Three Steps to Wealth & Financial Security
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Pew Research Center: According to a Pew Research Center study released in April 2013 - pewresearch.org – wealthier households in America tend to hold more of their worth in stocks and bonds. Real estate contributes most to the value of less wealthy house- holds. Stocks and bonds tend to make up about 65 percent of the wealth of households with $500,000 or more in net worth; homes contribute just 17 percent to their net worth. In contrast, for households with net worth under $500,000, home values contribute about 50% to net worth and financial holdings about 33 percent. The Pew study focused on the period 2009 to 2011. Home prices were depressed during that period, while the S&P stock index rose 34%. Thus, it is not surprising that households emphasizing financial holdings would increase their wealth.
Recommendation: If you want to achieve wealth and financial security, diversify investments. Ensure that financial holdings play a significant role in your portfolio. What is the right balance of stocks, bonds, real estate and other asset classes in your investment plan? The answer depends on your age, financial goals, and tolerance for risk. See our discussion in “Eight Guidelines to Successful Investing – Guideline Six – Control Risk” below.
Recommended reading: “How Much Does the Stock Market Actually Return?” J. D. Roth, Get Rich Slowly.org, getrichslowly.org/blog/2008/12/16/how-much-does-the stock-market-actually-return
3. HOUSES VS. THE STOCK MARKET
A View from the University of Southern California
“The average single family house has never been a particularly stellar investment”. Robert Bridges, USC
See “A Home is a Lousy Investment,” Robert Bridges, Professor of Finance and Economics, USC, Wall Street Journal, 7/11/2011, where he said, “An analysis of home-price and ownership data for the last 30 years in California indicates that the average single family house has never been a particularly stellar investment.” Between 1980 and 2010, the median-priced home in California rose by an average of 3.6 percent per year, i.e., about the same as inflation.
In same thirty-year period, U.S. stocks averaged 11.5 percent per year and after inflation about 8.5 percent per year.
Bridges: “So a dollar used to purchase a median-price, single-family California home in 1980 would have grown to $5.63 in 2007 and to $2.98 in 2010. The same dollar invested in the Dow Jones Industrial Index would have been worth $14.41 in 2007 and $11.49 in 2010”.
Bridges: “Here’s another way of looking at the situation. If a disciplined investor who might have considered purchasing that median-price house in 1980 had opted instead to invest the 20% down payment of $19,910 and the normal homeownership expenses (above the cost of renting) over the years in the Dow Jones Industrial Index, the value of his portfolio in 2010 would have been $1,800,016. The stocks would have been worth more than the house by $1,503,196. If the analysis is based on 2007, the stock portfolio would have been worth $2,186,120, exceeding the house value by $1,625,850”.
A View from the University of Vienna
“Why is housing (in the U. S.) such a popular investment?”
See “Why Is Housing Such A Popular Investment? A New Psychological Explanation” by Thomas Stephens and Jean-Robert Traynor, Vienna Center for Experimental Economics, University of Vienna, November 23, 2012; http://www.voxeu.org/article/why-housing-such-popular-investment-new-psychological-explanation
Highlights of the University of Vienna study include the following: “In the U.S., housing remains a popular investment. This popularity is surprising because, over the post-war period, U.S. house prices have been essentially flat in real terms, while over the same period the U.S. stock markets have risen more than fourfold in real terms.”
“Many view housing as an attractive investment with good potential, despite meager real capital gains over the long run. We find no evidence that property ownership reduces this bias but do find strong evidence that more education and greater cognitive reflection do. These results suggest that better financial education may reduce this bias towards overinvesting in housing.”
A View from Yale University
“Do not invest in houses”. Robert Shiller
“Home prices look remarkably stable when corrected for inflation. Over the 100 years ending in 1990 — before the recent housing boom — real home prices rose only 0.2 percent a year, on average” Robert Shiller, Sterling Professor of Economics, Yale University
Shiller: “Here is a harsh truth about homeownership: Over the long haul, it’s hard for homes to compete with the stock market in real appreciation”. Recommended reading: “Why Home Prices Change (Or Don’t)” Robert Shiller, The New York Times, April 13, 2013
Comment
The lesson for owner occupants: Do not depend on your house for retirement.
Think twice before putting too much money into a house, “trading up”, or buying a dream house.
Diversify investments; ensure that stocks play a significant role in your investment portfolio.
The lesson for real estate investors: Diversify investments; do not put all your money into houses.
Buy real estate to obtain a return on investment and as a hedge against inflation. Do not expect a house to compete with the stock market in terms of real appreciation.
4. INVESTMENT ACCOUNTS
“Be sensible and store up precious treasures”.
Proverbs 21.20, Contemporary English Version
Defined benefit plans or pensions are almost a thing of the past. Increasingly, both private and public sector employers are eliminating defined benefit plans for employees.
As a result, you are now in charge of your retirement planning.
Unfortunately, only a small percentage of people think about the importance of planning for retirement. Of those we counsel, less than 50 percent have an investment account. These include people in the top 10 percent of all income earners. Of those who have investment accounts, few have any significant money invested in them.
The lesson: If you don’t have an investment account, open one today; you do not want to rely on Social Security when you retire. Suggested brokerages to consider: Vanguard: vanguard.com – 877-662-7447
T. Rowe Price: troweprice.com – 800-541-6066
Schwab: schwab.com – 866-855-9102
After you open and fund an investment account, do not make the mistake that many make. Do not borrow against the account! See “Loans Borrowed Against Pensions Squeeze Retirees”, Jessica Silver-Greenberg, New York Times, April 27, 2013;
Recommended reading: “Is a Roth IRA Right for You?” by Jane Bryant Quinn, aarp.org/bulletin, April 2013; “Retirement Basics: IRA or 401(k)?” by Scott Holsopple, USNews.com/money, February 4, 2013; “Understanding the ROTH 401(k)” by Alexkandra Todorova, SmartMoney.com, February 5, 2013; and “Save More with a ROTH IRA and 401(k)” by Steve Vernon, Money Watch CBS, CBSNews.com;
5. TAX DEFERRED INVESTMENT ACCOUNTS
a. 401(k) – Employer Sponsored Plans
“When employees leave their company, many withdraw their 401(k) money and then have no savings or investments”. Dory Laramore, financial writer and certified registered tax preparer
“Borrowing from or cleaning out your account can come with consequences, the most dire being you won’t have enough money to live on during retirement”. Karen Blumenthal, Wall Street Journal
Two types—the traditional and the Roth: In a traditional 401(k), employee contributions are deducted from your taxes. At retirement, withdrawals are taxed at ordinary rates. In a ROTH 401(k), contributions are made with after tax dollars; the withdrawals may be tax free.
In a 401(k), employers may match employee contributions by as much as fifty cents on the dollar, a huge return. So, contribute as much as possible and get the full employer match. The maximum tax-deferred contributions are set by law. See your employer, tax counsel or review irs. gov.
401(k) plans have limitations: Investment decisions are left to you, but investment options are limited. Expenses can be high—extremely high—or hidden. Less than ha
lf the plans offer a bond index fund. Only one-fourth offer real estate investment funds. Government regulations now require that employers reveal the expense ratios for the plans, showing the cost per $1,000 invested. So, you may be able to compare what your employer offers with what is available on the open market. See Elizabeth O’Brien’s comments below.
Recommended reading: “How Good Is Your Company’s 401(k)?”, by Kelly Green, The Wall Street Journal, January 4, 2013, and “10 Things 401(k) Plans Won’t Tell You – How out of control fees and below par investment options could delay your retirement – or rob you of it entirely,” by Elizabeth O’Brien, Smartmoney.com, The Wall Street Journal, November 12, 2012. Highlights from Ms. O’Brien’s article are set forth below: “For more and more Americans, the quality of one’s retirement comes down to the quality of one’s 401(k).”
401(k) plans, first introduced in the 1970s, were not originally designed to carry the burden of future retirement. They were intended as “mere supplements” to defined benefit plans or pensions.
Workers are now on their own when it comes to figuring out how much to save for a comfortable retirement. “Once they stop working, it’s up to workers to figure out how to turn a nest egg into an income stream.”
“The burden on employees to provide for their own financial security is huge, and the best advice companies can give is simply to encourage their workers to save.”
According to the Employee Benefit Research Institute, the amount by which employee savings and Social Security will fall short of what they need is $4.3 trillion. “Clearly, folks aren’t setting aside enough for their post-work lives.”
“Employers and employees alike often have little idea what they are paying for, thanks to buried 401(k) fees. For example, a fund’s expense ratio can encompass everything from marketing fees paid to the investment firm to commissions paid to the broker who recommends particular funds.”
You may lose years’ worth of savings due to 401(k) fees: “A worker who makes $75,000 per year and saves 8% of that annually in a 401(k) would lose 2.8 years’ worth of savings in a fund with a 0.2% fee and 11.6 years in one with a 1% fee over the course of a career.”
“Twenty-five percent of assets invested in stocks in a 401(k) are invested in actively managed stock funds and just nine percent are in index funds. Actively managed funds . . . are expensive. Most people will be better off in indexed funds with costs as low as possible.” Steve Vernon, Rest-of Life Communications, a benefits consulting firm
Finally, when you change jobs or retire and move your money from the company’s 401(k) to an IRA, be careful about where you move your money. According to the Government Accounting Office, the advice given to employees by money management firms handling company 401(k)s is often misleading and self-serving. “Report finds financial firms’ advice on fund rollovers not in the best interest of holders”. Washington Post & Associated Press, April 8, 2013.
So, shop around! Go on line to compare different IRA options. Consider Vanguard, T. Rowe Price and Schwab.
b. Individual Retirement Accounts – IRAs
“People vastly underestimate how much money it takes to have a lifetime income”. Steve Vernon who helped employers design retirement plans for over 30 years.
If you do not have access to a company-sponsored 401(k), IRAs are an easy way to invest.
There are two main types of IRAs—the traditional and the Roth: Contributions to a traditional IRA can be deducted from your taxes, but withdrawals during retirement are taxed at ordinary rates.
For the Roth, there are no deductions upfront and may be no taxes when withdrawn during retirement. Which IRA is best for you? Invest in both!
In IRAs, investment decisions are left to you. The maximum tax deferred contributions are set by law. See your tax counsel for additional information or go to www.irs.gov. IRAs offer virtually unlimited investment options. You will also be able to shop for the lowest fees possible. The costs could be less – a great deal less - than a 401(k).
6. THE 529 COLLEGE SAVINGS PLAN & THE ROTH
“Cast your lot with business. Successful investing is about reaping the huge rewards provided by the dividends and earnings of our nation’s corporations”. John Bogle, Vanguard founder
Invest in a college fund for your kids. Tips for parents: Get your child a social security number and open an individual 529 college savings account as soon as possible after birth. Money spent on toys is gone forever. Money invested compounds. Invite relatives to participate.
Contributions are made with after tax dollars but taxes on returns are avoided if the money is used for qualified educational purposes. See IRS.GOV.
Invest in a total U. S. stock market mutual fund or a U. S. small-cap growth index fund, or the equivalent. Avoid conservative investments such as a money market or bond fund during the child’s younger years. Note U. S. stocks have averaged approximately 10 percent per year over the long term, while U. S. small-cap stocks have averaged about 12 percent per year long term. $10,000 invested for 18 years at a child’s birth into a low cost total U. S. stock market index fund could give you about $55,599 minus the expense ratio charged by the fund. $10,000 invested for 18 years in a small cap fund averaging could give you $76,900 minus the expense ratio. Historical returns are a guide but do not guarantee future results.
After making an initial investment, invest on a regular basis via auto deduction and stay invested. Do not take the money out until the child is ready for college.
Invest frugally. Avoid actively managed funds that charge high fees and expenses, some of which are hidden. Management fees and costs impact significantly on long term returns.
Shop and compare what is offered on the market. Consider Vanguard (vanguard.com), T. Rowe Price (troweprice.com) and Schwab (schwab.com).
Smart Tax Move: Consider a ROTH as another option; consider investing in both a 529 College Plan and a ROTH. Contributions to a ROTH are done with after tax dollars; the money taken out may be tax free.
ROTH funds can be withdrawn without penalty for educational expenses at any age.
In a ROTH the parent can withdraw funds for college expenses for the child or any family member, including the parent.
If the child does not go to college, ROTH funds can be used by parents for retirement at age 59½—a win-win situation.
7. TAXABLE INVESTMENT ACCOUNTS
“Investing is the single most effective way to get rich”.
Ramit Sethi, author, I Will Teach You to Be Rich
After contributing to a 401(k) or IRA, the next objective is to investigate, open and contribute to taxable investment accounts where contributions are made with after-tax dollars. You can put an unlimited amount of money into taxable investment accounts.
Everyone can open a taxable investment account.
Investment options are essentially unlimited; see vanguard.com, troweprice.com, and schwab.com.
The investment strategy is completely in your hands.
Most money in taxable investment accounts is invested in actively-managed mutual funds – not the best option.
Smart investment move: Move to low-cost index funds. Expenses are significantly lower, and you do not get better results by paying more for actively managed funds. See discussion below.
8. INVESTMENT ADVICE AND STRATEGIES
a. The 2004 Google Teach-Ins
“A winning strategy is to own the nation’s publicly held businesses at very low cost. The best way to implement this strategy: Buy an index fund that holds the entire stock market and hold it forever”. John Bogle, founder of Vanguard who created the index fund in the 1970s
In 2004, Google, pending a public offering, organized a series of teach-ins to help their employees understand investing. Top people in the investment field were invited to speak to Google’s employees. The faculty included the following experts: Bill Sharpe, Stanford professor and 1990 Nobel laureate in Economics;
Burton Malkiel, Princeton professor and author of
A Random Walk Down Wall Street;
John Bogle, founder of the Vanguard Group and creator of the index fund in the 1970s.
The faculty made following recommendations: Avoid individual stocks. Avoid actively-managed mutual funds.
Diversify and invest in low cost index funds.
Invest regularly and automatically.
Be careful about spending too much money on financial advisers.
Don’t try to beat or time the market. Take what the market gives you, and stay invested.
For a detailed discussion of the 2004 Google Teach-ins, read “The Best Investment Advice You’ll Never Get,” by Mark Dowie in the January 18, 2008, issue of San Francisco Magazine.
b. A Look at the Best Investment Portfolios in America
“Most investors are their own worst enemies”. Ken Fisher, money manager and financial writer, Forbes.com/fisher
Paul Farrell, “Money Watch,” The Wall Street Journal, tracked investment portfolios used by Nobel Prize winners, conservative fund managers, and economists. See “Six Reasons Why Wall Street Hates Lazy Portfolios,” in the March 27, 2012, issue of the Wall Street Journal.
Farrell learned that these investors do boring, unexciting things with their investments: None buy actively-managed funds or individual stocks sold by brokers or financial planners.
They invest regularly and often in low-cost index funds.
They buy and hold. They do not trade or try to time the market.
They use low-cost Vanguard index funds.