WHEN DECIDING WHETHER it’s worth taking an investment risk, your starting point should be the so-called risk-free rate. That’s the return you can earn by taking little or no risk. Got your eye on an investment that might perform better? You need to decide whether the potential extra return, relative to the risk-free rate, is worth the added danger involved.
When experts talk about the risk-free rate, they usually point to some sort of Treasury security. Lately, that’s been an easy bogey to beat, thanks to the Federal Reserve’s loose monetary policy. For instance, if you have a short investment time horizon, you might compare possible investments to three-month Treasury bills, which today yield a tiny 0.5%. Longer-term investors might look to 10-year Treasury notes, which currently yield almost 2.5%, or even to 10-year inflation-indexed Treasurys, which are paying 0.6% above inflation.
But arguably, for anyone with loans outstanding, the risk-free rate shouldn’t be a Treasury security, but rather the interest rate on their highest-cost debt—and that can be a much tougher benchmark to beat. Let’s say you’re carrying a credit-card balance costing 20% a year. Paying off that balance is likely a smarter bet than any investment, except perhaps funding a 401(k) plan with a matching employer contribution.
Even tax-deductible mortgage debt can prove to be a high hurdle. Suppose you’re in the 25% tax bracket and your mortgage is costing you 4%, so your after-tax cost is 3%. You should be able to outpace that 3% over the long haul by buying stocks. But if you’re inclined to purchase bonds or certificates of deposit, you would probably be better off paying down your mortgage.
I HAD AN EMAIL from a reader today, asking whether—"with the markets a bit overvalued lately"—he should invest his cash in the stock market as a lump sum or average in over time. It's a question that almost compels you to start guessing the market's direction—something none of us can do. What's the alternative? Think about risk.
My response: "It depends on how much you currently have saved vs. how much more you expect to save between now and retirement. If the former is modest and the latter is significant, I'd invest the cash as a lump sum. If the reverse is true, I'd take it slowly." The reason: The consequences of a large short-term stock-market decline would be much more severe for someone closer to retirement, who doesn't have many years left to repair the damage done.
REAL ESTATE SEMINARS. Initial public stock offerings. International lotteries. Hedge funds. Franchising opportunities. Penny stocks. Multi-level marketing companies.
This is the American lexicon of easy wealth—and yet the only people who seem to end up rich are those who peddle this nonsense. It’s the story of the California gold rush: Riches accrued not to the miners, but to those who sold them shovels, picks, pans and other supplies.
To be sure, hollow promises and empty hype are rife in other areas of our life. Just check your spam folder for the latest phony diet, male enhancement and nutritional supplement.
Still, the world of money seems especially prone to such garbage. If the financial stakes are low enough, I’m not much bothered. Arguably, if you buy a $1 lottery ticket with an expected payout of 50 cents, you’re getting good value—because, in return for the money lost, you get the chance to dream briefly of riches.
But much of the time, there’s far more than $1 at stake. Real estate seminars can cost $25,000. Hedge funds often charge 2% of assets, plus taking 20% of all investment profits. The psychic pleasure of dreaming a little couldn’t possibly match the price paid.
You might argue that, if the buyers are so naïve, they deserve to be separated from their hard-earned dollars—and I might agree, if a thorough understanding of personal finance were required to graduate high school. But as things stand, I find myself horrified by the shameful fleecing of the ill-informed.
The prosaic reality: For the vast majority of Americans, the only sure road to riches is socking away one dollar after another, month after month, year after year. Nobody’ll pay you $25,000 to deliver that seminar. But it’s the truth.
SINCE EARLY OCTOBER, I've been selling signed copies of my new book. As the orders have rolled into my P.O. box, I have noticed an interesting pattern: While there's some representation from the two Coasts and the South, probably a majority of the orders have come from the middle of the country.
I don't believe this is happenstance. I hew to a no-nonsense financial philosophy--spend thoughtfully, save diligently, diversify broadly, hold down investment costs, manage taxes, insure against life's big risks--that appeals to those who are financially prudent. The evidence suggests these views are more prevalent in the middle of the country. For instance, according to Experian, one of the three major credit bureaus, the 10 cities with the highest average credit scores are all in the Midwest, including Minnesota, Wisconsin, South Dakota, North Dakota and Iowa.
PORTFOLIO MANAGERS and financial advisors are apt to depict money management as rigorously analytical, and sometimes even as a science. Maybe that’s inevitable in an endeavor where almost every decision ends up with a number, whether it’s the amount of life insurance to buy, the percentage allocation to emerging markets or the age at which you should claim Social Security.
But just because the answer has precision doesn’t mean this is a precise business. Should you put 65% or 70% of your portfolio in stocks? Should you get a health care policy with a $500 or $1,000 deductible? Should you keep four or six months of living expenses in your emergency fund? You’ll know the right answer in retrospect but, when making the decision, you’re pretty much guessing.
Make no mistake: Managing money is a rough-and-ready business, and what matters is getting the decisions broadly correct. It’s hard to say precisely how much life insurance you should buy, but it’s important to have some coverage if your savings are on the skimpy side and you have a family that’s financially dependent on you. It’s difficult to figure out exactly how much you should have in stocks, but it’s important to have some allocation in your long-term investment portfolio, so you have a decent shot at outpacing inflation and taxes.
The bottom line: You should fret less about getting any particular decision precisely right, and instead worry about whether you’re tackling the right range of issues. Got the perfect rewards credit card? It won’t mean squat if you die without a will or you don’t start saving for retirement until age 50.
FORGET FIGHTING the shopping mall crowds on Black Friday. Want signed copies of my new book, How to Think About Money, to give to family, friends, colleagues or clients? To get your autographed copies, send a check—made payable to Jonathan Clements—to P.O. Box 247, Ardsley-on-Hudson, NY 10503-0247.
To cover the cost of the book, shipping and handling, I’m charging $16 each for one or two copies, $15 each if you buy three to nine copies, $13 each if you purchase 10 to 49 books and $12 each if you buy 50 or more. In other words, if you want, say, five copies, it would be $75. Be sure to specify where the books should be sent. To ensure delivery by Dec. 24, please mail all checks by next Wednesday, Nov. 30.
Don’t care about having my scrawl at the front of the book? For $13.99, you can buy the paperback directly from Amazon.com or, alternatively, purchase the $9.99 Kindle or Nook editions. Got questions? Send me an email.
Meanwhile, check out the review of How to Think About Money that was published today by Jim Dahle of WhiteCoatInvestor.com, who says it "might the best financial book I've read in the last 5 years."
THE MARKET FOR INTELLIGENT financial writing is, alas, surprisingly small. Why? I believe there are three culprits.
First, many of us don’t care enough about our future selves. Sure, we care somewhat—but not so much that we’ll spend less today, let alone educate ourselves about how to prepare for retirement and other distant goals. Just check out the most popular personal-finance blogs. They focus on topics like coupons, credit cards and juggling debt. Most of us, it seems, are just trying to get by, not get ahead.
Second, we want to believe in magic. Reams of research show conclusively that most investors—professional and amateur—trail the market averages. Yet an article with “10 stocks to buy now” will garner far more eyeballs than a piece on building a globally diversified index-fund portfolio.
Third, we associate sophistication with complexity. But in the financial world, complexity is usually a ruse to bamboozle and fleece investors. Exhibit A: Hedge funds, cash-value life insurance and variable annuities with living benefits, all of which entail exorbitant costs.
The reality is, managing money is best when it is simplest. And yet, if you take the financial world, strip out the nonsense, focus on the simple truths and make them understandable to everyday Americans, readers will complain that “I knew that already” or “that’s obvious”—and then head off in search of strategies with greater bragging rights and lower return potential.
You can sometimes sidestep such complaints by slapping a little lipstick on the pig. With a catchy headline and clever writing, you might convince folks to save more, pay down debt and abandon efforts to beat the stock market averages.
For those who want to read intelligent financial writing, there are still plenty of fine publications, including The New York Times, The Wall Street Journal, Kiplinger’s Personal Finance and Money magazine. But the pages and the number of reporters stacked against sensible personal-finance coverage seem to shrink every year. To be sure, there are some great bloggers who have taken up some of the slack, and you can find fascinating finance conversations every day on Bogleheads.org.
Maybe I’m just being whiny and unrealistic. (It’s been known to happen.) The market for intelligent financial writing has probably always been small. Still, we need it to grow. Thanks to increasing longevity, weakening job security, disappearing pension plans and the rise of 401(k)s, Americans are more responsible for their financial future than ever before—and yet there’s scant evidence we’re any more financially savvy.
AROUND THIS TIME OF YEAR, financial advisors and the media start talking about taking tax losses. The notion: You sell underwater investments in your taxable account, and then use those realized capital losses to offset realized capital gains and up to $3,000 in ordinary income.
There’s nothing wrong with taking tax losses, though I think the notion is oversold. Unless you’re an active trader or a really bad investor, you probably won’t have any losses to take. Let’s say you hold a diversified portfolio. Within a few years, all of your investments should be above your cost basis—and, absent a huge bear market, you’ll never again get the chance to take tax losses.
Still, if you do have a losing investment in your taxable account to sell, the math can be impressive—especially if you don’t have any realized capital gains. Let’s say you have a $3,000 loss on your international stock-index fund. You realize the loss. Because you don’t have any realized gains, you can offset the loss against your ordinary income. If you’re in the 25% tax bracket, that would mean $750 in tax savings.
To maintain your foreign stock exposure, you immediately buy another international fund. You can’t buy the fund you just sold, or one that tracks the same market index, or you could run afoul of the so-called wash-sale rule. Instead, you purchase a fund that tracks a different international index. That fund then rebounds, so you make back your $3,000 loss. If you held the fund for more than a year and then sold, your gain would be taxed at the 15% long-term capital gains rate, assuming you’re still in the 25% income-tax bracket. Result: You’d pay $450 in taxes, or $300 less than your earlier tax savings.
Better still, you’d hang on to the fund, so the tax bill is delayed, allowing you to use the money earmarked for Uncle Sam to earn additional gains. Even better, you might bequeath the fund to your kids—at which point the capital-gains tax bill would disappear.
WHAT’S THE STATE of your financial health? Forget your credit score, the past year’s handsome increase in your home’s value or how your salary compares to your brother-in-law’s. In the end, financial fitness comes down to two key numbers.
First, there’s your net worth, which is the value of your assets minus your debts. There’s some debate about what should be included. The easy answer: Don’t delude yourself by counting the value of your car, furniture or Beanie Babies collection.
More contentious: I probably wouldn’t include your primary residence, unless you’re committed to tapping home equity in retirement, either by trading down to a smaller house or taking out a reverse mortgage. Instead, when counting assets, I’d stick with true investments, such as rental properties and money in bank and investment accounts.
Even more contentious: If you aren’t adding in your home’s value, maybe you also shouldn’t subtract any outstanding mortgage debt or, if you do, you should include a mental asterisk. Why the asterisk? If folks go from renter to owner, their net worth would immediately plunge if we ignored their home’s value but took into account mortgage debt—and yet, in all likelihood, their house is worth more than their mortgage. Indeed, eventually, homeowners should end up in much better financial shape than those who continue to rent, because owners lock in their monthly housing costs.
What’s the second key number? How much you add or withdraw from savings each month. There are many folks who see great virtue in carefully tracking how much they spend. I’m not convinced. As I see it, as long as you save enough every month during your working years and don’t spend too much in retirement, it doesn’t much matter whether the dollars you spend are lavished on Jack Daniel’s or Ben & Jerry’s.
In midlife, many families are both adding to savings and have a positive net worth—a pleasant position to be in. Matters are often less comfortable for those who are older and younger. Young adults may be spending less than they earn, but often their net worth is negative, thanks to student loans. Meanwhile, retirees are in the opposite situation, with an impressive net worth, but one that might be slowly shrinking, as they gradually draw down their savings.
Neither situation is necessarily alarming. Young adults have 30 or 40 years of paychecks ahead of them, which they can use to get their debts paid off and turn their net worth from negative to positive. Meanwhile, for retirees, dissaving may be unsustainable in the long run—but, if they are careful, they’ll give out before their nest egg does.
Indeed, you can think of your net worth through life as a broad arc. In your early 20s, it might be negative. But as you pay down debt and add to financial accounts, your net worth should gradually climb, so that you retire with a sum equal to perhaps 12 times your final salary. From there, matters go into reverse, but—fingers crossed—it’ll be a slow reversal.
FOR THOSE INCLINED to move in or out of the stock market based on Trump's victory, consider this: Forecasting elections should be relatively easy. All you have to do is identify a representative sample of the U.S. population and then ask them how they'll vote.
By contrast, forecasting the stock market is infinitely more complicated, involving a two-step process: First, you have to predict the economic and political news--and then you have to forecast how investors will react to this news. The bottom line: If the pollsters can't accurately predict an election, do you seriously think you can accurately forecast the direction of stock prices?
The article below appeared in my Oct. 28 newsletter. But after the overnight global market volatility and today's expected steep drop in U.S. share prices, I figured it was worth reposting.
THE CURRENT GRUDGING ECONOMIC RECOVERY is in its seventh year and the stock market rally is in its eighth year. Here I earn nobody’s admiration by stating the obvious: These things don’t go on forever—but nobody knows when the music will stop.
That makes this a good time to hold a financial fire drill. Focus on three key questions. How would you react if the stock market dropped 30% next week? Would a market plunge derail your upcoming financial goals? How would you cope if an economic downturn put your job at risk?
This first question is about emotional fortitude, while the second and third questions are practical ones—but all three have profound implications for how you position your portfolio.
Let’s start with first principles: Most folks should own a portfolio that has healthy exposure not only to stocks, but also to bonds and other more conservative investments. That way, you should earn handsome long-run returns, but your overall wealth shouldn’t be too badly bloodied by a stock market crash and you shouldn’t find yourself selling stocks at fire-sale prices to buy shoes for the children.
Not sure you have the right balance between stocks and bonds? The tricky issue: What counts as a bond—and what counts as a stock?
Looks like a bond
Bonds typically deliver a steady stream of regular income. If that’s the defining characteristic, many parts of our financial life look like bonds. Think about all the income streams you collect: There might be Social Security retirement benefits, income from immediate annuities and any traditional employer pension you’re entitled to. If these provide a hefty portion of your retirement income, that can free you up to invest more heavily in stocks—and potentially earn higher long-run returns.
As you consider the bond-like income you receive, also give some thought to the regular drains on your finances—in the guise of mortgages, auto loans and other debts. You can think of these debts as negative bonds. Got $400,000 in bonds and a $300,000 mortgage? Arguably, your net bond exposure is just $100,000.
Between student loans, car loans and mortgages, many folks reach their 30s with what seems like an alarming amount of debt. But typically, their net position in bonds is still substantial—thanks to their paycheck, which can be viewed as another bond-like source of income.
Indeed, among academics, the four decades of income that we collect from our so-called human capital provides the intellectual justification not only for taking on debt early in our adult lives, but also for investing heavily in stocks. By taking on debt in our 20s and 30s, we can buy items—think college degrees, cars and homes—that we couldn’t afford if we had to pay cash. This has the added benefit of smoothing out our consumption over our lifetime. Meanwhile, the debt involved shouldn’t be of great concern, because we know we have plenty of paychecks ahead of us to service these debts and pay them off by retirement.
Those paychecks, with their steady bond-like income, also free us up to invest the bulk of our portfolio in stocks. We don’t need income from our portfolio while we’re in the workforce, so we can go light on bonds and instead shoot for higher returns with stocks. But as we approach retirement and the last of our paychecks, most of us will want to cut back somewhat on stocks and invest more in bonds.
Are you a stock?
Keep in mind that not everybody’s paycheck is bond-like. Let’s say you work on commission, you’re a Wall Street trader or you’re involved with a Silicon Valley startup. Your income isn’t bond-like. Instead, it looks more like a stock. Maybe you will have a huge payday—or maybe you won’t be so lucky, and you will find yourself with far less income than you had hoped and perhaps even out of work. To reflect this risk, you might want a healthy stake in bonds and other conservative investments, even if you’re in your 20s.
Whether it’s bonds, a regular paycheck, a pension, an immediate annuity or Social Security, you’ll likely discover that much—and maybe most—of your assets are in bonds and bond lookalikes. And, of course, you likely own other assets, notably a home and perhaps even a second home.
The implication: Even if the stock market tumbled 30% tomorrow, the hit to your overall net worth would probably be modest, so there’s scant reason to panic. But to avoid feeling unnerved, it’s important to stay focused on your overall net worth, or you won’t get the emotional benefit that comes with spreading your money across a broad array of assets.
Owning multiple assets doesn’t just make for a less unnerving financial life. It also has a practical benefit: If the stock market plunges, you can draw on these other financial resources to buy groceries and pay the mortgage.
For retirees, those resources might include their monthly Social Security check and their bond portfolio. For those in the workforce, they have a paycheck. What if that paycheck is at risk, because there’s a chance you’ll get laid off if the economy turns down? This may be the moment to accumulate cash and set up a home-equity line of credit—so, if the need arises, you can get your hands on enough money to make it through a long spell of unemployment.
FOREIGN STOCKS have become the investment that folks love to hate—and it’s easy to understand why. In the current decade’s first six full calendar years, foreign shares trailed the S&P 500 by almost nine percentage points a year—and they’re on track to lag behind the U.S. again in 2016.
But is this recent performance a good guide to the future? Almost certainly not. Foreign stocks are far less expensive than U.S. shares, as you’ll discover at StarCapital.de. On top of that, history tells us that there are plenty of decades when foreign stocks outpaced U.S. shares. I’ve been perusing the “big picture” chart from Investments Illustrated that shows the performance of different asset classes since year-end 1925.
At first blush, foreign stocks look like a dubious choice, returning 7.9% a year over the past nine decades, versus 9.8% for the S&P 500. But that huge performance gap was driven in large part by the 1940s, when some foreign markets were devastated by the Second World War, and by the 1990s, when the U.S. market was driven to giddy heights by the technology boom. Foreign stocks lagged behind the U.S. market by 13.9 percentage points a year in the 1940s and by 11.1 points in the 1990s.
What if you look at the other six full decades depicted in the chart? There was only one decade—the 1960s—when U.S. stocks outpaced foreign shares. Indeed, foreign shares occasionally proved to be a great diversifier for U.S. stocks, notably in the wretched 1970s, when foreign markets scored 10.1% a year, while U.S. stocks eked out an inflation-lagging 5.8%.
Moreover, if you look at the past 50 years, you find U.S. stocks clocked 9.8% a year, barely ahead of the 9.4% notched by foreign markets. My advice: Keep the faith—and keep those foreign stocks in your portfolio.
REFLECT. PAUSE. FOCUS. That’s my three-pronged strategy for getting more out of your money, whether you’re investing it or spending it. Want to learn more? Check out my latest newsletter.
Meanwhile, with the economic recovery in its seventh year and the stock market rally in its eighth year, this is a good time to hold a financial fire drill. How would you cope if the stock market dropped 30% next week or you lost your job because of an economic downturn? That topic is also tackled in the newsletter.
WE’RE OFTEN ENCOURAGED to follow our instincts. But if we did that, many of us would sit on the couch drinking margaritas, eating Cheez Doodles and cruising online shopping sites, when we should be eating less, saving more and heading to the gym. Often, the key to a better life—financially and otherwise—is to get ourselves to take action we instinctively resist.
This is obvious advice if we’re overweight, rarely exercise, panic when the stock market declines and find our credit-card balances balloon with every passing month. But fighting our instincts can also be good advice for folks with habits that typically receive a societal seal of approval.
For instance, your employer isn’t likely to raise any objections if you work seven days a week. Quite the contrary: You’ll likely find yourself showered with pay raises and promotions.
I think there’s great pleasure to be found in work, while endless relaxation can quickly turn to endless boredom. Still, a life devoted solely to work is an unbalanced life. To steal a line that others have used, “Nobody’s dying words have ever been, ‘I wish I’d spent more time at the office’.” If you’re working seven days a week, you probably aren’t as productive as those who take regular breaks, plus you’re missing out on so much—friends, family, nature and the amazing accomplishments of others that are on display in concert halls, books, museums, sports arenas and elsewhere.
Another example: if you’re a great saver and you amass a healthy amount of wealth, you’re unlikely ever to be a financial burden to others and, indeed, you may enjoy the admiration of family and friends. Yet, in the end, the rationale for saving now is so we can spend later.
Countless financial planners have told me that the clients who are best at accumulating money for the future are often the worst at making the retirement transition from saver to spender. If you can’t bring yourself to use a healthy portion of your wealth for your own enjoyment and that of others, your great savings habits seem less like a virtue—and more like an obsession.
IF YOU DROVE DRUNK but got home unscathed, you wouldn’t wake up the next morning and think, “I guess it’s okay to get behind the wheel after 13 beers.” Yet, when handling our finances, we do that all the time.
“Markets generate a lot of data, but they don’t generate a lot of clear feedback,” writes academic Terrance Odean in his foreword to Michael Ervolini’s thoughtful book, Managing Equity Portfolios. “Outcomes are noisy. Good decisions may have bad outcomes. Bad decisions may have good outcomes.”
The problem: We typically judge our financial choices by a single, crude yardstick—whether they make or lose us money. But that measure of success or failure can result in faulty feedback that validates bad behavior. Consider three examples:
- We bet everything on a single stock and it soars in value. We imagine we’re great investors. But in all likelihood, it was dumb luck—and our next big bet could wipe us out.
- We don’t bother with homeowner’s insurance, saving roughly $1,000 a year in premiums. Our home hasn’t burned down, so it seems like a wise decision—until we smell smoke wafting up from the basement.
- We dump bonds and foreign shares, because they’ve posted seven years of mostly lackluster returns. Instead, we make a big, undiversified bet on highflying U.S shares. The market cycle turns—and you can guess the rest.
What’s the lesson here? Dispassionate contemplation is a better teacher than personal experience—because contemplation leads us to consider the range of possible outcomes, while our personal experience represents a sample of one. So what happens if we consider the range of possible outcomes? We become focused not on whether a particular strategy has made us money in the past, but on how to improve the odds that we’ll make money in the future.