[Author's Note: Investing information included below provides a broad perspective and should not be construed
as specific financial advice. Please consult with a professional adviser and/or spend considerable time studying
academic-based literature. See the end-notes for further study or contact me for educational resources.]
Saving and investing can be quite complex. Thousands of
books are available, almost all claiming to make you rich. This
distillation provides the research viewpoint, augmented with
wisdom gleaned from doctors who have generated real wealth,
not just high income.
In my February 2013 article on cash flow, Dr. Bill and
Jennifer looked in detail at their after-tax budget of $193,000
per year on a combined income of $300,000. They contribute
$11,500 to a simple IRA annually, yet found they had only
$2,000 left to contribute to additional retirement savings, college
savings for their two daughters, other short-term savings
needs and an emergency fund.
Later, Jennifer found additional savings of $30,000 per
year from clothing, vacation, entertainment and home improvements/
maintenance allowances. We will see how they divvied
up that $30,000.
Bill and Jennifer's Financial Savings Goals:
- Emergency fund
- Retirement savings of 15 percent per year ($45,000 per
year with their income of $300,000)
- Home repairs: new roof and furnace
- New bathroom
- College savings for two daughters
Emergency Fund
First, Dr. Bill and Jennifer need an emergency reserve of six
months of spending, or $80,000. The most disastrous calamity
that can occur to a dentist is the inability to practice. Illness,
office fire, flood or personal accidents can financially debilitate
a family for years. Insurance helps, yet loss of one's building for
several months and disability insurance waiting periods of 90
days can cause huge cash flow disruption.
You should place emergency funds in a money market
account - no CDs, no HELOCs (if one can't return to work
for an extended period, one may lose one's home), no stocks or
bonds. You need immediate liquidity. Do not play games with
"but inflation will eat up any possible growth." This account
needs to be rock solid.
Dr. Bill and Jennifer realize that for the next three years
they will be growing their emergency fund, using money
market funds.
After establishing an emergency fund, it is preferable to
extinguish all debt except home mortgage and practice loans.
No auto loans, student loans or credit card loans. These beasts'
interest rates will normally overwhelm any but the most risky
investments and delay one's ability to save consistently.
The next step is to consistently save for retirement. Other
goals become secondary. The new roof, furnace, bath and college
savings will be funded after retirement savings annual goals
are met. Of course, if the roof collapses, emergency funds will
be used.
Long-term Investment Strategy
Basic Investment Strategy
Research shows that active investment strategy cannot
overcome manager's fees over any extended period. Passive
management with index funds wins in the long run.
From Warren Buffett:
Most investors, both institutional and individual, will find
that the best way to own common stocks is through an index fund
that charges minimal fees. Those following this path are sure to
beat the net results (after expenses and fee) delivered by the great
majority of investment professionals.1
From Larry Swedroe:
We have seen that the average actively managed fund
under-performs its benchmark by close to two percent per
annum... With the availability of tax-managed [index]
funds... we can now raise our underperformance estimate to
perhaps as much as three percent per annum.2
John Bogle, founder of Vanguard, says, "The stock market
is a giant distraction from the business of investing."3
There are many investment assistance options available.
They include:
Brokers: These people sell products. Many charge frontloaded
fees and a yearly "wrap" fee for active management. Your
investment growth may be impaired using a traditional broker
in many cases because of the high fees and active strategy.
Insurance Companies: Please be very careful, as many high
fees and costs will not be be divulged. Other than USAA and
TIAA-CREF, be very cautious.
Investment Managers: These people and companies
manage your assets, often starting at a one percent fee per
year for assets under management. Many use active strategies
that cannot overcome their fees. Passive managers, such
as Wealthfront and Betterment, charge 0.25 percent per year for passive portfolio management. They are worth a look!
Fee-only Financial Planners: A certified financial planner
(CFP), certified public accountant (CPA) or chartered
financial consultant (ChFC) can provide full-service advice
including estate planning, insurance advice, tax-planning
and other services. Oftentimes, a planner will offer to handle
your investments. Fees are either hourly, flat fee or a percentage
of assets. A fee-only planner who provides all services
including passive investing with a discount brokerage may be
a great asset.
Automated Portfolios: Several brokerage houses now offer
automated investment programs with lower fees than provided
by a typical adviser, yet higher than target-date funds. These
normally offer an initial visit with an investment adviser, phone
support during the year and often a year-end evaluation.
TD Ameritrade, Merrill Lynch, USAA, E-Trade, Charles
Schwab and Fidelity offer automated programs. Annual fees
range from a 0.5 percent to 1.75 percent.4 The fees may not
justify one annual evaluation and limited phone support.
Target-date Funds: Target-date funds offer a life-long
managed investment strategy without the need for monitoring
or rebalancing. Only one fund, invested in a wide variety
of asset classes of stocks, real estate, commodities and
bonds, is needed. Target-date funds invest heavily in stock
funds during one's early years, gradually becoming more
conservative with more bond funds as one ages.
According to Kiplinger, "Target-date funds' big advantage
is that investors tend not to panic and don't buy high
and sell low."5
Investing on One's Own
To actively invest on one's own using timing strategy and
picking individual stocks and bonds is often a loser's game.
Daniel Kahneman reflected on a University of California study
of individual investors' decisions in the AAII Journal recently:
"…every action the individual investor takes has negative
expected value. On average, they lose, and the more ideas they
have, the more they lose."6
Chris Gay remarked in a 2012 U.S. News Money article:
- The average equity investor underperformed the
S&P 500 by an annualized 4.32 percent over the past
20 years.
- In 2011, the average equity-fund investor lost 5.73 percent,
compared with the 2.12 percent simply holding
the S&P 500 would have generated.7
Newsletters: These are doctor's favorites. A newsletter
can be very hazardous to your financial health. If the "guru,"
book, or system promises returns above average of the total
stock or bond market, be very wary! For information on
newsletters' performance, check Hulbert Financial Digest.8
Lazy Portfolios: These are an excellent option for the
do-it-yourself investor. At Market Watch (www.market
watch.com/lazyportfolio), Paul Farrell lists eight "lazy" portfolios
that have done quite well over the 2000-2010 period
with yearly gains of three to six percent. So much for the lost
decade! These are all passively invested index funds with
super low fees.
For example, here is Dr. Bernstein's No-Brainer Portfolio:
Vanguard Total Bond Market Index Fund 25 percent
Vanguard 500 Index Fund 25 percent
Vanguard European Stock Index Fund 25 percent
Vanguard Small-Cap Index Fund 25 percent
The beauty of lazy portfolios is that you buy and hold,
then rebalance once a year. Too simple? Sorry math geeks,
it worked.
Long-term Investing Bottom Line
Investing by picking individual stocks and bonds
with market timing normally leads to poor to disastrous
long-term results. Using target-date funds (Vanguard and
others) may offer a good solution. Lazy Portfolios' allocations
are similar to target-date funds; yet one needs to
rebalance. Why spend the time when the price is essentially
the same? If you wish to use an investment manager,
a good option may be Wealthfront. They have a great
online tool to find your ideal investment mix. And their
0.25 percent wrap (assets under management) fee is not a
big drain on one's savings.
Where will Dr. Bill and Jennifer invest? At ages 40 and
39, Dr. Bill and Jennifer's only savings is $11,500 in a simple
IRA. It currently sits in a money market fund. Let's assume
that the couple will continue to invest $11,500 in their simple
IRA for the next three years, using the additional $30,000
Jill identified to establish their emergency fund. Finally, when
Dr. Bill is 43, they will up their savings to a total of 15 percent
of their total income until retirement.
Jennifer is interested in investing in either a Lazy
Portfolio, the Vanguard 2035 Target-date fund, or possibly
with a broker in diversified American funds. I also compared
to a similar American fund, often offered by brokers.
When can they retire? Using Financial Engines Monte
Carlo software analysis:
With the Vanguard target-date fund or the lazy portfolio,
they may retire safely at age 66.5. With the American balanced
growth fund, at age 67. Each fund has similar risk.
Jennifer decided the safety and ease of the Vanguard
Target Date fund was worth not hassling rebalancing or dealing
with a broker.
Short-term funds are used for one-time expenditures
families may need in the next few years. These would include
the roof, the furnace, the bath and college for the girls. This
may include auto purchases, major home repairs or upgrades
or special family events.
For up to a two-year time horizon, saving for anything
other than emergency funds, Christine Benz says to stay
solid in money market funds or short-term CDs.9
For funds needed from two to five years,
Vanguard total bond fund (VBMFX) provides
inflation protection, potential
growth and very low risk.
Dr. Bill and Jennifer's short-term plan is for 2013-
2015: half of any extra savings beyond the $11,500 IRA
and $30,000 emergency fund contributions will be used to
fund college expenses for Dr. Bill and Jennifer's two
daughters, aged seven and 10.10 The other half will go into
a money market fund, separate from the emergency fund,
for the roof and furnace. If one succumbs before full funding,
the emergency fund is used, and then reloaded with
future savings. After 2015, the emergency fund is now
complete. Dr. Bill and Jennifer have decided to divide
extra savings - half for the college funds and half for home
repairs. If home repairs aren't needed, then more money
will go toward the college funding. The new bathroom can
wait for now.
But, Dr. Bill, along with about 90 percent of you doctors
out there, want to play beat the market! Technical analysis,
fundamental analysis and Fibonacci numbers are fun! Unfortunately, all this number crunching, research and brain
trusting is normally not good financial strategy. I spent the first
two years of my financial education studying fundamental and
technical analysis through the American Association of
Individual Investors (AAII) and most of the Barnes and Noble
Business/Investing wall. I'm quite familiar with price-to-book,
cash-flow statements, MACDs, stochastics, Bollinger Bands
and candlesticks.
The academic research is compelling: an individual
investor or manager cannot beat the market picking individual
stocks with timing strategy over the long term. There are a few
anomalies, as there are a few that win Powerball lotteries. That
said, ethical and knowledgeable investment advisers adhere to
the five percent rule: It's OK to speculate five percent of one's
investment portfolio. But keep it to five percent!
AAII not only provides interesting and ethical articles, but
also avails great educational materials on fundamental and
technical analysis, options trading, hedging strategies, futures
and other financial oddities. Stock Investor Pro, the most
widely used professional stock screening and research program,
is available for only $200 per year.
Join AAII. The people are totally fun geeks; most are engineers
with more than $1 million saved. You can brag and
bemoan your triumphs and screw-ups to your heart's content.
I'm a member and love the camaraderie. But keep your speculation
to five percent!
References
- Larry Swedroe, The Only Winning Guide to a Winning Investment Strategy, Truman Talley Books, New York, NY, 2005, page 229.
- Ibid, page 242.
- Carolyn T. Geer, "Sometimes, Enough Really is Enough," Sunday Wall Street Journal, Dec. 23, 2012.
- "Are prefab portfolios right for you?" Consumer Reports Money Adviser, July 2012, page 6.
- "Target-date funds: the easy solution," Kiplinger’s Retirement Planning 2012, May 2012, page 44.
- Daniel Kahneman, "Behavioral Errors Hurt Your Return," AAII Journal, July 2012.
- Chris Gay, "Are Individual Investors Destined to Fail? US News Money," downloaded from http://money.usnews.com/money/personal-finance/mutual-funds/articles/2012/07/27/are-individual-investors-destined-to-fail? December 21, 2012.
- Find at http://store2.marketwatch.com/index3c.html?link=djmc_search_googleHulbert
- Christine Benz, 30-Minute Money Solutions, Morningstar Inc., Hoboken, NJ, 2010, pg., 93
- For excellent college planning advice, go to www.savingforcollege.com for complete information on 529 plans and Coverdell ESA’s.
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