRA, I also love the dependable income stream produced by rental residential properties. People will always need a place to live, so there will always be a demand for residential real estate. Though we’re certainly witnessing significant disruptions of rental income streams during the COVID-19 pandemic, I sleep better at night knowing I have three disparate sources of potential income: Employment, retirement accounts, and rental property.

My long-term plan for bear markets (significant stock market downturns) is to rely more on rental property income to fund my lifestyle while simultaneously leaving my 401(k) and IRA accounts untouched so as to not make paper losses real losses. In other words, while the stock market may be down and your retirement account balances may be down, these losses aren’t realized until you withdraw money from retirement accounts, thereby selling shares at lower prices when it would be better to sell at higher prices.

In the worst case scenario of both the stock market being significantly down and your renters not paying their rent, a scenario that is highly unlikely but that is occurring with some landlords in the country as renters lose employment during the pandemic, take advantage of your emergency savings to tide you over until either the stock market or rental income stabilize.

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Investing Retirement Saving

What Can You Learn from the Subprime Mortgage Crisis?

It’s hard to believe time has passed so quickly.  Ten years ago the subprime mortgage crisis led the U.S. economy into a severe recession and carnage ensued.   Many people lost their homes along with huge portions of their retirement savings.  Credit markets froze and taxpayer money was used to purchase toxic assets from the very banks that facilitated the crisis.

A decade removed from the great recession, what takeaways can help you succeed financially and prepare you for the next economic downturn or recession?

  • Only you have your best financial interests in mind.  Banks were more than willing to lend money to under-qualified borrowers, and this resulted in skyrocketing foreclosures when interest rates increased on adjustable rate mortgages (ARMs).  Some argue that banks were negligent in persuading under-qualified buyers into taking on supersized mortgages.  This certainly could be the case, but it hammers home an important lesson:  Understand your financial choices and don’t rely solely on someone else’s opinion to guide you, especially if they are in a position to make money off of you.  Educate yourself before you pay someone for their financial guidance, as this will better allow you to see if your adviser is pursuing your best interests or his.
  • Diversify your investments.  Plenty of folks who planned to retire in 2008-2010 had to delay retirement due to seeing their 401(k) plans shrink drastically as the equity markets plunged.  This meant several more years of work for this group.  What if, though, this group had rental property as an additional source of income for their retirements?  The recession economy saw an increase in renters, resulting in increased income for rental property investors.  These rental property investors could choose to withdraw a smaller amount from their 401(k) plans while relying more on the increased cash flow from rental property investments.  While I’m not advocating only for rental property investments as a source of retirement income (it certainly is a great option), I am advocating for a multiple-legged stool for your retirement portfolio that does not leave you in an anxious place should an investment class take a plunge.
  • Invest more than you need.  I’ve never heard anyone complain that they invested too much.  In the case of workers who had to postpone retirement due to the Great Recession, many of them could have continued with their retirement plans had their nest eggs been larger.  While this may go into the “thanks for the insight, buddy” category, your savings and investment rate is a better determinant for your success than rate of return:  http://www.thesimpledollar.com/five-most-important-factors-for-investment-success/
  • Follow your plan, not your emotions.  The S&P 500 lost about 57% of its value from October 9, 2007 to March 9, 2009, the day the index bottomed out during the Great Recession.  Thankfully, I didn’t check my retirement account balances much during this time, mainly because I had barely entered the workforce after graduating from college.  My plan, though, was to continue working for at least three, if not four, decades more until I retired, and equities with all of their volatility were the foundation for growing a large enough nest egg.  The S&P 500 took four years to reach its value on October 9, 2007 and has grown much more in the current bull market.  Investors who made an emotional decision to sell during the recession likely missed much of the growth during the subsequent recovery and likely missed the opportunity to purchase shares of the S&P 500 while they were on sale.  Recessions and downturns in the economy can be very anxiety inducing if you don’t remember that these are terrific opportunities to buy shares on the cheap and that the market provides substantial returns in the long run.  The past 30 years saw the S&P 500 return 11.66% (10.19% geometric return) with dividends reinvested.
The S&P 500 has returned 11.66% (arithmetic) and 10.19% (geometric) the past 30 years.  Courtesy of http://www.moneychimp.com/features/market_cagr.htm

For a terrific read about the subprime mortgage crisis and its causes, read The Big Short by Michael Lewis.  The book will hammer home my first point regarding educating yourself on financial decisions, especially major ones like taking out a mortgage.  While I think the majority of people in finance are well-intentioned, great people, The Big Short shows that there are individuals who will seek to take advantage of you (as there are in any industry).  While the financial industry may or may not be in a better position to avoid a similar crisis, you can certainly prepare yourself to not only avoid making bad decisions during a recession, but to take advantage of the opportunities presented by an economic downturn.

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Debt Investing Retirement Saving

Psychology and Fear in Personal Finance

Be fearful when others are greedy.  Be greedy when others are fearful.

-Warren Buffet

Warren Buffet is one of the most successful investors of recent times and provided this great quote in 2008 during the height of the subprime mortgage crisis.  During the 2007-2009 bear market, the S&P 500 lost over 50% of its value and many people close to retirement had to delay their exit from the 9 to 5.  In hindsight, as we sit in the middle of a bull market in 2016, Buffet’s quote is great advice, but how are you supposed to separate yourself from emotion when your nest egg loses over 50% of its value?

S&P 500 2007 - 2009 Bear Market
S&P 500 2007 – 2009 Bear Market (courtesy of Yahoo Finance)

There is no easy answer here, as personal finance is indeed personal, but you can certainly make good, informed decisions in the middle of emotionally charged circumstances.  Buffet was right about the subprime mortgage crisis and the need to buy while prices were low (i.e., while the market had lost lots of its value).  He likely looked at the history of the market and understood that it would bounce back.  As of September 16, 2016, the S&P 500 sat at 2,139.16 versus its lowest value during the subprime mortgage crisis of 676.53 on March 9, 2009.  As you can see, the market has more than returned.

S&P 500 - 2007-September 16, 2016
S&P 500 – 2007-September 16, 2016 (courtesy of Yahoo Finance)

How do you disarm fear and anxiety in personal finance?  Educate yourself.

Peace I leave with you; my peace I give to you. Not as the world gives do I give it to you. Do not let your hearts be troubled or afraid.

John 14:27

How should you manage fear and anxiety when making financial decisions?  Start with education, then don’t stop educating yourself.  Read personal finance books (I highly recommend The Millionaire Next Door), visit personal finance blogs (Afford Anything is my current favorite), and listen to personal finance podcasts (Marketplace is great for keeping up with current financial events; Afford Anything has a great podcast, too).  I’ve found that I pull pieces of information from each of these sources and, as a result, have molded a personal philosophy.

The key lesson here is that education will help you see that American equity markets have more than recovered from the multitude of previous crashes and bear markets.  Buffet understood this and saw that equities were simply on sale.

How else do you disarm fear and anxiety?  Understand risk and reward.

I recently listened to a personal finance podcast where I heard an interesting anecdote involving fear.  A caller indicated they hadn’t invested in the stock market for retirement due to their fear of losing money.  While the caller certainly is correct that avoiding the stock market and investing in something safer, like CDs or cash, will help you avoid risk and the large losses that can accompany risk, he is also missing the other half of the equation:  In finance risk is necessary for growth.

While the caller will seemingly preserve capital by avoiding the volatility of the stock market, their capital will erode over time due to the effects of inflation.  The eroding power of inflation will decrease buying power if not offset by gains.  One option for generating more gains than cash but experiencing less volatility than the stock market is the bond market.  The bond market, though, experiences a good amount of volatility, too.

While someone can certainly go to sleep peacefully knowing they will avoid the volatility of the stock market and keep their money safe (at least until inflation eats away at it), it would be rash to do so without being aware of the rewards that accompany carrying risk.  Over the past 30 years (specifically from January 1, 1985 through December 31, 2015), the compound annual growth rate of the S&P 500 was 8.2% with dividends reinvested and adjusted for inflation.

S&P 500 - CAGR for past 30 Years
S&P 500 – CAGR for past 30 Years (courtesy of MoneyChimp.com)

As you can see, $1 invested in an S&P 500 index fund on January 1, 1985 would have returned over 1,100% in 30 years.  While I can see how avoiding significant losses would allow someone to sleep peacefully, avoiding a significant amount of the S&P’s gains during this time period would cause me to lose sleep at night.  My advice to the caller:  Educate yourself about risk and reward, then understand how accepting additional risk could result in your nest egg multiplying in size.

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Investing Retirement Uncategorized

Why You Should Use Index Funds in Your Retirement Accounts

When I first started learning about investing and retirement accounts, I struggled to determine where I should invest my money.  Thankfully, several great personal finance web sites (including Motley Fool and Bogleheads) agreed that investing in index funds led to the most benefit for most people.  Index funds are mutual funds that track what is called a market index, like the Standard and Poor’s 500, and maintain small slices of companies in proportion to the companies’ share of the index.  For example, if Apple currently makes up 2% of the S&P 500, an S&P 500 index fund would place 2% of its holdings in Apple.

Why is indexing preferred over investing in actively managed funds, where fund managers buy and sell stocks on a frequent basis?  The frequent buying and selling of stocks generates commissions for the fund managers and their companies (this is your money going to pay the fund managers).  Additionally, there are often fees associated with the initial purchase of actively managed funds.  At the end of the day, actively managed funds must increase in value not only to match the gains of index funds, but also to cover actively managed funds’ much higher expenses.

Study after study indicates that index funds outperform actively managed funds:

http://www.cnbc.com/2015/06/26/index-funds-trounce-actively-managed-funds-study.html

http://www.usatoday.com/story/money/personalfinance/2016/03/14/66-fund-managers-cant-match-sp-results/81644182/

https://www.bogleheads.org/forum/viewtopic.php?f=10&t=88005

I recommend Vanguard Funds (www.vanguard.com) for index funds, as Vanguard’s funds have the lowest expense ratios.  One fund that is highly recommended by many proponents of indexing is Vanguard’s Total Stock Market Index Fund (VTSAX), which has an extremely low expense ratio of 0.05%.  In comparison, many actively managed funds have expense ratios of over 1.00%.  While this extra percentage point may not seem like a lot, when compounded over time, this extra 1.00% may result in you paying fund managers tens of thousands, if not hundreds of thousands, of dollars that could have been used to grow your retirement nest egg.

 

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Dave Ramsey Debt Investing Retirement Saving

Great Personal Finance Podcasts

One of my favorite things to do on long drives is listen to personal finance podcasts.  There are a handful that I have found (so far) to be better than the rest:

My favorite podcast is Afford Anything with host Paula Pant, as she combines an entertaining delivery with great guest speakers.  Paula encourages listeners to both increase their incomes while decreasing their expenses (increasing the “gap”).  Her focus on increasing income differentiates her from many, many other personal finance bloggers who put a great focus on limiting expenses and frugality.  I certainly think both are important, but Paula’s focus on making the gap bigger blows past the flawed binary view on many blogs that we should focus on either increasing income or reducing expenses, but not both.  Paula provides a ton of insight, too, into real estate investing.  I definitely, definitely recommend the Afford Anything podcast.

The Mad Fientist podcast focuses on reaching financial independence.  The Mad Fientist provides some original (to me) ideas:  How to use a health savings account (HSA) as a “super IRA” account; how to minimize taxes when investing in retirement accounts.

The Dave Ramsey Show podcast is targeted more toward people trying to get their financial house in order, but it is still very motivational.  Dave Ramsey releases three hours of the show every weekday, so there’s plenty to listen to.  My favorite segments are Dave’s millionaire theme hours, where millionaires are interviewed and insights are provided into their spending, saving, and investing habits.

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Retirement

How to Save for Retirement and Not Miss the Money

A recent Wall Street Journal article indicates that 28% of Americans have no confidence that they’ll have enough money saved to retire comfortably.  In the same article, 57% of those surveyed indicate that they have less than $25,000 in savings and investments outside of their home values.  Given that retirement calculators indicate you’ll need much more than $25,000 for retirement, the 57% cited in the Wall Street Journal article have a lot of ground to cover.  Undoubtedly, many Americans are being squeezed by the current less-than-stellar economy, so how can a person save more for retirement when they’re already using their entire paycheck?

A Painless Solution

As an employee, one of the financial benefits I look forward to every year is an annual pay raise.  The pay raise coincides with the new fiscal year at the organization where I work, so I can count on a pay increase at about the same time every year.  One thing I have done recently is increase my 401(k) retirement contribution by 1% when my pay raise kicks in.  The idea is that, if I have not gotten used to the larger paycheck yet, I won’t miss the 1% that automatically goes to my 401(k) account.

If every year you follow the pattern of saving 1% with each pay raise you receive, within several years you’ll have saved more for retirement without having missed the money.  Ideally, you’ll reach a 401(k) savings rate of at least 10%, which will provide a substantial sum for retirement.  In order to have a rough estimate of how much you’ll need saved for retirement, make sure to run through a retirement calculator or two, taking into account your expected retirement spending habits, retirement healthcare costs, and inflation.

Set it and Forget it

Some employers allow employees to sign up for automatic retirement contribution increases.  If this is the case for you and you’re not saving enough, take advantage of the opportunity so that you have one less chore to do come pay raise time.  As you approach retirement, you’ll be thanking yourself for making your life easier.

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Investing Retirement

Changes to 401(k) and IRA in 2013

The new year will bring changes to 401(k) and IRA accounts.  These changes will allow you to save more.  Here’s a list of what’s changing:

  • Increased 401(k) contribution limit – The maximum you can save annually will increase from $17,000 to $17,500.  These figures apply to 403(b) accounts, too.
  • 401(k) fee notifications – Quarterly statements will include more information regarding fees you are paying in your 401(k) plan.
  • Increased IRA contribution limit – Workers who meet the income requirement will be able to contribute up to $5,500 annually, up from $5,000.
  • Increased Roth IRA income limits – Single people can contribute to a Roth IRA until they reach $112,000 in income, at which point contribution limits are decreased until income reaches $127,000.  Couples can contribute to a Roth IRA until they reach $178,000 in income, at which point contribution limits are decreased until income reaches $188,000.

The 401(k), 403(b), Traditional IRA, and Roth IRA are great methods for growing your retirement nest egg.  The tax advantages these retirement plans provide allow your money to grow more than in a taxable account.  The 401(k) and 403(b) plans are provided by employers, but anyone with an earned income can open a Traditional IRA or Roth IRA.

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Investing Retirement

Target Date Retirement Funds – Silver Bullet?

Target date retirement funds are fairly recent inventions created by investment brokerages to simplify the lives of investors.  Target date retirement funds take care of asset allocation for you, adjusting holdings to a more conservative mix as you near a fund’s target year, presumably a date near your retirement date.  As the fund nears the target year, stocks are exchanged for bonds or cash, effectively lessening the volatility of the fund and, as a result, helping to preserve your all-important retirement nest egg.

More and more 401(k) plans are offering target date funds due to their “set it and forget it” appeal and, accordingly, more and more individuals are choosing to place their dollars in target date retirement funds.  Although the funds have a one-size-fits-all veneer, it’s important to ask a few questions before investing in them.

Painting with a Broad Brush

Brokerages typically offer several target date funds, with a fund available for every five years from 2010 to 2055.  At first glance, it seems logical that you should choose a fund that is nearest to your retirement date.  One piece of information you should determine, though, is what holdings a given target retirement fund contains.  The Vanguard Target Retirement 2045 fund (VTIVX) holds 88.6% stock and 11.4% bonds and cash.  Fidelity’s equivalent fund, Fidelity Freedom 2045 (FFFGX), contains 73.4% stock and 26.6% bonds and cash.  An investor who is apt to take more risk would lean toward the Vanguard offering due to its almost 90% stake in stock, while a more risk averse investor would prefer Fidelity’s fund that holds close to 70% stock.  One size may not, in fact, fit all.  Additionally, holdings will change as a fund’s target date approaches and may change when a fund’s manager changes.  It’s important to take a periodic glance at fund composition to verify you are content with its holdings.

Fees, Fees, Fees

Just like asset allocation can vary from fund to fund, fees can vary, as well.  The Vanguard Target Retirement 2045 fund has an expense ratio of .19% while the Fidelity Freedom 2045 fund has an expense ratio of .76%.  While the roughly .5% difference may not seem like much, when you calculate the potential loss over the course of 30 years for a significant amount of principal, you stand to lose a good sum of money if you let expenses mount.  You have limited control over the amount of money you lose via the ups and downs of the market, but you can control which expenses you incur, so select a fund with lower expenses when choosing between similar performing funds.

Create Your Own

Due to not being content with the asset allocations in various target retirement funds, I have effectively created my own target retirement funds in my retirement brokerage accounts.  I decided on an asset allocation that I am content with (25% large cap, 25% mid cap, 25% small cap, 15% international, and 10% bonds) and chose five mutual funds in amounts that reflect this asset allocation.  As the market fluctuates, I rebalance my portfolio to maintain the desired asset allocation.  One advantage to this method of retirement investing is that I am effectively my own target retirement fund manager, can modify my asset allocation on my own timeline, can choose from many mutual funds, and don’t have to worry about a brokerage modifying my asset allocation.  A drawback to this method is that some funds have significant minimum investment requirements, so beginning investors may need to accumulate investment money for some time before investing in multiple funds.

For investors who prefer a hands-off approach, target date retirement funds are great options.  Coupled with an early start to retirement investing and regular contributions to retirement accounts, target retirement funds can help you grow a sizeable nest egg.  If you find that target retirement funds don’t exactly meet your needs, though, consider filling your portfolio with funds that match your desired asset allocation while minimizing fees.  By following either approach, you’ll be on your way to financial freedom in your retirement years.