CYNICS SAY THERE ARE THREE KINDS of falsehood: lies, damned lies and statistics. Yet the right number can pack a mighty punch—and the financial world is full of them. Here are five examples:
Most folks don’t beat the market. Consider the miserable performance of most mutual funds. Standard & Poor’s found that 75% of actively managed U.S. stock funds failed to beat the market over the decade through June 30.
Stocks create amazing wealth, given enough time. Over the 40 years through Sept. 30, global markets climbed 9.6% a year, as measured by MSCI’s World Index. That’s enough to turn $10,000 into almost $400,000. An obvious conclusion: If you give up self-defeating efforts to beat the stock market, and instead simply capture the market’s performance using index funds, you’ll likely be thrilled over the haul.
Houses don’t appreciate much. According to figures from Freddie Mac, U.S. home prices climbed 4.7% a year over the 40 years through Sept. 30, not much ahead of the 3.7% inflation rate. Sound grim? It isn’t as bad as it appears: Homes may not climb much in value—but they do give you a place to live.
Money doesn’t necessarily buy happiness. In 2014, 32.5% of Americans described themselves as very happy, below the 42-year average of 33.3%, according to the General Social Survey. Over this 42-year stretch, inflation-adjusted per capita disposable income rose 110%.
Many Americans face a grim retirement. The Employee Benefit Research Institute’s 2015 Retirement Confidence Survey found that 52% of workers age 55 and older had savings of less than $50,000. This figure excludes the value of their home, Social Security and any defined benefit pension plan. Yes, money doesn’t necessarily buy happiness. But make no mistake: Not having money could make you miserable.
IT’S BEEN A ROUGH YEAR for yield chasers. But the damage can’t be blamed on a general rise in interest rates, which would have driven down the price of existing bonds. Today, the yield on the benchmark 10-year Treasury note is barely above where it stood at year-end 2014.
Instead, the dreary results stem from concerns about credit quality. Those drawn to the fat yields on Puerto Rican municipals have been rewarded with tumbling bond prices and the threat of default. This year’s biggest losers also include master limited partnerships, a high-yield play on the energy sector, which are down roughly 30% as oil production has fallen off.
Meanwhile, bank loan funds and high-yield junk bond funds are treading water or worse in 2015, as fat yields have been offset by falling share prices. Take the Fidelity High Income Fund. It’s currently boasting a yield of almost 7%. But even with fat dividend payments, the fund is posting a loss for 2015, down 2.7%, thanks to the slide in the fund’s share price.
Will 2016 be kinder? It’s impossible to say, in part because so much depends on how the economy fares. But for now, the margin of safety doesn’t look great.
Again, take high-yield junk bonds. During 2015, the yield above Treasurys has widened from 4.9 to 6.3 percentage points. That means today’s buyer has a bigger cushion, should we see a wave of bond defaults. On the other hand, the average spread historically has been 6 percentage points, so the current buffer isn’t exceptionally large, plus the spread would look a lot tighter if Treasury yields weren’t so low.
STOCKS GET ALL THE ATTENTION, which seems a tad unfair. The value of bonds worldwide is some 35% greater than the value of all stocks—plus many other parts of our financial life look suspiciously like bonds. How so? Think about all the streams of steady income that folks collect.
We pull in interest from bank products like savings accounts and certificates of deposit. We collect Social Security retirement benefits. If we’re lucky, we are the recipients of a traditional employer pension plan. Most important, we have our regular paycheck.
The more we receive from paychecks, pensions, Social Security and other bond-like streams of income, the more risk we can take with our investment portfolio, by tilting toward stocks. At times of stock market turmoil, when we’re feeling unnerved, we should focus not only on the money we have in conservative investments, but also on the various streams of income we collect. The key question: How long could we go without being forced to sell shares? In all likelihood, it’s many years, if not decades—which means there is no rational reason to fret over the stock market’s decline.
Our financial life doesn’t just include many bond-like streams of income. We also have negative bonds, otherwise known as our debts. While bonds pay us interest, our debts cost us interest. Typically, our debts charge us a higher interest rate than we can earn by buying bonds, because we’re considered less creditworthy than, say, the U.S. Treasury or IBM. One implication: It often makes sense to pay down debt rather than to purchase bonds, because the interest payments we avoid are greater than the interest we could have earned.
SINCE RETURNING TO LIFE as an ink-stained wretch early last year, I have been talking about the likelihood of modest stock returns. My best guess: A global stock portfolio might notch 6% a year over the next decade, while inflation runs at 2%.
It turns out that the person I admire most on Wall Street, Vanguard Group founder John Bogle, also has modest expectations. This is no great surprise: How I think about stock returns has been greatly influenced by Jack’s writing.
Back in 1991, Jack presented a delightfully simple method for analyzing stock returns. He distinguished between the market’s investment return and its speculative return. The investment return consists of the market’s initial dividend yield, plus growth in earnings. What about the speculative return? That’s reflected in the varying price put on those earnings, as measured by the market’s price-earnings ratio, or P/E.
When investors are exuberant, the P/E ratio might climb above 20. When they’re fearful, it could fall below 12. But if there’s no change in the P/E, then all you collect is the investment return: You pocket the dividend yield, plus the price of your shares should march higher along with earnings.
So what does the future hold? In an article just published in the Journal of Portfolio Management, Jack and co-author Michael Nolan note that the U.S. market’s initial dividend yield is around 2% and that “earnings seem likely to increase at around 5%, or perhaps even less, during the coming decade.” That would put the market’s investment return at 7% a year. But they say a decline in the P/E ratio toward historical norms might knock one percentage point a year off the market’s return, “reducing stocks’ annual investment return of 7% to 6% per year in nominal terms.”
What should investors do? That’s easy. Americans need to save like crazy to compensate for the market’s likely modest gains—and they should make sure they capture as much of those gains as possible, by opting for low-cost market-tracking index funds.
FAMILY CAN BE A WONDERFUL ASSET. Your parents, siblings and adult children might help with home repairs, offer free advice based on their professional expertise and take care of the dog while you’re on vacation.
When the circumstances are right, I think there’s an opportunity to take this even further. For instance, earlier this year, I provided my daughter with a private mortgage, which allowed her to purchase her first home. There aren’t many people I’d strike that deal with, but Hannah is both gainfully employed and financially responsible, so the risk seemed modest. To handle the paperwork and keep this as an arm’s length business deal, we had National Family Mortgage in Belmont, Mass., set up and service the mortgage.
Earlier this year, National Family Mortgage came out with a new product: a private reverse mortgage. To help their parents pay for retirement, adult children or other family members might provide a credit line that’s secured by the parents’ home. That gives the parents access to extra cash, while the adult children can be fairly confident they’ll eventually get their money back, plus interest.
Obviously, a private reverse mortgage is an option only available to well-heeled families. Still, for those who can afford it, it’s an intriguing possibility—and notable for how it changes our perceptions. Many folks resist reverse mortgages, because of the hefty costs, complexity, fear that they’re putting their homes at risk and a sense that they’re spending their children’s inheritance. A private reverse mortgage helps to ease these concerns, making the transaction far more appealing.
Indeed, I wonder whether there are other unpopular financial products that might catch on if they could be structured as family deals. Take immediate-fixed annuities, which many folks resist buying, because they hate the idea that they’ll purchase the annuity and then go under the next bus. Now, imagine the people on the other side of the transaction were your children, who would provide you with lifetime income in return for a lump-sum payment. Suddenly, if you go under the next bus, it would be your children who gained financially, not the insurance company—and the deal might seem a whole lot more compelling.
TWO KEY CHANGES to Social Security retirement benefits were wrapped into the budget bill passed by Congress last week. The changes have big implications for married couples.
First, after April 2016, if you suspend your benefit, any family members collecting benefits on your earnings record will also have their benefit suspended. Second, those who aren’t age 62 by Jan. 1, 2016, will lose the right to file a restricted application, where you claim just spousal benefits, while leaving the benefit based on your own earnings record to continue growing.
For the uninitiated, all this might sound utterly baffling—and, trust me, it is—but Mike Piper has a good summary on his blog. I’ve been emailing with Mike, in an effort to get up to speed on the changes. Mike is revising his guide to Social Security, and hopes to have a new edition out before the end of the month.
In the meantime, I thought I’d spell out a few of the implications. The obvious: If you have reached your full Social Security retirement age of 66 and you’re thinking of using the “file and suspend” strategy, you need to move fast. The idea is to file for benefits, which is necessary for your husband or wife to claim benefits based on your earnings record. You then suspend your own benefit until as late as age 70, thereby increasing both your benefit and potentially also the survivor benefit collected by your spouse.
When it comes to filing restricted applications, those who will be age 62 by year-end will be grandfathered. That means that, once they reach their full Social Security retirement age of 66, they can apply just for spousal benefits, while leaving the benefit based on their own earnings record to continue growing. For this grandfathered group, often the best strategy will be for the lower-earning spouse to claim Social Security retirement benefits first. The higher-earning spouse, at age 66, then files a restricted application, claiming just spousal benefits, while leaving his or her own benefit to grow until age 70. That way, higher-earning spouses not only lock in the largest possible monthly benefit for themselves, but also a larger survivor benefit for their spouse, assuming the higher-earning spouse dies first.
What about those affected by the new rules? Much will depend on the relative ages of the spouses, the relative size of their benefit and the state of their health. Still, for most folks, the top priority remains the same: You want the higher-earning spouse to delay benefits until age 70, thereby ensuring both a maximum monthly benefit for that spouse and also a maximum survivor benefit.
This strategy will be a lot more palatable if the higher-earning spouse is older than his or her wife or husband. If the higher-earning spouse is, say, three or four years younger, there will be a greater temptation to claim benefits before age 70. Why? First, the lower-earning spouse can’t receive spousal benefits until the higher-earning spouse files. Second, because of their relative ages, there’s less chance the higher-earning spouse will die first—and thus there’s less chance the survivor benefit will prove important.
STOCK MARKET GYRATIONS since mid-August have investors focusing intently on short-run returns. But if you can drag your gaze away from the daily turmoil, you’ll realize this is a colossal waste of time—and a huge distraction from the big story.
This thought occurred to me as I was playing around with the data available at MSCI.com. Take the MSCI World index, which includes 23 developed markets, including the U.S. From the index’s year-end 1969 inception through Sept. 30, 2015, global stock markets have clocked 8.6% a year, with net dividends reinvested, while U.S. inflation ran at 4.1%. That was enough to turn $1,000 into $43,700, or $6,800 after adjusting for inflation.
Yes, stocks got a big boost from the great 1980s and 1990s bull market, as well as the strong gains in the current decade. But the MSCI index’s results also reflect the 1970s and the 2000s, neither of which were stellar for stocks. Performance was also dragged down by the Japanese market’s dismal losses over the past quarter-century.
My best guess is that stocks will return 6% a year over the next decade, while inflation runs at 2%. That’s somewhat below the return that global markets have generated since 1969, but still enough to create impressive wealth when compounded over many decades. There will, of course, be bumps along the way, but those who regularly shovel money into stocks will benefit as they buy shares at cheaper prices. My advice: Forget this year’s turmoil—and instead ponder the riches that will accrue to those who can ignore it.
SOCIAL SECURITY RETIREMENT BENEFITS may eventually get cut. But it shouldn’t influence when today’s retirees claim benefits.
I have argued frequently that it makes sense to delay Social Security, especially if you’re the family’s main breadwinner. By postponing benefits from age 62 to age 70, you can lock in a lifetime stream of inflation-indexed income that’s 76% or 77% larger. That income stream could salvage your retirement if you outlive your nest egg, while also providing a handsome survivor benefit to your spouse, assuming you’re married and you predecease your husband or wife.
But many folks disagree, in part because they figure they should get every dollar they can before the politicians slash benefits. Yet this doesn’t appear to be a risk: Even Republican presidential candidates, who have addressed the thorny issue of how to fund Social Security, aren’t proposing to shrink the monthly checks of existing retirees.
For instance, New Jersey Governor Chris Christie has proposed raising the Social Security retirement age starting in 2022, which means it would affect those currently age 55 and younger. Similarly, Senator Marco Rubio wants to raise the retirement age, but he says he’d like to do so without affecting those currently over age 55. The implication: Today’s retirees shouldn’t rush to claim Social Security, because they fear their benefits are on the chopping block.
WITH 2016 RAPIDLY APPROACHING, I’m gearing up to put out the next annual edition of the Jonathan Clements Money Guide. It’s the same drill as last year: I wait for the markets to close, spend the next few hours updating a slew of numbers throughout the manuscript, send off the files to Amazon and Barnes & Noble—and, fingers crossed, the book is available for sale the following afternoon.
I’ll go through this exercise twice, first on Nov. 30 and again on Dec. 31. The Nov. 30 edition will only be available as a paperback—I’m hoping folks will buy it for the holidays—while the Dec. 31 version will be available as a paperback, Kindle e-book and Nook e-book. You can now pre-order the Kindle edition, which costs $9.99. The book’s Amazon page says it will be auto-delivered on Jan. 15 but, barring technological glitches, it should be out Jan. 1.
UNDERSTANDING COMPOUNDING is fundamental to managing money. Without a good grasp of the way money grows and shrinks over time, folks can’t fully appreciate the value of starting to save when they’re young, the damage done by large investment losses or the true cost of carrying credit-card debt.
Yet I fear compounding isn’t well understood. This has dawned on me over the past month, as I’ve been teaching an undergraduate course on personal finance. Many of my students repeatedly make the mistake of adding together investment returns. For instance, if an investment earns 10% this year and 10% next year, they think the cumulative gain is 20%. But in truth, you would make 21%. The reason: In the second year, you earn 10% not only on your original investment, but also on the money earned during the first year. Thanks to compounding, if you earn 10% a year, you double your money roughly every seven years.
But compounding isn’t always your friend. It also comes into play with debt, as you incur interest not only on the original sum borrowed, but also on interest from earlier periods that wasn’t repaid. This is the trap that many credit-card borrowers fall into, as their minimum payments barely offset the financing charges they incur.
Just as my students add together investment gains, they also make the mistake of adding together gains and losses. For instance, if a hypothetical investor loses 50% this year but makes 50% next year, many of my students think our investor is back to even. But in fact, the cumulative result is a 25% loss. The grim reality: To recoup a 50% loss, you need a 100% gain. This highlights the danger of betting heavily on a few stocks, buying investments with margin debt and purchasing leveraged exchange-traded index funds.
Struggling with the notion of investment compounding? You might try playing around with a simple investment calculator, such as the one offered on Dave Ramsey’s website. Unfortunately, the calculator doesn’t allow you to assume a negative rate of return. But it does show how your money can balloon, given enough time, good savings habits and even a modest rate of return.
AS THE STOCK MARKET YO-YOS up and down, I figured it was worth taking a step back and talking about how investors should behave. Below is an excerpt from the Jonathan Clements Money Guide. What does it mean to be a seasoned investor? Here are eight signposts:
- You have mixed feelings about rising markets. Yes, it’s great that your portfolio has grown fatter. But it also means future returns will be lower. By contrast, tumbling markets excite you, because you could get the chance to scoop up investments at bargain prices.
- You select stock and bond funds that you would be happy to hold for a decade or longer—and you do indeed hold them for that long.
- When you make investment decisions, you think not only about the potential return, but also about risk, investment costs, taxes, why you’re investing and your broader financial picture.
- You can succinctly explain why you own the portfolio that you do, including the reasons behind each investment.
- When your investments lose value, you’re never surprised, because you have a good handle on the likely risk and reward for every investment you own.
- You can coolly decide whether to buy or sell, without getting fixated on what’s happened in the market recently or what price you paid for a particular investment.
- You’re mentally prepared for parts of your stock portfolio to have wretched results over five and even 10 years, you have the patience and tenacity to stick with these sectors—and your financial goals wouldn’t be at risk if stock returns were truly awful.
- You realize that markets are unpredictable and that it’s extremely difficult to earn market-beating returns, so you always have some money in bonds and some money in stocks, and you avoid overly large bets on individual investments and narrow market sectors.
IT'S ONE OF THOSE INDELIBLE teenage memories: visiting the Bank of Baltimore in suburban Washington, DC, in the late 1970s. I would hand over my babysitting or lawn-mowing money to the bank clerk, who would slide my green bank book into some magic typewriter. After a joyous clatter of keys, my bank book would be returned, and there would be recorded not just my deposit, but also the latest quarterly interest payment.
My children and stepchildren—ages 10 to 27—all have bank accounts. But there’s no joyous clatter of keys and, more important, there’s little or no interest to be had. As it happens, they are better off today than I was then. In 1978, we earned around 5% in pretax interest—but inflation was 9%. Today, my kids earn nothing—but annual inflation is running at just 0.2%. It’s hardly the stuff of playground or barroom boasts, but they are losing money far more slowly.
Still, I suspect I was more motivated to save. I may have been the victim of a money illusion—imagining I was making money when I was actually losing ground—but I had the pleasure of watching my account grow both because of the money I socked away and because of the interest I earned. By contrast, my children and stepchildren’s accounts are firing on just one cylinder, the raw dollars they deposit.
How can you making saving money more exciting for your kids? You could beat Federal Reserve Chair Janet Yellen to the punch and raise interest rates for your kids. Every three months, you might pay 5% interest, adding an extra $5 to their bank accounts for every $100 they have saved at that juncture. Depending on how good your kids get at saving money, this could become an expensive proposition. But that, of course, will be the sign that you’ve succeeded.
AFTER A TURBULENT FEW MONTHS for stock prices and with 2015 winding down, talk will soon turn to tax-loss harvesting. The notion: You sell losing stocks in your taxable account, and then use the realized capital losses to offset realized capital gains and up to $3,000 in ordinary income, thus trimming your 2015 tax bill.
Sound like a smart strategy? If you trade individual stocks actively or you’re a really bad investor, tax-loss harvesting might make sense. What about the rest of us, who sit quietly with a handful of mutual funds and exchange-traded index funds, and perhaps also own a few long-term individual stock holdings? Most of the time, there won’t be any losses to harvest.
Yes, if you’re a long-term investor, you might get the chance to realize losses in the first few years that you own a fund or an individual stock. But soon enough, your investments will likely be above your cost basis, and the chance to benefit from tax losses is probably gone forever. Instead, you’ll face an entirely different problem: How do you rebalance your holdings without getting whacked with big capital-gains tax bills?
The upshot: If you’re a sensible investor, I wouldn’t spend too much time worrying about tax losses, and instead focus your efforts on two far more important tax-minimization strategies. First, make sure you keep tax-inefficient investments in your retirement account. That list would include taxable bonds, actively managed mutual funds, stocks you plan to trade and real estate investment trusts.
Second, aim to hold tax-efficient investments in your taxable account, including stock index funds, tax-managed stock funds and individual company stocks you plan to hold for the long haul. These investments might generate dividends each year, but you shouldn’t pay much in capital-gains taxes, unless you opt to sell. You might also hold tax-free municipal bonds in your taxable account, though—as I’ve argued elsewhere—you’ll probably fare better by favoring taxable bonds in your retirement account, while reserving your taxable account for tax-efficient stock holdings.
"SOMETIMES, YOU HAVE TO GO BACKWARD to go forward." That's my advice to financial advisors in my latest article for Financial Planning. The advice is equally applicable to the typical investor. To get the most out of your money, occasionally you may want to take steps that trim your portfolio's value in the short-term.
Examples? It often makes sense to live entirely off savings in your early retirement years, while delaying Social Security benefits to get a larger monthly check. It might also make sense to sell certificates of deposit, money-market funds and high-quality bonds, and use the proceeds to pay off debt. Your debts are likely costing you more in interest than you're earning on these conservative investments, so you'll be ahead financially, even if your investment portfolio is a tad smaller. Got a year with relatively little taxable income? You might seize the opportunity to convert part of your traditional IRA to a Roth IRA. That may trigger a big tax bill--and hence take a slice out of your savings--but you will enjoy tax-free growth thereafter.
SOMETHING HAD TO GO. The final chapter of the Jonathan Clements Money Guide 2015 was devoted to 31 rules for the financial road ahead. For the Money Guide 2016, I'm replacing that chapter with a new final chapter, which details how to create your own financial plan in 18 easy steps.
But even as I axed the 31 rules from the manuscript, I figured they deserved a permanent home. Every year, we see changes in tax thresholds, financial products, market performance, economic numbers and what worries investors. But while the financial world changes constantly, sensible financial advice doesn't--and that, I like to think, is what's captured by the Money Guide 2015's 31 rules of the road.