A big concern for people seriously thinking about retirement is whether they are on track for the retirement they want. The question is particularly relevant today as finance gurus talk about a possible new normal, with low interest rates potentially indicating low future returns. Consider this situation: You set a goal, estimate your annual savings towards retirement, and have a target year in mind. You use a retirement calculator and find that at the current rate of savings, you fall short of your goal. What do you do?
It would be great if we could just pick companies like Amazon, Apple, 3M, or [your favorite growth story here] and invest in those very early on, but we can’t. There is plenty of evidence that highly paid professional investors can’t do that reliably, let alone average investors. Accepting this fact is the first step to a much better investment experience and low levels of investment-related anxiety.
So what can we do? As we showed in part 1 of our series, we don’t need to be able to pick winners or have a crystal ball to benefit from the stock market. We can leverage the idea that, while fluctuating, stocks have tended to rise in value on average and over time, generating handsome returns for long-term investors. These potential returns can be pursued by investing broadly across stocks, a strategy that goes by the name of diversification.
Diversify, Diversify, Diversify
There is simply too much risk in picking single companies. Differences in returns across stocks are such that a small number of stocks strongly outperforms the average, while the majority of stocks underperforms the market average. In fact, fewer than 50% of stocks beat short term Treasuries in a given year. The chances of picking the right one year in and year out are stacked against you.
But you can use the diversity of returns across stocks over any given period to your advantage by spreading your investment across many stocks. Doing so means that the bad returns of some companies can be offset by the good returns of other companies. The more companies you include, the closer you will get to earning average or market returns. This will help you eliminate extreme risks and smooth out some of the bumps in investment performance over time.
How many stocks should you include? The answer is basically all of them. Investment solutions are available that let you do just that, and at a very low cost. The three golden rules of stock investing are Diversify, Diversify, Diversify.
Choosing Mutual Funds and ETFs
Most individual investors don’t buy stocks directly. They invest in stocks using pooled investments like mutual funds and exchange traded funds, or ETFs. Because putting together and managing a portfolio of stocks requires expertise, time, effort, and a sizable investment, most investors prefer to use a professional manager to do that for them. That’s what mutual funds and ETFs do, they professionally manage a portfolio for you. Unfortunately, given the variety of funds out there, choosing a fund can be even harder than choosing stocks individually. According to the Investment Company Institute or ICI, there were over 11,000 mutual funds and ETF as of December 2019. So, how is one to pick?
Avoid Actively Managed, High Fees, And High Turnover Funds
The first thing we can do is to eliminate actively traded mutual funds. These are funds that try to beat a market index (like the S&P 500) by trying to actively pick winners or by timing when to enter or exit a certain sector or market. Professional money managers aren’t much better than the average investors at beating the market average. Recent research by S&P Dow Jones shows that over the last 15 years, 87% of funds that actively managed US funds failed to beat a passive market index. Not only that, less than 50% of the funds at the beginning of the 15 year period are available for investing today, because they did not survive for 15 years! Turns out the median life of an active fund is only about seven years. The risk of losing everything after seven years is not what most investors sign up for when they are saving for important goals.
You can find out whether a fund is active from the prospectus of the fund, which is usually readily available on the manager’s website. However, a good indicator of active management are high fund fees. The median active fund has fees well over 1% per year. You can safely eliminate all funds with total annual fees above 0.65%, which is the 10th percentile across equity funds according to ICI data.
High fees are also a good indicator to eliminate funds that target a narrow market or don’t have enough diversification (like industry specific funds), and funds that target asset classes that are not appropriate for most investors (e.g. individual commodities). Reading the prospectus sections on fees, investment objectives, investment strategies, and turnover can also help you determine whether the fund is worth considering.
You don’t necessarily want to eliminate a fund just because of higher than average fees, but the fund must have compelling objectives and strategies for your goals. This is where you may want to consult with a trusted and objective advisor before investing.
Get to know index investing
As we reviewed in part 1, an index includes all stocks in a selected group or category, called a universe. For example, the S&P 500 includes the 500 largest companies traded in the US stock market. The Russell 3000, another index, includes the 3000 largest companies traded in the US stock market. Because there are a total of about 4000 stocks in the US market, the Russell 3000 is more comprehensive as a market index than the S&P 500. The S&P 500 is a better representation of the performance of large US companies.
Index funds are mutual funds and ETfs whose investment objective is to track a specified index. Their investment objective is the conceptual opposite of an actively traded fund, which makes active attempts to beat the index by picking stocks or bonds.
You can find out if a fund is an index fund in the prospectus, under the investment objectives or investment strategies sections. The way stocks are combined in most indexes is by market capitalization: if company A is twice the market value of company B, it gets twice the weight in the index.
Index funds are an effective way to build a highly diversified portfolio for your goals. The returns of an index fund should approximate the return of the market or market segment it is tracking, minus the cost it takes to manage the fund. Because index funds don’t have to spend money on the research and management necessary for actively managed funds, their fees tend to be much lower. The median index fund charges 0.33% in fees, and many common index funds charge between 0.04% and 0.12% in fees, a fraction of what active funds charge.
Some Common Indices by Market Segment
The most common index providers are S&P Dow Jones, CRSP, and Russell for the US market, and MSCI, FTSE for international markets. Some of the most common indices in terms of invested assets are listed in the table below. The goal is not to be complete, but to get familiar with some of the names and the market they represent. Your 401(k) plan or IRA may have fund options that track some of these.
Region
Company Size
Index
US
Total Market
CRSP Total Market Index
S&P Total Stock Market Index
Russell 3000 Index
Large Cap
S&P 500 Index
Russell 1000 Index
Small Cap
S&P 600 Index
Russell 2000 Index
International Developed
Total
FTSE Developed ex-US All Cap Index
Large
MSCI World ex-US Index
FTSE Developed ex-US Index
Small
MSCI World ex-US Small Cap Index
Emerging Markets
Large/Mid
FTSE Emerging Index
MSCI Emerging Markets Index
Source: DESMO Wealth Advisors, LLC
There are thousands of indices. However, most investors will benefit from a very broad exposure to different markets, so just look for broad coverage areas, like the table above. For the US, total market indices are preferable. However, even an index like the S&P 500 covers over 80% of the total US stock market value. Stocks of smaller companies are typically riskier than stocks of large, established ones, but have yielded higher returns, on average. International developed indices track the markets of 23 internationally developed countries around the world. Emerging market indices track the performance of 26 emerging market countries.
A global market index would have approximately 60% US stocks, 30% internationally developed stocks, and 10% emerging markets stocks. These percentages represent the share of each region in the global stock market. So with three funds one can build a highly diversified portfolio containing over 12,000 securities, at a fraction of what the average actively managed fund may charge.
Additional Considerations
Index investing is common sense investing. All investments involve a certain amount of risk, for which we expect to be compensated by future returns. We can’t eliminate all risk if we want to benefit from higher potential returns. However, with a diversified portfolio we can eliminate extreme risks that go with trying to pick winners and instead focus on earning average market returns, which historically have been substantial.
Is indexing the best we can do? If all investors held the same portfolio, it would have to be a portfolio with 60% US stocks, 30% international stocks, and 10% emerging markets stocks, like the index approach. That’s because in aggregate all investors have to hold the market, which is roughly split this way. So the market aggregate is a great starting point for the average investor. Deviating from the market may make sense, but whether and how to do it depends on individual needs and preferences. We will describe some general framework for doing so in future posts.
Until Next Time!
Massi De Santis is an Austin, TX fee-only financial planner and founder of DESMO Wealth Advisors, LLC. DESMO Wealth Advisors, LLC provides objectivefinancial planning andinvestment management to help clients organize, grow, and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
Stocks and bonds are very effective tools to grow and manage wealth. You can combine stocks and bonds to help you save for virtually any goal, from growing a nest egg for retirement to saving for college education, to a safety net. In practice, however, many people don’t have the confidence needed to select stock and bond investments. In addition, they may have had bad past experiences, particularly with stocks. The difficulty in selecting portfolios of stocks and bonds, combined with individual biases and past experiences, causes many people to hold suboptimal investments or others to avoid stocks and bonds altogether, to the detriment of their financial plans.
If you have felt like one of those investors before, we have good news for you. It turns out that a few basic principles grounded on economics and data can help us make sense of stocks and bonds, and guide us in making better decisions with our savings. We start with stocks this week, so follow us to learn more about bonds and how to put your investment portfolios together in future posts.
Stocks vs Bonds
When you buy stocks, you buy a small piece of the corporations that issued them. Therefore, with stocks you have a claim to a company’s current and future profits, after costs and other obligations have been paid. Bonds are a promise to make payments back at specific times in the future, and typically include semi-annual payments and a repayment of principal (the amount invested) at the end of the term of the bond (which can be up to 30 years). Both governments (from local to federal) and corporations issue bonds.
Generally, neither bonds nor stocks guarantee investors that they will get back the money they invested. However, because bonds are typically issued by governments with tax powers or more mature companies, bond repayments are relatively more predictable. In contrast, because a company’s future profits can vary unpredictably over time, the amount that can be returned to stockholders is much less predictable. If a company issues both bonds and stocks, payments to bondholders have priority over payments to stockholders.
Present Values and Stock Prices
Many goods and services that we consume provide us with value over time, including cars, clothes, watches, our home, and many others. Their market value depends on the total value or benefit they will provide over time. Compare two identical houses in the same location, one with a brand new AC system and one with a 10-year-old system that works great today. Both houses can provide you with the same benefits, today. However, the house with the brand new system will be worth more because it can provide air conditioning for many more years to come. The market value of the house represents the present value of all future benefits, net of future costs.
The same concept applies to businesses. The value of a business depends on the total amount of profits that it will be able to generate over time. Therefore, the stock price of a company reflects the present value of all the profits that the market believes the company can generate in the future. Even a company with no profits today can have a positive present value, if investors in the stock market believe the company will generate profits in the future. For example, Amazon was founded in 1994, and had no profits until 2001. However, a share sold for $18 when it went public in 1997. Over time, the value of Amazon has changed to reflect investor’s expectations of its ability to generate future profits.
Uncertainty and Risk
The idea that the market value of a business is the present value of future profits helps us understand why stock prices fluctuate so much. Future profits are hard to predict, even for large, established companies, let alone smaller ones. Profits depend on many factors, including the overall state of the economy, the amount of competition, technological factors that may make a product obsolete, government intervention, the weather, pandemics, and many other factors. As all these factors change over time, so does the market view of a company’s future profits. If we think about it this way, it’s no surprise that stock prices change so much over time.
The degree of fluctuations is such that some companies experience exceptional growth (Amazon, Google, Apple, 3M, Coca Cola, etc.), while others succumb after a few years. Research shows that the average company is listed on the NYSE for about 7 and a half years. Unfortunately, you can’t know ahead of time which companies will survive and prosper and which ones won’t. This makes investing in single stocks very risky. But should this surprise us? Not really. Estimates of the median life of any business are of similar length of time.
The lesson here is that while stocks attract a lot of attention and feelings of both greed and fear, common sense and economics can go a long way in explaining what we see in stock markets. We should not be afraid to invest in stocks any more than we are investing in any business or investment property. If anything, financial markets make it easier to invest in stocks relative to other alternatives.
Risk and Return
The good news about stocks is that bearing the uncertainty that comes with stocks has benefited investors historically. While stock prices fluctuate over time, they also tend to grow. After all, who would invest in a risky investment without the potential of future returns?
The growth potential of stocks is easy to understand in the Amazon case by comparing the stock price at the end of 2000 with the price in 1997. Even though there were no actual profits in either year, the company was worth much more in 2000. Not only the profits that were expected in 1997 started to look much more real, but by the year 2000 investors expected even higher future profits from Amazon.
Amazon is a particular case that has experienced exceptional growth, both in value and in actual profits. But the idea applies generally to stocks. As the general economy grows and brings a general increase in profits, we expect stock prices to increase in value. Historically, stock returns, including dividend payments and stock price appreciation, have been positive over long periods of time in the US and globally. For example, the US stock market has delivered annualized returns of over 10% between 1926 and 2019, as measured by the S&P 500 index, an index of the current 500 largest corporations traded in the US. A dollar invested in the S&P 500 in 1926 would be worth $9,237 today!
The high average returns did not come without risk. There have been relatively long periods of negative or very low growth, most notably during and in the aftermath of the Great Depression (1929-1941), and in the decade 2000-2009. The high average return on stocks is earned on average and over time for bearing periods of low returns.
A Key Point: It is important to realize that the S&P 500 contains the largest 500 companies at a point in time. The companies that make the index in 2000 are different from the ones in 2020, although some do overlap. Many companies are added and many drop out over time as some grow to become the next Amazon while others may not grow or even fail and get delisted. The returns you see in the chart above are obtained by buying all of the companies, the ones that grow, and the ones that fail. The chart shows that you don’t have to be good at picking stocks or have a crystal ball to realize handsome returns if you are a long-term investor.
What’s a Market Index?
The S&P 500 is a “market-weighted” index of the 500 largest companies in the US by market value. It represents the returns of a hypothetical portfolio that invests in the 500 largest companies in the US, where companies are assigned a weight proportional to their market value. So if company A is twice the market value of company B, the index gives twice the weight to company A relative to B. This means that the returns on the index are equivalent to the returns of a hypothetical investment that purchased the 500 companies in their entirety. It turns out that the 500 largest companies represent about 85% of the total value of the US stock market. That’s why an index like this is often called a market index. There are other indexes besides the S&P 500, and we will review some of the most common ones in a future post.
These basic facts and principles can go a long way in getting us started with investing in stocks. How many stocks should you own in your portfolio? What is the most effective way to do that? Stay tuned for part 2 of our guide to find out.
Until Next Time!
Massi De Santis is an Austin, TX fee-only financial planner and founder of DESMO Wealth Advisors, LLC. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
When should you rebalance your investments? As with many questions, the best place to start is with why. Why should we rebalance in the first place? Your asset allocation, how you allocate your savings to different investments, is a key element of an investment strategy. It represents the risk-return tradeoff you are willing to make to achieve your investment goals. You typically arrive at your asset allocation through a process that includes goal setting and understanding your risk tolerance and risk capacity. Your asset allocation, not timing market cycles or picking stocks, determines 90% of how your investment is going to perform in good and bad times.
With the market gyrations and economic uncertainty we are experiencing, investors are feeling the pain of market losses and many may lose faith in their investment plans. The potentially bigger risk, however, is that the focus on short-term losses can lead investors to bad long-term decisions. It’s natural to feel anxious and wonder if there is anything we should be doing to improve the situation. We just have to make sure our natural tendencies do not lead to bad decisions. Remember that investing is a long-term endeavor, and it is important to put the short term losses into the right perspective before you can make any changes to your investments. Here is how.
You don’t have a sound plan for your desired goals in life until you plan for emergencies and setbacks. In financial planning, this means planning for and building the right ‘safety net’, an amount of savings you set aside and only touch in case of an emergency. How should we evaluate the amount of savings required in a safety net? The answer varies by individual and household, but here are some general guidelines.
What are your needs?
The first step is to figure out what your needs might be. One of the main things we plan for is the loss of a job. If you lost your job, how much do you think you will need on a monthly basis to maintain a comfortable standard of living? It helps to have a budget, but getting a rough idea should not be too hard. Keep in mind that if you had to, you’d probably be able to cut some expenses, like eating out or expensive vacations. For example, say you make $100,000. If you lost your job and had to live on your safety net, your taxes will be minimal and you can probably postpone saving for other goals until you find another job. So you might only need to generate about 50% of your initial income to live relatively comfortably, or about $4,200 a month. One factor you may want to consider is your health condition. If you have recurring health expenses or there is a likelihood you may need additional funds for health expenses, you should plan for those separately in your safety net.
For How Long?
According to the Bureau of Labor Statistics, the median duration of unemployment is about 10 weeks. So a starting point can be to plan for about three months of expenses. But here is where individual circumstances can change quite a bit. The data shows that for about ⅓ of the population, unemployment can last longer than 15 weeks. If you are married and have only one source of income, it may make sense to increase the safety net up to 24 weeks, in case your unemployment lasts longer.
Your profession can help you determine how long you should plan for. Some professions are in demand, so a shorter time frame may make sense for those. Other, highly skilled workers in specialized fields may need a longer time to land the desired job, and so they may need to plan for a longer period. Continuing our example, if you are single and comfortable with the median estimate, your safety net estimate could be about $12,600 ($4,200 x 3). If you are married and your need is $6,000 for 6 months, your estimate would be $36,000.
Are you flexible?
Being flexible is always helpful. If you think you can get partial employment and income to cover part or all of your basic needs while you look for a better option, that income can help you lower the size of your safety net. But you have to be realistic, and consider that you may lose your job when there are few opportunities available. Having flexible needs can certainly help too. If you are renting, you could look for a cheaper option, or decide to have roommates. The more room you have to decrease your spending, the lower your safety net can be. Having some form of budget, even a simple one, can help you figure this out.
Do you have any flexibility with other goals? The goal of your safety net is so that you are prepared for an emergency, and you don’t need to give up on other important goals in case of an emergency. But perhaps you can use some flexibility with other goals. If you have been saving for a new car, you may decide to delay the purchase or to choose a less expensive model. Being flexible gives you more room to play across your savings.
Add a buffer
We don’t really know how much we might need when we actually need it, so it may be a good idea to add a buffer. The idea is to go through the steps outlined above, get a good idea of the size of your safety net, then add a buffer of 10-15% to it. One reason is to be on the safe side, in case you underestimated your needs. The buffer can also help you account for unexpected cost of living adjustments. With a buffer of 15%, the estimate in our example of a single individual goes up to about $15,000, while our married couple example goes up to over $41,000.
How to invest your safety net
By definition, the safety net should be invested in safe assets. High yield savings accounts work well, but you may also consider short-duration bond funds and Treasury inflation-protected securities or “TIPS.” The inflation protection can help you reduce the risk of unexpected inflation. If you use a buffer as we described above, you can invest your buffer more aggressively. It could even be completely invested in stocks. In our example of the single individual, you could invest $12,600 in a high yield savings account, and $2,400 in a stock market index fund. If the stocks increase in value, say to $3,000, move the additional $600 to the high yield account. If they drop in value, do not replenish it with the $12,600 you have in the high yield savings, as that is your core safety net. With this dynamic strategy, your buffer helps you increase the value of your safety net over time while protecting your essential safety net ($12,600) in down markets.
Safety net and Total assets
You may have been saving for a number of goals and have accumulated some savings. But unless your total assets are one or two orders of magnitude greater than your safety net needs, you should have a dedicated safety net, and only dip into it in an emergency. For many people, as they start saving, the safety net should be the first goal they fund. After that is taken care of, additional savings can be dedicated to other goals. The safety net is part of your basic risk management strategy that helps you grow your assets over time while giving you peace of mind that you and your family are taken care of in case of a financial emergency.
Your safety net should not feel like a waste of capital that could be used to get higher returns. On the contrary, It is the first step to achieving financial independence, as we are learning in this period of crisis. If you have a safety net, you can focus your portfolio on other goals and can take more risk with these investments, because you won’t need to dip into your investment portfolio in case of unforeseen expenses.
Until Next Time! Massi De Santis is an Austin, TX fee-only financial planner. DESMO Wealth Advisors, LLC provides objectivefinancial planning andinvestment management to help clients organize, grow and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
With everyone talking about the coronavirus, you may wonder what to do, if anything, with your portfolio. There has definitely been a lot of action in financial markets this past week, with no lack of dire predictions and recommendations for your investments. You can expect more of this in the coming weeks. So how should we interpret all the information thrown at us? As we discussed recently, do it like a scientist. While it is impossible to make any reliable prediction about market performance, over 90 years of data on stock market returns can help us put last week’s volatility in the right perspective.
How should we choose among the 8,000+ funds available to us as investors? It’s not an easy choice given that most of us don’t have the time, knowledge, and expertise to consider all these funds. Many investors end up choosing based on unreliable metrics, like the cost of a fund, a promising name, or emotions.
Mutual funds are a great investment tool for people saving for retirement, education and many other goals. According to the Investment Company Institute, over 60% of households invest in mutual funds for their retirement, and about 50% of all households hold some mutual funds. But how do people choose them, and are they getting what they pay for?
You may have heard that a good plan starts with meaningful goals. But how can we use goals to design our plan, monitor our progress, and manage key risks to our retirement? Read it in our contribution to The Street’s Retirement Daily publication, edited by Robert Powell (aka Mr. Retirement).
Massi De Santis is an Austin, TX fee-only financial planner. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
