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What You Should Do When the Stock Market Swoons

Nothing.

Now, what would be really great is if we could invest more money in the stock markets when they are going up and get out of the stock markets when they are going down. Our return would be much better if we could avoid those nasty market downturns. Many attempt to do just that, but few are any good at it.

The trouble is if you missed just the months with the top 5 percent of returns in the market since 1950, you would have cut your returns almost in half. Of course, if you were able to avoid the bottom 5 percent of months in the process, you would perform just about as well as the market. But given the uncertainty of when those occur, that doesn’t seem like a good trade-off.

To illustrate, take a look at what happened during and after the financial crisis. The following chart shows the total return for the S&P 500 and cash flows in (bars going up) and out (bars going down) of equity mutual funds during the crisis and through the recovery to 2012.

S&P chart

The peak in value for the S&P 500 prior to the crisis came in September of 2007. From there the stock market began a gradual decline, with some investors selling sporadically. However, in September of 2008, the floodgates opened, and mutual fund investors began pouring out of equity funds. The S&P 500 had already lost more than 36 percent of its value.

The bottom of the market came in February of 2009, just four months and 16 percent later. But money kept leaving the stock markets. Even as the stock market crested its prior peak, equity funds saw growing withdrawals through the end of 2012.

If you had perfect foresight, you would have sold in September of 2007 at the peak. You would have avoided the following drop in value of 51 percent. Then you would have bought back your investment at the low in February of 2009. If you had done that, then ten years later—by September 2017—your investment would have risen by almost four times, or 14.2 percent per year.

But be realistic. You only have perfect hindsight. You know nothing about the future. You can’t tell whether the market is at a peak or just a nice viewpoint along the way. And you certainly can’t tell when the market has hit bottom.

The biggest monthly net sale of equity funds was in October of 2008, and the biggest monthly net buy following that was January of 2013. If you had sold and bought back in those months, as many other market participants did, your return for the ten years ending in September 2017 would have been just 10 percent, or about 1 percent per year.

What if you had done nothing? If you had not touched your stock market investments, in the following ten years your money would have more than doubled for an annualized return of 7.3 percent. Doing nothing is certainly easier than picking both the top and bottom of the stock market. Steadily adding to your investments, as you would in your retirement account, would have been even better.

Timing the market is a fool’s game. Seeing your nest egg shrink is no fun for anyone, but if you don’t have to spend your money right away, it can recover. So, as the market is adjusting, your task is simply to do nothing.

Photo by Chris Liverani on Unsplash

When Your Money Makes More Money Than You Put In

Saving money is hard. As human beings we are naturally wired to place our immediate needs (or wants) ahead of our future needs. Long term goals, like retirement, seem particularly daunting. The numbers are large, and the payoff is a long way off. Would it help to know that it gets easier the longer you do it?

Yes, the more consistently you set money aside the easier it becomes, because you are developing a habit of saving money. If you save through your company retirement savings plan, it’s even easier, because the money is whisked away before you get it.

But that isn’t what I’m talking about. The more money you save, the more your money works for you. Your money starts making money through the magic – actually the math- of compounding. Here’s what you could look forward to if you were to save the same amount of money each year, and earn an annual investment return of 7 percent.

  • In eleven years, the earnings on your total savings will match your contribution in that year.
  • In about six more years, the earnings on your total savings will be double your contribution in that year.
  • In about three more years after that, the earnings on your total savings will be triple your contribution in that year.

Of course if your investment return is lower, it takes a bit longer for your investment earnings to match your savings contribution. If your return were only 5 percent per year, it would take about fifteen years for the earnings to match your contribution. But there is a similar pattern of doubling and tripling your contribution over ever shorter time frames following that.

Admittedly, I’m both a money and a math nerd. I find this half-life of time to essentially gain an extra year of savings through the earnings on what you’ve already saved exciting. Who wouldn’t appreciate their money working harder than they do?

That is why it is so important to begin saving for your long term goals as soon as possible. The more time you have, the more your money can do the heavy lifting for you. Your total contributions toward your goal can be smaller.

If you are struggling to find the motivation to save for something that is decades away, keep in mind that you don’t have to do all the work. Saving money is hard, so make it as easy as you possibly can. Take advantage of the magic of compounding. Save early and save often, and you won’t have to save as much.

Photo by Mert Guller on Unsplash

 

 

 

The Key to Following Through on Your Good Intentions

Do you find it hard to follow through with your intentions? Whether it’s sticking to a budget or signing up for your company retirement plan, it’s easy to get off track. Everyone is busy, and your good intentions may fall victim to life’s frenetic pace. The key to following through with all you want to accomplish is to have a plan.

Of course you need a plan to achieve the big goals in your life. But you also need a plan to just get through your day. Simply knowing what you will do will make your life easier.

Say that you intend to cut back on eating out so you will have some extra money to save for your emergency fund. After a long day at work, you’re tired and hungry. Instead of making something from the groceries you have at home, you head off to the local Thai restaurant. You weren’t planning to go out to dinner. But in the moment it just seemed easier.

Though you have groceries at home, if you don’t know specifically what you will do with them, you have to decide what to cook under stress. The decision making process takes energy you simply don’t have, so your good intentions go out the window.

Scientists have found that under stress an enzyme attacks a synaptic regulatory molecule in the brain. As a result, fewer neural connections are made, and we think less clearly. We are physically less able to make good decisions. Our judgment in these circumstances is literally impaired.

The key to sticking with your good intentions is to not have to make a decision when your synapses are under attack. Just knowing what you will do will help you follow through. If you know exactly what you will make for dinner, it’s easier to carry out that plan than it is to decide when you’re tired and hungry. The following example illustrates why a plan works.

Plan No Plan
Planned to make meat loaf, green beans and steamed potatoes for dinner Check refrigerator for options
All ingredients on hand and defrosted Nothing is thawed, so need to wait for meat to defrost in the microwave. Choose ground turkey
Mix ingredients for meat loaf and put in the oven Out of eggs, so meat loaf is out – opt for turkey burgers
Steam green beans and potatoes in microwave No buns. Burgers are out, maybe pasta
Serve dinner What else do I have?

It’s the figuring it out that drains you, not the doing. You could make that meat loaf in your sleep. But without a plan, it’s no wonder you would choose to go out for dinner.

Simply planning what you will do will help you carry out all of your good intentions. If you’ve been meaning to sign up for your retirement plan or even just call your mother, but you are always too busy, try putting it on your calendar on a specific time and day. It  will substantially increase the likelihood that you will actually do it.

If you are committed to following through on your intentions, make a plan.  If you know specifically what you will do and when you will do it, you are much more likely to follow through. Your plan eliminates the need to make a decision, which if made at the last moment, may not be a good one.

Which of your good intentions could use a plan? Leave me a comment.

Photo by The Journal Garden | Vera Bitterer on Unsplash

The #1 Obstacle to a Successful Budget

When I talk to people about setting aside savings or creating a budget, I often hear things like this:

“It’s pointless. Whatever I save gets used up by some unexpected expense.”

“Every time I try to live by a budget something comes up that throws the whole thing off.”

Unexpected expenses can throw a monkey wrench into anyone’s plans. They can be a big contributor to increasing debt.

What is the solution? Expecting more of your expenses.

If you sit down and think for a moment, you can likely predict the vast majority of your expenses. You won’t necessarily get a monthly bill for all of them, but you can manage them as if you did.

If you have a car or a home, you will have maintenance and repair expenses. If your health care plan has a deductible and copay, you’ll eventually pay something for a doctor’s visit. If you have family, you’ll buy gifts or travel to see them.

It’s a given. So you really can’t call these costs unexpected, though they may be untimely. Since they can reasonably be predicted you can set some money aside for them in your budget, even if none of these expenses are imminent. Here are a few tips for estimating what to include.

Car

To estimate how much you should save for maintenance costs, use the Total Cost of Ownership Calculator from Edmunds. There you can enter the make, model, and year your car was made to find out what you can expect to pay for maintenance and repairs for the next five years. If your car is expected to cost you $1,200 per year, set aside $100 per month in your budget.

Home

Typical home maintenance and repairs average about $1 per square foot per year. If your home has 1,500 square feet, you should be saving $1,500 per year, or $125 per month. You won’t necessarily pay that every year, but if you live in your home long enough, you eventually will. You should be saving at least that amount so you have the money available when a costly repair is required. You may need more if you know your furnace or roof is on its last legs.

Health Care

Health care expenses are a frequent cause of financial stress. In fact, medical bills are the leading cause of bankruptcies in the US. To minimize your risks, work toward accumulating at least your plan’s deductible in savings. If your annual deductible is $2,500, to accumulate that in a year, you would set aside $208 per month. Your stretch goal is to accumulate your maximum out-of-pocket expenses over time.

Family

Birthdays, holidays, celebrations, and family gatherings can all put a dent in your bank account. But you know when they’ll happen, so plan for them. Decide now how much you will spend for the family obligations in your future, and set a bit of money aside each month to cover those expenses.

These types of expenses are part of your cost of living. They need to be part of your budget. If they are not, they will inevitably cause to you to blow it. Making the effort to predict your future expenses is the key to successful budgeting. Setting money aside for them in advance will allow you to stick with your budget and allow your savings for other things, like emergencies, and retirement, to stay saved.

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Are You Saving Too Much?

This may seem like a strange question coming from me. As a huge proponent of saving, my usual advice is to save early and save often. Mostly I think there isn’t any such thing as saving too much. However, if you have debt, and you are finding it difficult to pay it down while you save, you are saving too much.

It can be confusing. Everyone says you should be saving for retirement. And it’s true. The earlier you begin saving for retirement, the easier it will be to save enough to support yourself when you stop working for pay.

However, there are a couple of things that need to come ahead of maximizing your retirement savings, and one of them is reducing your debt. If you have outstanding debt, other than your mortgage, saving money may not be improving your financial situation. You may be simply running in place.

Debt reduction is a form of saving that is as good or better than others, and paying down your debt can offer you a better return than saving.

According to Wallet Hub, the average credit card interest rate in the second quarter of 2018 ranged between 14.2 to 22.4 percent. When you pay down your credit card debt, you are saving the interest expense. That translates to a guaranteed return on your money that is better than any investment opportunity.

If you have car payments or student loans, the interest rates may be lower. But the lower rate doesn’t make it less important to pay them off.

If you have debt, you may be able to earn more by paying it off than you can by saving and investing in the investment markets. But that isn’t the most important advantage of paying off your debt. The biggest advantage is in the flexibility and security you will gain.

Debt payments are a mandatory expense. You can’t choose to not make them. As a result, when you have debt you are closer to the financial edge. If you lose your job, or can’t work because you’ve become ill, your reserves will be chewed up faster if you have debt payments. Your emergency fund needs to be larger because your mandatory expenses are larger.

You will be better off if you reduce your savings, so you can pay off your debt faster. However, there are two exceptions.

  1. Before you begin aggressively paying down your debt, make sure you have an emergency fund. You should be able to cover your mandatory expenses for three months. Make only minimum payments on your debt until your emergency fund is in place. Having the emergency fund will help you stay out of debt in the future.
  2. If your employer offers to match your 401(k) contributions, and you can make extra payments on your non-mortgage debt while getting the match, then contribute enough to get that. It’s free money.

Beyond establishing an emergency fund and getting your 401(k) company match, focus  all your extra money on paying down your debt.  You’ll be able to save more once your debt is paid off.

If you are having trouble getting rid of your debt, then save less. Debt reduction is a form of savings, that offers a guaranteed return equal to the interest rate on your loan. Getting rid of it is an important step in building your financial security, and once it’s gone, you’ll have the flexibility to put even more in savings.

Photo by Justyn Warner on Unsplash

Why Life Insurance is Not a Good Way to Save for College

Recently a friend asked me about a strategy proposed to her by a financial adviser. The adviser was recommending that she and her husband invest their children’s college savings in a life insurance policy. Here were the benefits as given by the adviser:

  • The money grows risk free.
  • It is life insurance the children can keep for the rest of their lives.
  • The money isn’t counted as family assets for financial aid purposes.

On the surface these seem like good ideas. Saving for college in a life insurance policy has been a strategy promoted for ages. In fact, Gerber Life has promoted these policies on national TV for years. However, life insurance is probably the least effective way to save for college there is. If someone recommends a life insurance policy for your college savings, run.

The policies promoted are known as permanent or whole life policies. As long as you pay the premium you will have life insurance for as long as you live and a guaranteed death benefit when you die. A portion of your premium pays for the death benefit and a portion earns interest which builds up a cash value. Over many years, the cash value grows, and it and the death benefit become one and the same.

The money does grow risk free at a low interest rate. The cash value will not decline, unless you withdraw it or stop paying the premiums, and it will grow slowly over time. However, there are many college savings options that offer a  greater return and much lower expenses. The death benefit is a big expense that cuts into your college savings, as does the hefty commission the adviser earns for selling you the policy.

Many state 529 plans offer age based investment options that gear their investment strategy to the remaining time until your child starts college. Though not guaranteed, these options offer sound strategies that can more efficiently grow your college savings.

As a permanent life insurance policy, your children can keep the policy at the same premium rate for their lifetimes. However, to withdraw the cash value to pay for college, they will either need to take a withdrawal, which is a taxable event, or borrow from the policy. Any amount you withdraw or borrow reduces the death benefit, and withdrawals can be subject to a fee called a surrender charge.

Children don’t need life insurance. You only need life insurance if there is someone depending on your income, and that is not the case for anyone until they have a spouse or children of their own. Your children can buy their own, much cheaper, term life policy when they get married.

Life insurance is not included in family assets for purposes of determining eligibility for financial aid, whereas money saved in a 529, or other college savings plan is. However, the first $20,000 in savings is exempt from the Expected Family Contribution (EFC) and the EFC is capped at 5.64 percent of parental assets. You can save quite a bit before your child’s eligibility for financial aid is impacted.

When your children are young, it is important for you to have life insurance on yourself. You’ll want your children to have all the advantages you would have provided if something happens to you. However your children don’t need their own life insurance, and it is an expensive and inefficient way to save for college. If you have money to put toward your children’s education, check out your state’s 529 college savings plan instead.

Photo by Colin Maynard on Unsplash

Four Hidden Reasons to Never Borrow From Your Retirement Plan

If you need money and you have money in your retirement account, it can be very tempting to borrow from it. It is your money after all.

Most retirement plans allow participants to borrow against their balances. About one in five 401(k) participants have an outstanding loan, and over a five-year period, almost 40 percent of participants borrow from their account at some point. Most loans are taken to pay off debt, usually of the credit card variety.

That can make some sense, since the loan rate on a 401(k) loan is lower than rates on credit cards. But there are other costs beyond the interest rate. While you are essentially borrowing from yourself, there are several consequences to taking the loan that make this a bad idea.

  1. While your loan is outstanding, your money is not invested in the market. You are earning the interest on the loan to yourself, but you are missing out on the greater growth you could get from stock market-oriented investments. The market rate of return is the true cost of your loan. Historically the stock market has returned on average 10 percent per year.
  2. Some employers don’t allow you to make contributions while you have a loan outstanding. If that is the case with your plan, you will miss out on the opportunity to grow your retirement account balance. If your employer matches contributions, you will also miss out on that.
  3. Your loan is repaid with after-tax dollars. When you retire, the money you repaid, like the rest of your balance, will be taxed when you take it out to meet your living expenses. So your loan will be taxed twice.
  4. If you leave or are let go from your job, you will only have sixty days to repay the loan or it will be considered a distribution. The distribution will be taxed as ordinary income in the year you take it, and you will pay an additional 10 percent penalty.

Instead of taking out a loan from your retirement account, consider what other options you have. If you are consolidating debt, have you considered taking advantage of a zero or low interest promotion on a credit card? Instead of adding to your debt, can you reduce your spending either by cutting discretionary expenses or by making bigger changes to lower the cost of where you live or how you get around?

In some cases, a loan on your retirement account may be the best of a few bad options, but that doesn’t make it a good one. There are costs that aren’t obvious, and they put you at risk of a big tax bill if you lose your job.

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How to Take Advantage of the Mutual Fund Company Price Wars

Fidelity has added two zero cost funds to their line-up of low-cost index mutual funds. One fund tracks the U.S. stock market and the other tracks international markets. These new funds are the latest volley in the index fund price wars. So it’s a good time to talk about the impact of fees on your investments and at what point it makes sense to switch.

Mutual fund fees are extracted from the value of the underlying fund investments. While you never have to pay out-of-pocket for these fees, they reduce the value of your investments, and are therefore, worth paying attention to.

Average fees for funds investing in large U.S. companies are 1.25 percent per year. If you assume the stock market will return 7 percent per year, after fees, your return would be 5.75 percent.

However, there are many index funds with much lower fees. Index funds track a market index, which is a fixed list of company stocks, like the S&P 500, or the Dow Jones Industrial Average. There are hundreds of indices which slice and dice the investment markets every which way you can imagine.

Because index funds track a fixed list of companies, the investment process is largely automated. The fund companies don’t have to pay expensive research staff, and therefore the funds are cheaper to manage and less costly to you.

The following table compares investment minimums and fees among a sample of a few low-cost index funds similar to one of the new funds from Fidelity.

Index Mutual Funds Minimum Investment Annual Fees
Vanguard Total Market Index Fund Investor Share Class  $3,000 0.14%
Vanguard Total Market Index Fund Admiral Share Class  $10,000 0.04%
Schwab 1000 Index Fund  $ 1 0.05%
Fidelity Zero Total Market Index Fund  $ – 0.00%

All of these funds are substantially less expensive than the average fund investing in U.S. stocks. That is why index investing has become so popular. Over a ten year period, a $10,000 investment will be worth around $2,000 more in any one of these index funds, versus a fund with a 1.25 percent expense ratio. Give yourself thirty years and the difference will be around $20,000.

However, among these already low-cost funds, the differences are much smaller. The following table shows the difference in expenses over time on a $10,000 investment for the funds above.

Cumulative Expenses Over Time

Ten Years

Twenty Years

Thirty Years

Vanguard Total Market Index Fund Investor Share Class

$256

$1,000

$2,932

Vanguard Total Market Index Fund Admiral Share Class

$73

$288

$849

Schwab 1000 Index Fund

$92

$360

$1,060

Fidelity Total Market Index Fund

$0

$0

$0

If you are just starting out and planning to invest in index funds, going with the low cost provider is a reasonable strategy. While Fidelity has these two new zero cost funds, they also have several index funds with expenses ranging between 0.015 percent and 0.11 percent.

However, if you already have investments, there are a few things to consider when deciding whether to change fund companies for the purpose of getting a lower fee.

  1. It’s important to keep your financial life simple by holding as much of your investments as possible at one institution. If most of your investments are already with Vanguard, it probably isn’t worth it to open a Fidelity account just to take advantage of the new zero cost funds.
  2. While the fund fees may be lower, you could pay a premium to buy and sell a low- cost index fund away from the fund company that manages it. For example, if you buy the Vanguard Total Market Index fund through Charles Schwab, the trade will cost you $76. The Fidelity Zero funds aren’t available there (at least not yet).
  3. If your investments are in a taxable savings account, you will have to pay capital gains taxes on the sale of the fund you already hold to move to a lower cost fund. If you have a high expense fund, it could still be worth it, but it probably won’t pencil out among already low-cost index funds. Of course there are no tax consequences to transactions in your retirement savings accounts.

The mutual fund company price wars are making investing cheaper and more accessible to all investors. Mutual fund fees take a bite out of your returns, so the lower the better. But if you are already invested in a low-cost fund, there can be drawbacks to switching to a new fund, even if it costs less. It may not be worth it to chase the fund companies to save a few bucks.

Image courtesy of sheelamohan at FreeDigitalPhotos.net

How to Use a Check Register to Take Control of Your Money

I may be dating myself by discussing check registers. In this age of ubiquitous electronic payments, few use checks anymore. Today payments are posted to your account nearly immediately, so what you see online in your account really is what you have.

But it still may not be what you can spend. If you haven’t accounted for future expenses, it is easy to overspend, and that can result in an increasing credit card balance. With a simple check register you can create a plan for your money and avoid overspending.

Before electronic payments became so prevalent, it used to be you paid all your bills with a check, and it could take days, if not weeks, for the money to be withdrawn from your account. To avoid over drafting your account, you had to keep track of the checks you had already written but which hadn’t yet cleared. You did this in a check register.

Now days, I see people running into a different problem with their bank accounts. Because they aren’t keeping track, it’s easy to overspend. While you don’t have to worry that your account balance shows more money than you really have due to outstanding, un-cashed checks, you still can’t just go out and spend the money that’s there.

I recently helped a young woman, Kara, take control of her money by using a check register. Rather than using it to record money she had already spent, I encouraged her to use it to record money she expected to spend.

With each paycheck, Kara listed the deposit and then what would happen with every dollar of the money. She listed each bill she had to pay with the check. She also listed what she expected to spend on groceries, hair cuts, gas for the car, and other unavoidable expenses. Before she spent a dime, she knew exactly what it would be spent on.

In addition to the expenses that came up every month, she also allocated money for expenses that would come up in the future. Each paycheck, she set aside money for future car repairs and a trip she wanted to take. This way she knew how much money she really had to spend on non-essentials.

Back in the day, at the end of each month, good money management practice was to reconcile your bank balance with your check register. In this exercise, you accounted for all outstanding checks and made sure you corrected any errors. Similarly, Kara needed to reconcile the way she actually spent her money with how she had planned to spend it.

In addition to recording the deposit of her paycheck, Kara verified that the balance she predicted she would have was the balance she did have. In between paychecks,  if she had unavoidable unplanned expenses, she recorded those and adjusted her spending plans accordingly.

Sometimes things come up that you don’t foresee. You forget your lunch, so you have to buy it. You’re running late, so you have to drive, and pay for parking, rather than take the bus. Your electric bill is unusually high. By recording these kinds of unplanned expenses in her check register, Kara could see what needed to change before she spent more than she wanted.

It didn’t take long for Kara to get out of debt and begin to save money. She no longer needed to bridge the gap between her bills and her money with a credit card. She did it with a very old fashioned tool, the check register.

What she had actually done was create a budget. There are all kinds of high-tech tools for creating a budget. But when you boil it down, you still have to do the work of figuring out where your money is going to go. Sometimes it’s easier to see how things will play out if you build your plan by hand.

While you may no longer need to write checks, you do still need to keep track of where your money is going. A simple no-cost tool for doing that is a check register. It’s value today isn’t in recording the money that you’ve already spent. Instead, use it to record the money you plan to spend, and you will avoid spending more than you can afford.

Freedom and Financial Security

Wouldn’t it be nice to have complete control over your life?

Quit the job you hate. Travel for a year or two. Work for a non-profit despite the lower pay. Wouldn’t it be great to be able to do these things, or whatever else is on your list, without fear?

You don’t have to be rich to live your life on your terms. Saving in a retirement account can give you this freedom. I’ve talked to many people who have been able to do all these things because they had retirement savings. And they didn’t even have to touch their accounts.

One couple I know took two years off work and traveled the country in their RV. They weren’t rich. One was a public school teacher and the other was an IT manager at a financial services firm. Yet they were comfortable giving up their jobs to see the country while they were still young enough to enjoy it.

They were diligent savers. They had no debt, their retirement savings were on track, and they had money for emergencies. While they traveled, they took part-time, minimum wage jobs to cover their costs. They didn’t need to draw on their savings, and because they had retirement savings, it was not a setback for them to skip contributing for a while.

A woman I met with recently, plans to leave her career early and work for a non-profit in a field for which she is passionate. She’s not rich either. She is a project manager now, but she’ll spend the last decade or so of her working career doing something she loves.

It doesn’t matter that she won’t be bringing down the same pay, because she’s already built up her retirement account. Her low living expenses will allow her to maintain her lifestyle with less income, and she won’t need to dip into savings. She won’t need to contribute to retirement savings either, because what she has will continue to grow.

Saving for retirement early in your career is more valuable than saving later in your career. The early money you invest earns investment returns longer, and grows larger, than money you invest later in your life.

Saving early gives you a cushion that can allow you to stop saving sooner. With a 7 percent average annual rate of return, you would only need to save half as much per month now as you would ten years from now to accumulate the same amount of money at a traditional retirement age. The earnings on your money’s earnings will carry you.

If retirement seems a long way off, or you can’t imagine what you would do if you weren’t working, it still pays to save for it. Your retirement account can give you the flexibility to do the things you want without touching it. It frees you to save less, or take a break from savings all together. It gives you both freedom and financial security.

 

 

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