Volatility and Saving

We talk about saving for “retirement”, but what we really want is to create financial independence where you can work if you want to, but not because you have to. We create that wealth by saving.

When the market does well, people want to save and invest. It feels good when it is working! When there is volatility like in December 2018 (the worst December since 1931 according to Barrons), people don’t want to invest and saving becomes a lower priority. If they do save, it is either just going into checking or paying down debt. Both of those are part of a good financial plan, but that’s not the path to becoming a millionaire.

I think most Americans have a hard time imagining that they could become a millionaire, but one million dollars is not a vast amount of wealth in 2019. At a standard 4% withdrawal rate, a $1 million nest egg only provides $3,333 a month in distributions. And that is pre-tax! Take out  20% for taxes and you’re left with $2,666 a month net. 

With inflation of just 2-3%, one million dollars will have less than half the purchasing power when today’s 30-somethings reach retirement age. If you think you need $1 million in today’s dollars, you might need $2 million or more when you are 65 to maintain the same lifestyle.

I’m glad that the market has rebounded nicely in the first quarter of 2019. Looking ahead, there remains a great deal of uncertainty: rising inflation, falling corporate profits, an inverted yield curve, and so on. It’s easy to feel uneasy today. No one knows what will happen in 2019. In spite of Q1, it looks like a rough road ahead.

But it doesn’t matter. At least not to a long-term investor. And most of us are long-term investors. I don’t just mean people in their twenties – even if you are in your sixties and retiring soon, you’re not going to be pulling all your money out in the next two years. You still have an investment horizon of 20, 30, or more years.

We can’t let market volatility – or the fear of any one year – impact our commitment to saving and investing. Don’t try to time the market with your savings strategy. I have no idea what will happen in 2019 or even for the next five years, but I’m going to keep on saving and adding to my diversified portfolio. (I follow our Growth Model.)

I have been thinking recently about 10 years ago, March 2009. It was a terrible time in the market. The S&P 500 had been cut in half. It felt like every day was a new disaster. 2% drops were the norm, and there were the really bad days when the market would fall by 5% or more. As a financial advisor, I talked with people who were afraid, upset, and angry. My own account was down $200,000 at one point. I remember thinking that I could have paid off my mortgage if I had sold (at the top), and I’d still have more money left over than I had right then. Lots of would-a, could-a, should-a regrets.

I told people to stay the course, and that’s what I did. Thankfully, most followed my advice. Looking back with the gift of hindsight, it was an incredible buying opportunity and would have been a terrible mistake to sell. But it didn’t feel so obvious at the time! I didn’t get any calls from people who wanted to buy in February or March 2009.

Fast forward to 2019: if you had purchased the S&P 500 Index ETF (ticker IVV), your ten year annualized return to February 1, 2019 would have been 14.95% (source: Morningstar). Incredible!

Now, that is cherry-picking the bottom of the market. So to be fair, let’s take a longer look. If you had invested 15 years ago, even with riding it all the way down in 2009, your 15-year annualized return of IVV still would have been 8.13%. Even with the biggest financial disaster since the Great Depression, investors in a basic stock index fund still have earned an 8% annual return over 15 years. That’s the sort of time horizon we should be thinking about.

At a hypothetical 8% return, you would double your money every nine years, with no additional contributions. If you had invested $100,000 into a fund and received 8.13% for 15 years, you’d end with $322,993. This is why we should keep saving and investing, despite whatever fear we may have about the market, politics, global risk, or whatever we may face in 2019 or in any single year.

How much should you save? IRA contribution limits have been increased in 2019 to $6,000 (or $7,000 if age 50 or older). That’s $500 a month, which is a lot for many Americans, but very doable and certainly a good place to start.

If you can earn 8% on your $500 a month, you will have $745,000 after 30 years. You will break $1 million in less than 34 years. For a couple, you can both invest in an IRA, so you could double these amounts. Most studies of retirement planning assume 30 years of accumulation. The question facing each of us is when to start. If you can start saving at 22, you could (potentially) have a million in your IRA by your mid-fifties. If you don’t start saving until age 40, it would take until your mid-seventies to reach the same level.

Some of you reading this have household incomes over $200,000. Can you save $5,000 a month? It’s possible, especially if you both have 410(k)’s with matching contributions. If you save $5,000 a month for 30 years, at 8%, you’d have $7,451,000. With that size nest egg, and a 4% withdrawal rate, you’d have nearly $300,000 in annual income. That’s actually more than your previous income.

Save early, save often, save as much as you can. No one has a crystal ball about what the market is going to do, but thankfully, accumulation has not been dependent on market timing. What has been successful in the past has been having a well-diversified asset allocation, using index strategies, and keeping expenses and taxes low.

Maybe instead of focusing on what the S&P 500 did in 2018 or your portfolio return over 12-months, we ought to track our savings rate. How much did you save in 2018? Are you increasing your savings in 2019? Are you saving enough to meet your goals? At your current savings rate, how long might it take to become financially independent?

If you are concerned about low rates of return in the years ahead, we may need to save more. But there’s no intelligent process for becoming financially independent, becoming a millionaire, that doesn’t include regular savings. We are always happy to talk about our investment strategy and why we invest how we do, but the conversation that more of us should be having is how to save more.

Past performance is no promise of future results. Historical returns are not guaranteed.

Skin In The Game

Leading up to the last financial crisis, bankers made hundreds of millions by packaging together mortgages and selling them. They were paid upfront and had no repercussions when those mortgages went into foreclosure and both the homeowners and investors lost money.  The asymmetry that bankers had an enormous upside to sell something but shared none of the downside risk led to catastrophic losses.

This is the subject of Skin In The Game, a new book by Nassim Nicholas Taleb, perhaps the foremost writer on risk and the practical application of the mathematics of probability. I’ve just finished the book and while it was not an easy read, its ideas are relevant to investors.

Skin in the game – having shared risks and rewards – is essential for investors to achieve better outcomes with their advisors and investment managers. Taleb points out interesting and not always obvious situations where these asymmetries present potential pitfalls in investing, politics, economics, and everyday life.

Investors would be well-served to think about whether their advisors have skin in the game and aligned interests, or if they are like the bankers who win regardless of whether their clients profit or not.

Before starting my own firm, I worked at two companies for 10 years. I had one colleague, who in spite of making a lot of money over many years, actually had less than $50,000 in investments. His top priority was paying down his mortgage. He talked about investments all day long yet had almost no interest in putting his own money in what he recommended to clients.

Another colleague invested significant sums every month and became one of the three largest clients of the firm. And every purchase was into the exact same funds as our clients. Which of those Financial Advisors would you prefer to manage your money? One who didn’t want to invest or one who couldn’t get enough of the funds we bought for clients?

Strangely, to me at least, clients rarely ask questions about Skin In The Game. I became a Financial Advisor because I was fascinated with investing and found myself spending all my evenings and weekends reading everything I could find and investing every dime I could scrape together. I opened my firm with one purpose: to treat every client as I would want to be treated.

That’s why I’d encourage investors to think and ask about Skin In The Game. Here are some ways to do that:

1. Doing not Saying. If you really want to know what people believe, find out what they do, rather than what they say. Understanding the difference is a BS-detector. Do you invest in this fund? How much of your net worth is in this strategy? Have you bought this investment for your mother’s account? Those answers, if you can get an honest one, are more telling than any pitch. In other words, don’t buy a Ford from someone who drives a Toyota.

2. Appearances. Taleb is trying to choose between two surgeons: one has an Ivy League undergraduate diploma, and wears immaculate bespoke suits. The other wore rumpled clothes, was a bit slovenly, and came from a middle class background. Taleb suggests choosing the latter surgeon, because he had to work much harder to achieve his career and is therefore likely more skilled. The first was more successful in looking like a surgeon rather than being the best possible surgeon.

(Thank you to all the clients who have hired a former music teacher to manage millions of their dollars. I used to get up at 5 am for years to study for the CFP and then CFA exams before going to work. It hasn’t been an easy road.)

3. Simple is better than complex. Complex solutions are sometimes created as a hook to sell something. Often, a simple, well-tried approach is more effective. Convoluted structures conceal many flaws, hidden fees, and conflicts of interest. If something seems unnecessarily complex, that’s a red flag.

4. “Scientism”. Facts and book knowledge can be bent to your point of view. Consider for example: “homeowners have 30-times the wealth of renters”. I heard this statement this week, along with the conclusion that buying a house therefore causes wealth. Correlation is not causation! You could also reach the opposite conclusion: you have to be very wealthy to afford a house in America.

Both are flawed because the thought process of going from the fact to the conclusion is biased. If I got an apartment, would I become poor? No, of course not. Taleb calls this “Scientism”, dangerous ideas which sound scientific, but don’t actually follow the objective hypothesis-testing process demanded by real science.

You cannot become wealthy without taking risks. The best way of ensuring a good outcome is through the fairness of symmetry and shared risks. That means both sides have an upside and a downside.

I don’t have a crystal ball about what the market will do, but I do invest in the same ETFs and Funds as my clients (I use our Growth Portfolio Model). By having Skin In The Game, I think it does provide an important motivation to spend extra time on due diligence, think carefully about risks, and follow our positions closely.

Vanguard’s Measure of Our Value

We create value for you through holistic financial planning, looking at your entire financial picture to create a comprehensive approach to investing your money, gaining financial independence, and safeguarding you from risks. This sounds great, but let’s face it, it’s pretty vague. The numerical benefits of hiring a financial advisor can be difficult to evaluate. Since 2001, Vanguard has spent considerable resources in measuring how I can add value for investors like you.

Their study is called Vanguard Advisor’s Alpha and they have identified areas where financial advisors create tangible value. Their aim is to quantify how much a client might benefit from each process a financial advisor could offer. Vanguard’s conclusion is that an advisor like me can add 3% a year in benefits through effective Portfolio Construction, Behavioral Coaching, and Wealth Management.

Their recommended approach in these areas very much reflects what I do for each client. Not all advisors use these steps with their clients. If your advisor isn’t talking about these actions, you could be missing out. Vanguard has analyzed how much a client might gain from each step in our financial planning process. Benefits, below, are measured in basis points (bps), where 1 bp equals 0.01% in annual benefits.

1. Portfolio Construction

  • Suitable Asset Allocation / Diversification >0 bps
  • Cost Savings (Expense Ratios) 40 bps
  • Annual Rebalancing 35 bps

Our approach is to create long-term, diversified investment strategies for each client. We start with a top-down asset allocation and use ultra low-cost ETFs and institutional-class mutual funds to implement our allocation. Portfolios are rebalanced annually.

2. Behavioral Coaching

  • Estimated Benefit 150 bps

There is a huge benefit to coaching and that’s why we prefer to write about behavioral finance topics than giving you “weekly market updates”. You can’t control what the market does, but you can control how you respond. And how you respond ends up being one of the biggest determinants of your long-term results.

We take the time to create a solid plan, educate you on our approach, and reinforce the importance of sticking with the plan. There are real risks to having a knee-jerk reaction to a bear market, chasing performance, or buying into bitcoin or whatever fad is currently making the headlines. Based on Vanguard’s calculations, the value of Behavioral Coaching is actually greater than investing steps like asset location or rebalancing.

3. Wealth Management

  • Asset Location 0 to 75 bps
  • Spending Strategies (withdrawal order) 0 to 110 bps
  • Total Return versus income approach >0 bps

Asset location is creating tax savings by placing certain investments in retirement accounts and certain investments in taxable accounts. Spending Strategies, for retirement typically, are another area of considerable attention here at Good Life Wealth. Go to our Blog and you can find all of our past articles (currently 197). In the upper right, use the Search bar and you can find several articles explaining these concepts and how we implement them.

Vanguard lists some of these benefits as 0 bps with the explanation that the value can be “significant” but is too individual to quantify accurately. When they do add up the benefits we can achieve in Portfolio Management, Behavioral Coaching, and Wealth Management, Vanguard believes we are adding 3% a year in potential benefits for many clients.

We hope this may help those who are on the fence, wondering if it is worth it to hire us as your financial advisor. There is a value to what we offer or I wouldn’t be in this profession. The Vanguard study doesn’t consider our benefits in helping you with tax planning, risk management, estate planning, college funding, or other areas. They also don’t consider intangible benefits, such as peace of mind, saving time by hiring an expert versus trying to do it yourself, or the fact that investors who create a retirement plan with an advisor save 50% more than those who do not.

We offer two distinct programs to meet you where you are today and help you get to where you want to be. We are welcoming new clients for 2018. Do you have questions about how we might add value for you? Let’s talk.

Premiere Wealth Management
Comprehensive financial planning and portfolio management
Cost is 1% annually, for clients with $250,000 or more to invest

Wealth Builder Program
Subscription program to build your net worth with expert financial planning in the areas you need
Cost is $99/month, for clients with $0 to $249,999

Putting February in Perspective

2017 was not only a great year in the market, but an anomaly of historic proportions for its extremely low volatility. There were no large daily swings in 2017, and no big drops or corrections regardless of the economic data, corporate earnings, or political turmoil. The market never fell below the January 1st level in 2017, so the year-to-date numbers were positive for the entire year.

This January continued 2017’s winning streak, but February was another story altogether. The market plunged roughly 10% in a week, including the largest single day point drop in the history of the Dow Jones Industrial Average. The market regained much of its loss, but has sold off by 3% or so in the past week. Investors are wondering is whether this is the end of the bull market and what to do next.

Here is the frustrating reality about being an investor: No one can predict the future. Forget about Wall Street forecasts – their track record of accuracy is horrible. The market doesn’t care what we think, positive or negative. The old saying that “the market climbs a wall of worry” has certainly been true the past year or two.

If you would have asked me at the start of 2017 if I thought the S&P 500 Index would go up 22% that year, I would have said no way. The prices were relatively high, we faced rising interest rates, and the political climate was a mess. Uncertainty is not supposed to be the backdrop for a 20%+ year.

Thankfully, I did not act on my opinions in January of 2017 and get out of the market, because we would have missed a tremendous year of investment returns. We should recognize that even when we think our feelings about the market are based on a rational examination of facts, there is no guarantee that the outcome will be as we expect. We are too easily influenced by recent performance and allow our fear or greed to drive investment decisions about what should be a decades-long plan.

For those who are disturbed by February’s action, I’d suggest taking a 30,000 foot view. Although the market did correct by 10%, we basically only gave up the gains from a few weeks and put accounts back at the level they were in December. The market pulled back towards the 200-day moving average, a key level of support, but did not cross or violate those levels. In other words, the overall trend upwards has not been broken. Perhaps the market just needed a correction and chance for profit-taking. That’s healthy and not necessarily a bad thing.

The US economy looks strong, and while the stock market could diverge from the economy, I think we can take comfort in knowing that wages are rising, unemployment is very low, earnings are growing, and many companies are robust and profitable. The tax cuts going to corporate America will increase earnings. Although we’ve gone nine years without a bear market, we are in unprecedented times, so it is possible that the market continues up for a while longer.

I share this not because I think my job is to be bullish or to convince people to buy stocks. Rather my objective is to educate investors, moderate our behavior, and encourage consistency. When fear starts to pick up, that’s the time when it becomes challenging to stick to the plan. Our focus should be on looking out 10 or 20 years. That’s the sort of time frame we really need to have in mind as an investor.

Just like the seasons, there will be a bear market – a drop of 20% or more – in the future. But investors would be better served by worrying less about the inevitability of market cycles and instead focusing on what they can control: how much they save, diversifying, keeping costs and taxes to a minimum, and having a long-term strategy.

We will continue to watch the market closely and evaluate whether a temporary correction threatens to become a more prolonged decline. If that were to occur, we would take action. For some investors, we may choose to become more defensive. For those with a longer time horizon, I think you want to buy when the market is on sale. This decision would be based on technical indicators – what the actual price movement of the stock market suggests – rather than a decision influenced by news, market sentiment, forecasts, or opinions. (We will explore this topic in more detail in an upcoming post.)

Presently, there is little from February to indicate that we’ve had anything more than a garden variety correction. Volatility is a normal part of investing, something we need to remind ourselves after 2017. If you’re not currently investing with us, let’s talk about how you are currently positioned and see if we might be able to recommend some ways to improve your investment strategy.

The Seven Deadly Sins of Investing

Successful investing is as much about managing our personal tendencies and behaviors as it is about picking funds. You don’t have to be a financial whiz to be a thriving investor, but you do have to avoid making mistakes. Investing errors do not mark you as a novice or as unintelligent; even professionals can easily fall into these traps. Mistakes are easier to see in hindsight, but in the present moment, the choices we face may not be so obvious.

Here are what I consider to be the Seven Deadly Sins of Investing. I firmly believe that if we can avoid these errors, we will have a much higher chance of success as long-term investors.

1. Not Accepting Losses (Pride)
If you’ve made a losing investment, sell it and move on. Too many investors are unwilling to do this, hoping that if they wait long enough, they will be proven correct or at least get their money back. Unfortunately, this may not occur, and even if it does, there may be an opportunity cost in waiting. With today’s strong markets, you might not have losses, but if you have high-expense funds that are under-performing the market, you should recognize that this too is a mistake and move on.

2. Market Timing (Greed)
Speculating to make as much profit as possible and trying to avoid temporary market drops drives many people to move in and out of the market in a largely futile attempt to improve returns. Neither individual investors nor professionals have demonstrated any success in market timing, although great time and effort are spent in the process. The reality is that market returns are a good return, but when investors say “I want more, I need more”, they are very often rewarded with lower returns rather than higher returns.

3. No Asset Allocation (Lust)
Did you pick the funds for your 401(k) by selecting the options with the best one-year performance? If so, you likely will end up with a poor investment plan, because you are investing based solely on past performance. Don’t fall in love with today’s hot funds, those are the ones that will break your heart at the next downturn, when you discover how much risk they were taking. At any given point in time, one or two categories may dominate returns, fooling investors to think that owning 10 different technology funds makes you diversified. Start with a globally diversified asset allocation and then pick funds that represent each category. Yes, even buy those segments which are out of favor and under-performing today. That’s how you build a better portfolio.

4. Performance Chasing (Envy)
With thousands of mutual funds and ETFs at our disposal, it takes only a few clicks to find a “better performing” fund than the ones currently in your portfolio. There are hundreds of funds which have outperformed their benchmark over the past year. Of course, that number will fall dramatically over time, and typically 80% or more of funds fail to match their benchmark over five or more years. But even still, that means some funds have beaten the index. Unfortunately, there is no predictive power in past returns of actively managed funds, so even those that beat the mark over the last five years are unlikely to continue their streak over the next five years.

Perhaps even more dangerous is when investors “discover” that a sector or country is outperforming. Maybe it’s a technology fund, or Argentina ETF, which has rocketed up in the past six months, and they switch from a diversified fund to a narrow investment. Performance chasing creates a lot of risk which may go unnoticed until it’s too late. We avoid single sector and country funds; almost every argument for these funds is some version of performance chasing.

5. Single Security Risk (Gluttony)
Most of the heart-breaking investing stories I’ve heard from the past 20 years were caused by investors having a large investment in a single company. The 55-year old Nortel employee who had his whole retirement account in his company stock and rode it down from $1 million to $100,000. The Cisco employee who exercised $600,000 in stock options, but kept the shares to try for long-term capital gains; the shares tanked, and he didn’t know he would owe AMT on the original $600,000. The IRS had a lien on his house while he paid them $200,000 over five  years.

Diversification is the only free lunch in investing. The average stock will return about the same as the index by definition, but you take on tremendous risk when you have a concentrated position in one stock. The best choice is to not have too much in any one stock, including that of your employer.

6. Breaking Your Plan (Wrath)
Anger, frustration, and despair were what investors felt in 2008 and 2009, and we will undoubtedly feel the same way when the next bear market occurs. Some investors threw in the towel near the bottom and missed out on much of the rebound. The best way to prevent future frustration is to make sure you have the right asset allocation and understand how your portfolio might perform in up and down years. When you begin with a smart plan and take the time to educate yourself, it is much easier to understand the importance of staying invested rather than allowing emotions to get the best of us.

7. Failing to Monitor (Sloth)
Even for passive investors, you still need to do some work monitoring and managing your portfolio on a regular basis. Rebalancing annually or when funds move a large amount is important to maintain your target risk levels and to create a process to “buy low and sell high”. Additionally, too many investors have stayed with poorly performing active funds and variable annuities they don’t understand, paying high expense ratios, unnecessary 12-b1 fees and sales loads, without having any idea about how they are doing. You only have three or four decades of work and investing, you can’t let 5 or 10 years go by without knowing if your plans are on track. It’s your money, surely you can spend a handful of hours every quarter to analyze your situation and make changes when they are needed.

Successful investing is not complicated, but it can be difficult to have the patience with how boring it can be most of the time and how unpredictable it can be other times. Establish a diversified asset allocation that will help you achieve your long-term goals, then invest in low-cost, tax-efficient vehicles with a good track record. Focus on what you can control: your allocation, costs, and diversification, and don’t worry about the short-term movements of the market.

We all face the temptation of these seven investing sins. Maybe the greatest attribute for an investor is faith. Do what is right, do what is smart, but then to let go of the worry about what will happen today or tomorrow. Market returns will be whatever the market returns. We have no control over the market, but we can focus on our own saving (frugality), patience, and positive thoughts. In the end, the true measure of wealth is more about our faith and gratitude than it is about the dollars and cents.

How Exercise Can Make You a Better Investor

There are a lot of parallels between getting in shape and being a successful investor. Both take time and consistent effort to achieve results. We’d love to have overnight, instant results, but that isn’t how life works!

Here are five key factors to an effective exercise program that you can apply directly to helping you achieve your financial goals. If you are already doing great with your workout program, why not apply that same process to getting your finances in shape?

1. One pound at a time. Your goal may be to lose 30 pounds, but you can’t lose 30 pounds at once. You have to take it one day at a time and lose the first pound, then the second, and so on. In investing, everyone wants to be a millionaire, but you have to save that first thousand dollars, then the next thousand and so on. You can’t just wish for it, you have to work for it.

2. Set a goal. Having a specific goal such as “lose 20 pounds by March 1” or “achieve a BMI of 15 by January 1” is better than a vague goal such as “get in better shape”. Otherwise, how will you know if you achieve your goal? How will you know if you are on track? What is your motivation and sense of urgency?

A long-term goal creates short-term steps. If you want to lose X pounds in X weeks, you might use an app like myfitnesspal to calculate how much you need to workout and how many calories you can eat in a day. Your goal determines a path and mileposts. For investing, if your goal is to have $500,000 in your 401(k) at retirement, how much would you need to save from each paycheck to make that happen?

3. Make good choices. When you have a fitness goal, some decisions, like eating half of a cheesecake for dinner, will put you further away from your goals and negate all the hard work you have been doing. Similarly, if you have a financial goal, spending $15,000 on a European vacation may be inconsistent with that goal. When your goal is more important than the eating or spending, you learn to make better choices.

That’s not to say that you can’t indulge from time to time, but you can’t let those choices derail your progress. If you view these choices as a sacrifice or as deprivation, you will resent your fitness or financial goals. You may find it easier to stick to the plan when you observe and celebrate the positive results you are achieving.

4. Create new habits. For a workout program to get results, you have to stick to it and have it become an unchangeable part of your routine. Maybe you workout Monday through Friday at 7:30 am before work. Or maybe you spend your lunch hour on Tuesday and Thursdays at the Gym and then workout on Saturday and Sunday mornings. Maybe you learn to watch TV without eating food at the same time!

The point is that you create new habits that will help achieve your goals. For investors, people are more likely to be successful when they put their saving on autopilot. Have that money come directly out of your paycheck into your 401(k). Start a Roth IRA and establish a monthly draw of $400 from your checking account. Set up a 529 college savings plan and even if you only start with $50 a month, get going today!

5. Human support. You are more likely to succeed in your fitness goals if you are part of a group or have a coach to make sure you actually get to the gym! They can motivate you, applaud your progress, and help you regroup after the inevitable frustration of temporary set-backs. When you go it alone, your weekend choices may not be as good as someone who has a weigh-in on Monday morning with their trainer. Having someone who supports you, who can lend an ear, and can also provide objective guidance will help you get there faster.

When it comes to investing, many people make the same excuses as they have for fitness: I am too busy, exercise is too expensive, it’s so boring, my career/family/hobby is takes all my time… And yet, many of the busiest, most successful people I know manage to find time to workout and stay in shape. When it is an important priority, you figure out how to make it happen.

If you want to get in better shape financially, apply what you know works for exercise. We can help you identify realistic goals and put into motion new habits to help you achieve your objectives. You will learn about finances and you might even find that you enjoy yourself! But most of all, you will know that you are doing the right thing today and that your future self will thank you for not waiting another year to get started. You can schedule your call online here.

Are You Making These 6 Market Timing Mistakes?

Market timing means moving in and out of the market or between assets based on a prediction of what the market will do. Given the extreme difficulty of predicting the future, market timing is frowned upon by most academics. Many studies have shown that the majority of investors who time the market under-perform those who stay invested.

Even though many people know intellectually that market timing is detrimental, it is actually pretty difficult to stay invested and not be influenced by market timing. Even for those who say they don’t time the market, there are a number of ways that investors inadvertently fall into this trap.

1. Being in Cash. “We are going to sit on X% in cash and wait for a buying opportunity.” Seems prudent, right? Except that investors who have been holding out for a 10% or 20% crash for two, three, four years or more have missed out on a huge move up in the market. Yes, there are rational reasons to say that the market is expensive today, but those who have been sitting in cash have definitely under-performed. Will they eventually be proved right? The market certainly has cycles of growth and contraction. This is normal and healthy. So, yes, there will be another bear market. The problem is that trying to predict when this will occur usually makes returns worse rather than better.

2. Greed and Fear. The human inclination is to want to invest when the market has done well and to sell when the market is in the doldrums. I remember investors who insisted in going to cash in November 2008 and March 2009, right at the bottom. In 1999, people were borrowing money to put into tech funds, which had given them returns of 30%, 50%, even 100% in a year. Our natural reaction is to buy high and sell low, the opposite of what we should be doing. It’s only in hindsight that we recognize these trades as mistakes.

3. Performance Chasing. Investors like to switch from Fund A to Fund B when Fund A does better. Who wouldn’t want to be in the better fund? This is why people give up on index funds. Index funds often only beat half of their peers in any given year, so it’s super easy to find a fund that is doing better. However, when we go to a five-year horizon, index funds are winning 80-90% of the time. That’s why switching to a fund with a better recent track record is often a mistake. (And then watch the fund you just sold soar…)

4. Sector and Country funds. Investors want to buy a sector or country fund when it is a standout. This is market timing! You are buying what is hot (expensive) rather than buying what is on sale. I have yet to have any client ever come to me and say “sector X is doing terrible, should we buy?”. Instead, some will ask me about biotech, or India, or some other high flyer. I remember when the ING Russia fund had the best 10-year track record of all mutual funds. If you bought it then, I think you would have regretted it immensely in the following years! When people buy sector or country funds, the decision is almost always a market timing error of extrapolating recent performance into the future, instead of recognizing that today’s leaders become tomorrow’s laggards.

5. Factor Investing. If you haven’t heard of Factor Funds, you will soon! Quantitative analysts look for a set of criteria which they can feed into a computer and it picks the best performing stocks. How do they come up with a winning formula? By back-testing strategies using historical stock prices. This sounds very scientific, and I admit that it looks promising, but there are still some market timing landmines for investors, including:

  • Historical anomalies. It’s possible that a strategy that worked great over the past 10 years might be a dud over the next 10. It is unknown which factors will perform best going forward and it seems naive to assume that the future will be the same as the past.
  • Choosing which factor. Low Volatility? Value? Momentum? Quality? Those all sound like good things. There are now so many flavors of factors, you have to have an opinion on the market in order to pick which factor will outperform. And that’s right back to market timing: investing based on your prediction of what the market will do. This isn’t Lake Woebegone, where all the factors are above average. Some factors are bound to do poorly for longer than you are likely to be willing to hold them.
  • Investor switching. In most single years, a factor does not have very exciting performance. I predict that many investors are going to buy a factor fund, and then switch when they see another factor outperform for a year or two. If you’re really going to buy into the factor philosophy, you need to buy and hold for many, many years. Even in back tests, there are quite a few years of under-performance. It was only over long time periods that factors were able to deliver improved returns.

6. Product development. Asset managers are paid on the assets they manage. It’s a business. They will always be coming out with a new, better product to attract new investors. You are being marketed to every day by companies who want your investment dollar. Many new funds will not survive the test of time and will disappear into financial history. Their poor track records will be erased from Morningstar, which is why we have “survivorship bias”, the fact that we only see the track records of the funds that survive. Please use caution when investing in a new fund. Is this new fund vital to your success as an investor or just a marketing ploy for a company to capitalize on the most recent fad?

At Good Life Wealth Management, we are fans of the tried and true and skeptical when it comes to the “new and improved”. We aim to avoid market timing errors by remaining invested and not trying to predict the future path of the market. We avoid emotional investing decisions, performance chasing, and sector/country funds. For the time being, we are watching factor funds with curiosity but a wait and see attitude.

How then do we choose investments and their weight in our asset allocation? Our tactical models are based on the valuation of each category. This is by its nature contrarian – when large cap becomes expensive, it becomes smaller in our portfolios. When small cap becomes cheap, its weighting is increased. We don’t predict whether those categories will go up or down in the near future, but only tilt towards the areas of better relative value. This is based on reversion to the mean and the unwavering belief that diversification remains our best defense.

If you’d like to talk about your portfolio, I’d welcome the chance to sit down and share our approach and philosophy. What keeps us from the Siren song of market timing is our belief in a disciplined and patient investment strategy.

Stop Trying to Pick the Best Fund

So much attention is paid to picking “the right fund” or “the best fund” by investors, but in my experience, this question has little bearing on whether or not an investor is successful in achieving their goals. In fact, I don’t even think fund selection is in the top 5 factors for financial success. There are so many more important things to consider first!

1) How much you save. If you contribute $500 a month to your company 401(k) and your colleague contributes $1,000 a month, I would bet that they will have twice as much money as you after 10 years, regardless of your fund selection process. Hot funds turn cold, so most investors just average out over time. Figuring out how to save and invest more each month will get you to the goal line faster than spending your hours trying to find a better fund.

2) Sticking with the plan. Your behavior can have a greater impact than your fund selection. Many investors sold in 2009, incurring heavy losses and then missing out on the rebound in the second half of the year. Trying to time the market is so difficult that investors are better served by staying the course rather than trying to get in and out of the market.

I know that people think they are being rational about their investments, but what usually happens is that we form an opinion emotionally and then find evidence which corroborates our point of view. This is called confirmation bias. Better to remain humble and recognize that we don’t have the ability to determine what the future holds. Buy and Hold works, but only when we don’t screw it up!

3) Starting with an Asset Allocation. People may spend a vast amount of time picking a US large cap fund, but then miss out on the benefits of diversification. Other categories may outperform US large cap stocks. I recently opened an account for a new client, whose previous advisor had him invested in 180 positions – all of which were US large cap and investment grade bonds. No small cap, no international equities, no emerging markets, no floating rate bonds, no municipal bonds, etc.

The most important determinant of your portfolio return is the overall asset allocation, not which fund you chose! Our process begins with you, your goals, timeline, and risk tolerance to first determine a financial plan, including an appropriate asset allocation. The asset allocation is really the portfolio and then the last step is to just plug in funds to each category. Funds in each category perform similarly. If it’s a horrible year, like 2008, in US large cap, that fact is more significant than which large cap fund you chose.

A famous, and controversial, 1995 Study found that 95% of the variability of returns between pension funds was explained by their asset allocation.

4) Not chasing performance. The problem with trying to pick the best fund is that you are always looking through today’s rearview mirror. There will always be one fund that has the best 5, 10, or 15 year returns. There are always funds which are doing better than your fund this year. But if you buy that new fund, you may quickly become disappointed when the subsequent returns fail to match its “perfect” track record.

So then you switch to another new fund. And like a financial Don Juan, the performance chaser is quick to fall in love, but just as quick to move on, creating a tragic, endless cycle of hope and failure. If you are investing for the next 30 years, changing funds 30 times does not improve your chances of success! By the way, if you exclude sector funds, single country funds, and other niche categories from your portfolio, you will be well on your way to avoiding this pitfall.

5) Setting Goals. If you have a goal or large project at work, you probably create a plan which breaks that goals down into a series of smaller steps and objectives. Unfortunately, very few people apply the same kind of discipline, planning, and deliberate process to their finances as they do to their career and other goals. When you begin with the goal in mind, your next steps – how much to save, how to invest, what to do – become clear.

Bonus, 6) Doing what works. Why reinvent the wheel or take on unnecessary risk? We know that 80% or more of actively managed funds lag their benchmarks over five years and longer. With 4 to 1 odds against you choosing a fund that outperforms, why take that risk at all? Even if you get it right once, do you realize how small the possibility is that your choice will outperform for another five years? Better to stick with Index Funds and ETFs. Besides the better chance of performing well, you will also start with very low expenses and excellent tax efficiency. When you use Index funds, it frees up your mind, time, and energy to focus instead on numbers 1-5.

Choose your funds carefully and deliberately because you should plan to live with those funds for many, many years. There are genuinely good reasons for changing investments sometimes and we won’t hesitate to make those trades when necessary. But on the whole, investors trade way too much for their own good. The grass is not always greener in another fund!

Applying The Rule of 72

The Rule of 72 is a very simple financial short-cut: divide your rate of return into 72 and you have (approximately) the number of years it takes for your money to double.

Double Your Money
2% = 36 years
4% = 18 years
6% = 12 years
8% = 9 years

This gives you an idea of the importance of compounding. But aside from being a way to impress children and small animals with your math prowess, is there a practical application of the rule of 72? Yes, there are a number of ways that thinking about The Rule of 72 can improve our behavior and give us better financial outcomes with our investing. For example:

1) Think Long-Term. Think in terms of “doubling periods”. If you are targeting a 7% rate of return, your doubling period would be 10 years. If you have 20 years until retirement, you would expect your money to double twice. If you have $200,000 today, you should have $800,000 in 20 years, in this hypothetical scenario. And that is without any additional saving!

2) Start Early. You want to double your money as many times as you can, but let’s face it, a life expectancy of 85 years can only contains so many periods of 9 or 12 years. To maximize your wealth, you have to start as early as possible.

Let’s consider two investors: Smart Sally and Late Larry. Sally starts investing $500 a month at age 22, while Larry waits until he is 32. He’s still young, right? He also invests $500 a month and they both earn an 8% return until retirement at age 62. At age 62, here’s where they stand:

Smart Sally has $1,745,503. Late Larry has $745,179. Sally has a million dollars more because she started 10 years earlier! Not saving in your 20’s could mean you have a million dollars less for retirement. Don’t miss out on getting that extra doubling period.

3) Invest for Doubling. I see people with money markets in their retirement accounts even though they aren’t going to retire for decades. Nobody knows what the market is going to do tomorrow or this year, but if you are investing for 20 years, recognize that a 2% return will take 36 years to double and a 1% return will take 72 years. What does your money market pay in 2017? Less than 1%? At that rate, even your great-grandchildren won’t live long enough to see that double.

Stop thinking that a lack of volatility equals safety. Investing at a low rate of return basically guarantees that your money isn’t going to grow significantly. In that regards, cash is a riskier investment to your goals than stocks.

Use the rule of 72 to choose diversified investments that are in line with your goal of doubling your money. If you have the time and risk tolerance, you need to be invested in a way that will generate long-term returns of 6%, 8%, or more. The S&P 500 Index returned 12% annually from 1926 to 2010. Although our expected returns are lower today for stocks, they are also lower for cash, bonds, and inflation.

Let’s say that you are 41 and plan to retire at age 65, in 24 years. You have $250,000 today. if you are investing in a high quality bond fund that returns 3%, you will double your money once in 24 years, to $500,000. Invest in a balanced allocation at 6% expected return, and you will double every 12 years, bringing you to $1,000,000. But if you can invest aggressively, and achieve a 9% return, you could doubles your money three times, once every 8 years. That would bring you to $2 million at age 65.

If you understand the Rule of 72, you can focus on long-term results, starting early, and investing for growth. There will be volatility along the way; there will be down years and bear markets. But if you are in the accumulation phase of your life, your focus should be to strive for long-term returns that will double your money. And with retirement often lasting 20 to 30 years, age 65 is not the end, or a finish line, but just the start of a new phase of investing. You still need growth even in retirement!

My Used Car Adventure, Part II

Some people in Dallas pour more money into new cars than they do their investments and financial future. They get a new luxury car every three years, but tell me they cannot afford to put $5,000 into an IRA. I think their priorities are backwards! To sink our hard-earned cash into a depreciating asset will keep us poor and stressed, rather than allowing us to enjoy the peace of mind of financial independence.

Last night, a friend was asking me whether he should fix up his 10-year old Toyota (facing a $400 expense) or buy a new car. Previously, I have written in this blog about my real costs of buying a high-mile used car. Three years ago, I purchased a 2002 Toyota 4Runner with 179,000 miles for $4,500. Seems like an invitation to disaster and disappointment, right? Well, here’s how things turned out…

I sold the 4Runner last fall, after two years of ownership, with 197,000 miles on the odometer. During my ownership, it never broke down and always started on the first try. It was completely dependable and there were no unexpected repairs, only routine and preventative maintenance. I sold it for $4,150, my full asking price on a (free) Craigslist ad, to the first person who looked at it.

That means that over the two years, my total depreciation was $350. I cleaned the car meticulously before selling, and you truly can polish money into a car. If it looks great and you can show detailed maintenance history, you will do well.

While my depreciation was very low, I had maintenance expenses over the two years. The biggest expense was a set of four new tires, $744.84. (Those are some big tires, 265’s!) The rest of the work I performed myself and included: four oil changes, replacing the rusty radiator, hoses, and thermostat, changing the differential oil, steering fluid, and brake fluid, wipers, air filter, PCV valve, two indicator bulbs, and one headlamp. Sounds like a lot, but most of those are 5-minute jobs. My total spend on maintenance over two years was $574.33.

The average car on the road is over 11 years old, but many of us still hate older cars. It is definitely a headache when a car breaks down and leaves you stranded, but that can happen even in a new car. From a behavioral perspective, the inconsistency in our thinking is that we have such a strong aversion to paying for unexpected repairs but are so willing to accept the known and inevitable loss of depreciation.

Why is spending $1,000 on a repair so much more painful than losing $4,000 in depreciation over a year? Depreciation is the bigger expense. Almost every new car will lose 50% of its value in 5 years. By 10 years, you will have an 80 to 90 percent loss.

The reality is that today’s cars are more dependable than ever. When you trade in your 8 year old car with 100,000 miles, chances are that someone else is going to drive that vehicle for another 8 years and another 100,000 miles. But you will have paid 80% of the depreciation!

Now, I realize that a sample of one (my experience with one 4Runner) does not prove a statistical case that all used car purchases are going to be effortless and inexpensive. It is entirely possible that I was just lucky. The car could have blown up the day after I bought it and I’d have lost my $4,500 investment. Fortunately, it did not, but that is a gamble I can afford to take.

My advice remains that the least costly course of action is to keep your current vehicle for as long as possible so that you can spend years on the flat end of the depreciation curve. Maintenance costs should not be unexpected, even though the timing and amounts are always unknown. The key is to remember that your repair costs are still likely to be a fraction of the depreciation costs of a new car. When you have to get a new vehicle, consider a used car and let someone else pay the steep depreciation of the first 3, 5, or even 10 years of the car’s life.

I know rationally that keeping cars for 10+ years is the best option, but truthfully, I get bored with cars. If you are fine with the same vehicle for a decade, that is fantastic. You are undoubtedly being very smart to keep one vehicle for 10 years. But I’d rather get a different vehicle every couple of years, a habit which could get very, very expensive. Luckily for me, I don’t really care if a car is new or used, just that it is new to me.

When I sold the 4Runner, everything still worked and I could have kept on driving it. But I just wanted something different. I purchased a 2006 Mercedes E350 sedan with 123,000 miles for $5,300. Now I am not only flouting the conventional wisdom of avoiding older, high mileage cars, I am doubling down by going from a dependable Toyota with cheap parts, to a luxury car with very expensive German parts.

I’ve had the Merc for a few months and have already put on 5,000 miles, with zero issues. The engine seems quite strong and everything on the car feels very well made. Fingers crossed that it holds up! We’ve had a number of BMWs in the past and I always wanted a Mercedes. I’ve gotten a number of compliments on it, but I think people would be very surprised if they knew how little I paid for it! I expect that, unlike the Toyota, I will not do all the work myself and that my maintenance costs will be higher. I will continue to keep a spreadsheet and report back to you, my readers, and let you know how it turns out – good, bad, or ugly!