The Truth About Retirement Planning: Part 1

“If I read this twenty years ago I’d already be retired.”

Retirement investing doesn’t have to be complicated to be effective.  In fact, for most individual investors, the more basic their approach, the more successful they will be.

In this three-part series, I take the complex and make it simple to understand, highlighting the fastest and easiest ways to add “free money” to your retirement account.  By following and adhering to a few simple concepts you’ll be able to achieve the elusive worry-free retirement. It’s one small part of what we share in our Retirement Investing Journal.

What would you do if you could retire with more money while saving less along the way?

I’m five years off retirement (I hope) and wishing I had read this or something like it 30 years ago; I’d be retiring very rich. CL Brown

We’ll start with four things that you must absolutely know about retirement planning if you want to retire earlier, with more money, while saving less.

This Simple Short-Cut Doubles Your Retirement Money

Stay with me for a moment because this is the first key to unlocking free money in your retirement savings – without having to save more money or take unnecessary financial risks that could put your retirement in jeopardy.

According to multiple surveys, individual investors don’t have a clue as to what they’re being charged in financial fees, not to mention the devastating impact fees have on their retirement accounts.

In the March/April 2013 issue of the Financial Analysts Journal for actively managed funds, the “All-In” Investment Expenses calculated by William F. Sharpe was 2.27%. (The typical fee a top financial advisor charges is 1-2% of your retirement assets, plus fund expenses).

To keep this simple, I’ll use 2% as the all-in costs of using a financial advisor or actively managed funds.

If you had $100,000 in your retirement account, at the 2% level, you would be paying $2,000 a year in financial fees. That’s lost money, but a fair price to pay for professional investment advice.

This is where it gets interesting.

Most people mistakenly believe that paying $2,000 a year in retirement fees over 20 years would cost them $40,000 (if their account balance stayed the same).

It’s a lot worse than that.

What if I told you the real cost isn’t $40,000, it’s $153,021.13!!

Let’s look at how to quickly calculate the real costs of financial fees to you over 20 years. Why 20 years? That’s the average lifespan after the current retirement age.

The average annual return of an investment portfolio containing 50% stocks and 50% bonds has been 8.3% since 1926.

If you had $100,000 in your retirement account when you retired, didn’t add or withdraw money and earned the historical rate of 8.3% a year, you would have $492,384.76 after 20 years. That’s the power of compounded interest (and demonstrates why it’s so important to start saving early).

Let’s subtract 2% a year for financial fees and see what happens. If you started with $100,000, didn’t add any more money and earned 6.3% annually (the average historical rate of 8.3% minus 2% a year in financial fees), you would have $339,363.63 after 20 years.

That’s a difference (loss to you) of $153,021.13.

Granted, the above doesn’t consider everything – I’m keeping it simple. But you get the point of this little exercise.

Now you know how the investment banks make so much money and why it’s so dang hard for you to retire with enough money to live a worry-free retirement.

Essentially, the results across various scenarios show you’ll lose more money due to the current average cost of financial fees over 20 years than you’ve put into your account (due to the power of compounded interest). Read that again, it’s that important. In the above example, you had funded your account with $100,000 – but paid $150,000 in financial fees over twenty years.

What’s worse:

  • The more money you have saved for retirement,
  • The higher your annual returns and
  • The longer you have your money invested,

-the more money you lose to financial fees.

It’s one reason why Warren Buffett (link to essential Warren Buffett) and Jack Bogle continually warn investors about the destructive capacity of financial fees. Here’s what Warren Buffett has to say on fees and investing;

The best way in my view is to just buy a low-cost index fund and keep buying it regularly over time…”

“ periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when “dumb” money acknowledges its limitations, it ceases to be dumb.”

“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 fees and expenses) delivered by the great majority of investment professionals.”

Here are three other hidden secrets that investment bankers and financial planners hope you never find out about

The Insane Benefits of Saving Early

We’ve seen the devastating effects financial fees can have due to compound interest. Now let’s look at how compound interest works in your favor and why it’s so important to save for retirement as early as you can.

The assumption that I’ll use for this example is the historical return rate of 8.3%, which was used previously.

Saver number one doesn’t start saving for retirement until age 35 and then saves $400 a month towards retirement until age 67. Total invested in their retirement is $153,600. After 32 years they have amassed $512,972.59 at retirement.

Saver number two saves $300 a month starting at age 25. After 42 years they have invested almost the same amount, $151,200. The big difference is that due to an annual compound interest rate of 8.3% they have amassed $1,191,520.28 at retirement. Investing slightly less money, but starting earlier – doubled their retirement savings!

The news isn’t all horrific though if you haven’t saved up as much as you should have by now. As you grow older, your earnings tend to be significantly higher and hopefully; your discretionary income will be as well. You may be able to put aside $800 a month towards retirement at age 40 and still live a more comfortable lifestyle than putting away $200 or $300 a month when you’re younger, and money is tight.

Quick Tip – Always try to at least put enough in your retirement savings to get the full benefit of your employer’s match (They’ll match 50% of your monthly contribution up to 6% for example)

The most important thing to remember is this. Save as much money as you can, as early as you can, without depriving yourself of a satisfying life (after all – we don’t all make it to the end).

When’s the best time to start investing? Now!

The Two Biggest Mistakes That Ruin Retirement Accounts

The biggest mistake individual investors make is trying to outsmart the market by not diversifying their retirement investments. They’ll put all their money in stocks, only U.S. stocks, etc. Consider this…

Did you know that a portfolio of 70% U.S. stocks and 30% international stocks or 50% U.S. Stocks, 25% developed country international stocks and 25% emerging market stocks has earned about 2% more a year compared to just holding U.S. stocks with LESS risk over the past 40-50 years?

You’ve already seen how much money an extra 2% a year can add to your retirement account after 20 years.

Diversification helps you manage risk to make sure you don’t suffer devastating losses (think financial crises of 2000 and 2008) and have enough money saved for retirement. This is particularly important for those nearing retirement age.

If you think you can outsmart the market and don’t have to diversify, consider this. CXO Advisory Group measures a group of market “gurus.” These include professional money managers, newsletter writers, and financial columnists. Everyone on the list is an expert. The average accuracy of the group in predicting future price moves is less than 50%. That’s worse than a coin flip! These are the best in the business, and they can’t even predict the future over half the time.

John Templeton was one of the most successful investors and mutual fund managers of all-time. Here’s what he has to say on the subject of diversification; In my 45-year career as an investment counselor, humility did show me the need for worldwide diversification to reduce risk.”  

REMEMBER THIS: Manage risk first, growth second.

The Great Lie Told to Passive Index Fund Investors

If you still believe you can sock away 80-90% of your money in stocks without harm, you’ve never lived through the lows of the U.S. stock market from 1896-1932 or 1962 to 1974. That’s not even mentioning the two devastating stock market crashes from 2000-2002 and 2008-2009 during which time the stock market lost over half its value.

Don’t buy into the lie that all you to do is keep your money in stocks no matter the current valuations and you’ll be safe. The market doesn’t work that way. The stock market doesn’t return the average of 9% every year or even every 20 years.

When the market is considered overvalued by most financial measures such as it was in 1927, 1999 and 2007-2008 (and we believe 2016-2017) among other times, the expected returns are much smaller over the next few years.

When the market is undervalued such as it was in the early 1980s, 2003 and 2010, the expected returns will be much higher than the 9% average over the next few years.

While it’s virtually impossible to time the market consistently with any degree of accuracy, you can use valuations and probabilities to reduce risk and make more money in the long-term.

I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.” – Warren Buffett

The Big Lesson

When the stock market has been steadily rising in price investors, get a false sense of security and believe everything is safe. During this time they start to allocate more of their investment funds to stocks and other risky investments telling themselves that this time is different, they’re money is safe because……We saw this is the leading up to the great depression, dot com bubble and real estate bubble.

The four most dangerous words in investing are this time it’s different.’” – John Templeton

When the market crashes, investors become fearful, pulling their money out of the stock market.

If you want to retire with more money with less risk, you have to do the opposite.

Quick Tip: Don’t try to predict the future but use probabilities and valuations to guide your long-time investment decisions and put the numbers in your favor.

Reducing Your Risk of Large Losses

To reduce your risk of large losses, you need to diversify your investments. Diversification is the process of simultaneously investing in different types of financial markets to eliminate company and industry risk (risk of massive investment losses in one company or industry), leaving only overall market risk which cannot be diversified away.

The benefits of diversification are dependent on the correlation of assets. The best diversification is achieved by combining investments that have “low, zero, or negative correlations to each other.” Correlation refers to how investments rise or drop in price in relation to each other. If you have two separate investments that fall and rise in price at about the same percentage rate over time, they have a high correlation in performance, and you would not achieve diversification despite being invested in different markets.

On the other hand, if they are a mirror image of each other, where one goes up in price when the other goes down in price or vice versa, you have a negative correlation because the prices move in opposite directions.

For maximum diversification, you’re ideally looking for investments with a negative or zero correlation. These are hard to find, so the best options are lower positive correlations.

The most common diversification for investors is that of bonds and stocks. Bonds have lower absolute returns than stocks over the long term, but the correlation in price moves is only about 30% compared to stocks.

T. Rowe Price conducted a study over for a 15-year time period ending in 2010. They found that holding a portfolio of 50% bonds and 50% stocks during that period achieved 100% of the returns of an all-stock portfolio with only 51% of the risk. That shows the power of diversification.

However, remember this before you jump to conclusions and take the easy way out by following that strategy. The last 15 years prior to 2010 had been a bull market for bonds due to falling interest rates. The stock market meanwhile was flat the previous ten years with two major corrections. Therefore, if T. Rowe Price did another study over the next 15 years or picked another period, the results could be completely different. We have no way of knowing the future, which is why diversification through assets without high correlations can be significant.

Correlations for U.S. stock markets are highest within the country, (U.S. small-cap stocks vs. U.S. large-cap stocks), followed by developed countries with the U.S. highly correlated with Canada and the UK. The lowest correlation for stocks in relation to the U.S. stock market has been with Emerging and Frontier Markets. The less trade there is between countries and the less similar their monetary policies, the lower the correlation and higher the diversification benefits.

The correlation between Emerging Market and Frontier Market Bonds to U.S. Bonds, and the correlation between Emerging Market and Frontier Market Stocks to U.S. stocks have both been under .5 since 1988 in U.S. dollars returns. U.S. Equities have almost no correlation with world government bonds (*Data from MSCI).

As you can see, if you’re looking for ways to limit risk through diversification, the effect is muted by investing in different stock market classes within the U.S. or adding investment from the UK, Canada, or most other developed countries to your portfolio. You would get your greatest diversification benefits by gaining exposure to Emerging and Frontier Markets. Remember though; correlations do change over time depending on international trade, economic growth, fiscal policy, exchange rates, and monetary policy

Here’s some food for thought if you’re still reluctant to add foreign investments to your portfolio. The U.S. Proportion of the Bond and Stock Market declined from 65% of the total market to 46% in 2006. It will continue to fall if world GDP (minus the U.S.) continues to grow faster than the U.S. because emerging markets will have to fund growth with more debt.

There will be times when the U.S. market does better, but there will also be times, like the first decade of 2000, where emerging markets will do much better.

Please Note: Diversification is not meant to provide you with the highest absolute total returns. It’s used to attempt to provide you with the highest returns for a given level of risk.

In closing, consider joining our family and becoming a member of the Value Investors Association to help protect your financial future and that of your loved ones.

Sincerely Bob Howe

Value Investors Association