10 Investment Mistakes to Avoid (from NY Times article)

Okay, after a long posting hiatus due to a combination of laziness, summer fun and European vacation, I’m back and ready to post!  Here’s a good article I found on 10 common and critical investment mistakes.

Read it (it’ll only take a few minutes) and apply to your own situation.

(Yes, that was a lame post after a ~3 month dry spell, but don’t worry,  some really good original works are coming soon, I promise!)

Why I rent (even though I could buy) – Price-to-rent ratios

One rule of thumb in determining whether it’s better to buy or rent a home is the ratio of the price of the home to the cost of renting the home (actual or estimated.)  15 times annual rent  is one starting point.  (I’ve also read 150 – 200 times monthly rent, which equates to 12.5 – 16.7 times annual rent.)  For example, if a house was selling at $300,000 and it (or a very similar place) could be rented for $15,000 per year ($1250 per month), that house’s ratio would be 20, meaning it would be better to rent it than buy it.

I read an article on CNN Money that looked at 10 cities to either buy or rent in depending on the ’15 times annual rent’ rule for average home prices.  Seattle, my hometown, came in at 25 times rent, meaning it’s generally better to rent rather than buy (from a financial perspective.)  As the article shows, the general trend is that desirable coastal cities (Manhattan, San Francisco, Portland [Oregon]) tend to be overpriced using this metric, meaning it may be better to rent than buy in these cities.  Midwestern and Southern cities (Minneapolis, San Antonio) tend to be undervalued, meaning it may be better to buy than rent.  (There are other reasons why you might do one thing or the other, but I won’t get into them here.)

While useful, one problem with this simple ratio is that it doesn’t account for growth rates in real estate in these various markets.*  Presumably, home prices in markets with higher price-to-rent ratios like the coastal cities are likely to grow faster than sleepier midwestern cities.  Thus, some adjustment for growth should be made for a better evaluation.

Lastly, while knowing this average ratio for a whole city is a good starting point, one should always do the calculation for each property.  Even in a city where property is cheap relative to rents, it’s possible to overpay on an individual property.  Similarly, in a city where real estate is expensive compared to rents, you can still end up paying too much rent given the worth of the property.

Remember to account for homeowner’s dues if the property you’re considering is a condo or townhouse where such fees apply.  (As an arbitrary way to compare apples to apples, take the monthly dues and multiply by 60 and add that result to the purchase price of the condo.  Use that adjusted value as the ‘true’ cost of buying for the purposes of the above calculation.)

The graph below shows some housing data for various cities (circa April 2010.)  The skinnier bar at the bottom for each city corresponds to the price-to-annual rent scale at the bottom of the graph.  The fatter bar at the top for each city corresponds to the foreclosure rate scale at the top of the graph.

* For investing geeks, the Price-to-Rent ratio for homes is similar to Price-to-Earnings ratio for stocks.  The PE ratio also doesn’t account for the future growth of companies.  Hence, fairly valued high-growth technology stocks tend to have higher PE ratios than fairly valued, mature consumer goods companies.  Even so, the PE ratio is a useful starting place since the market often overvalues high-growth stocks under the false assumption that the steller growth rates will continue indefinitely, which they never can.  (Think of the tech boom when we saw PE ratios at astronomical levels of 100 – 200, suggesting that investors expected such companies to maintain absurd growth rates well into the future.)

The PE ratio can be adjusted to account for growth by dividing by historical/expected growth rates to get the PEG ratio.  Like all ratios, the PEG is fraught with its own problems as well.

Automating your finances (Ramit Sethi-style)

I’m a big fan of automation, especially for personal finance & investing (think automatic 401k withdrawals.)  A ‘classic’ video from Ramit Sethi is at the bottom of this post, outlining his approach to automating your money.  I recommend watching it (12 minutes) and trying to automate your own money to the extent possible.  It takes a little up-front effort (which you never have to leave your computer chair for), but it pays off big time in making life simpler & helping you effortlessly hit your financial goals.

Using INGDirect for online banking is a big step in the right direction on the automation front.  I use them to automatically mail out my monthly rent checks, and to automatically put pieces of my direct deposited-paycheck into various high-interest savings sub-accounts.  Here’s how I do it.

How I automate my money

I generally have a ‘cycle’ of automatic things that happen per each paycheck.  A certain percent goes to my 401k at Vanguard (and invested according to the index funds I picked.)  The remainder (minus taxes and insurance premiums) is direct-deposited into my ING checking account online.  Of that, a fixed dollar amount goes into a vacation sub-savings account, an account for money that I spend on myself to make more money, and to my no-ATM-fee Charles Schwab checking account that I use for miscellaneous cash needs.

Once a month, my rent check is automatically mailed out to my landlord from my ING checking.  All my other bills (including utilities, cell phone, internet, etc) have been set up to be automatically paid by my credit card.  Thus, I just have one automatic credit card payment out of my ING checking that occurs monthly.  (Some bills can be set up to automatically come out of your bank account if paying by credit card is not an option; but I prefer the latter for the simplicity.)

Anything left over is available for me to either spend (without feeling guilty since I’ve hit all my savings goals), or add to my savings.  If you know me, you can guess that I generally choose the latter, but every once and a while I loosen the purse strings and splurge on myself in the form of good beer or relatively-inexpensive travel.  (I know, I know, I’m a wild man when it comes to my spending sprees.)

Below is a picture from Ramit’s post (linked below) that illustrates how this works:

Having my money automatically going to various savings places BEFORE I get to spend it on discretionary items is part of the idea.  I’m ‘paying myself first’ as the mantra goes.  Of course, you’ll want to have a rough idea of your more ‘mandatory’ spending like rent/mortgage, utilities, gas, groceries, plus a little spending money so that you can estimate how much you can sock away.  If you want to have more money to save, scroll down to the 30 excellent tips in this post.

Ramit’s more detailed explanation

Ramit outlined the approach he discusses in the below video in a blog post here as well.

On happiness and choice: mindful ways to feel better about life

I watched a ‘TED Talk’ by author & psychologist Barry Schwartz on the ‘paradox of choice‘.  He explained why too much choice can make us less happy than we would be if we had fewer choices.  This is because with many choices we 1) have more regrets about our choices, 2) feel the loss of the ‘opportunity cost’ of the options we don’t choose, 3) expect more from the choice we make, and thus are more frequently disappointed, and 4) blame ourselves when we’re disappointed, since, with so much choice, we have no one to blame but ourselves if we make a bad decision.

Check out the video for more on this reasoning.  Schwartz’s arguments are a stark departure from the usual line of reasoning in Western thought which argues that more personal liberty and freedom equals more choices (and vice versa), and hence greater societal welfare.

As Schwartz argues, and as empiricalhappinessstudies have shown, this appears to be false for prosperous societies like ours.  While choice is wonderful up to a point, too much of it can be bad for us.  (Unlike poorer or dictatorial societies, whose problem is not enough choice.)  Studies suggest that, despite the proliferation in material & social gains, human happiness has not increased in the United States since 1950.

I wanted to share my own thoughts (warning: this is an ‘opinion’ piece!) on this, and provide some personal recommendations on how to minimize the harmful effects of too much choice.

Simplify, simplify

Take a page out of Thoreau’s book (it’s called ‘Walden’) and voluntarily cut down on choice by simplifying your life.  By reducing the things that absorb your time and energy without producing commensurate benefit, you can focus on what really matters to you.  Consider limiting your exposure to television advertising and shopping malls.  They increase your material options for things that probably won’t make you much happier after owning them for a couple months.

Experiences, on the other hand, increase in value over time.  Spend money & time acquiring good memories instead.  Or, provide more choices for those who WILL benefit from them by contributing charitably to poor nations.

The secret to happiness

Simplification notwithstanding, there are obviously many benefits to choice.  Being able to decide whom to marry, how many children to have, what job to work at, where to live, etc allow people to pick and choose the things that they believe will make them the happiest (within the range of their ability to attain these things.)  One of the problems with all of the great choices we have (think food, electronics, cars), is that people’s expectations have increased along with their improved options.  There’s much truth to Schwartz’s statement that ‘the secret to happiness is low expectations.’

To me, I think of this as a difference between absolute and relative value.  The standard economic model of human behavior is that humans care about absolute value, or how much stuff/money/time/pleasure we have on a zero to infinity scale.  Thus, if you can choose between 25 different digital music players, and can select the one with the most valuable features, you’re better off than only being able to pick from 2 players with less gadgets.

However, what humans also care about is how things match up to their expectations.  If you already expect your digital music players to do 10 things, and the new player does 11 things, you may only feel ‘1 thing’ better, but not 11 things better.  This may be easier to see in how people feel about their jobs.

Folks in the western world have more purchasing power, work less hours in more comfortable surroundings, and have more free time than any generation before us.  Despite this, many of us still hate our jobs, even though, on an absolute scale, we’re way better off than even our parents’ generation.  (Read ‘The Progress Paradox‘ if you don’t believe the last part of that sentence.)  A big reason for this is because we’ve come to expect certain characteristics in our jobs.  We measure our happiness by how much our job meets, exceeds or fails to exceed the things we take for granted.  (Like leisure time, health benefits, wages that allow us to live in large houses, own multiple cars, and never go hungry.)  If this is true, how do we learn to appreciate the ‘absolute’ value in the objectively luxurious (by historical standards) lifestyle we live?

Be appreciative at every opportunity

One way is to be actively conscious of how fortunate we are, and to remind ourselves of the good things in our lives (rather than constantly grouse about the negatives, something humans are particularly skilled at.)  For example, the next time you’re at the grocery store complaining about the unripe bananas in January, remind yourself of how amazing it is that we have access to cheap, out-of-season produce every day of the year.

Being appreciative is also important when confronted with even better versions of the stuff we already have.  Some of the happiness literature (cited above) suggests that envy is responsible for part of our failure to enjoy the immense material wealth that’s been created over the last 60 years.  When your neighbor gets a new BMW, your own Toyota Corolla doesn’t look so great in comparison.   (Never mind that your car has excellent comfort, performance and safety features, especially when compared to cars of just a few decades ago, or the fact that you were perfectly happy before your neighbor’s purchase.)

Be appreciative of people as well.  Complimenting those around you for what they do increases your happiness as well as theirs.  (Psychologists have shown this empirically; people who are more appreciative are happier than those who aren’t.)  It’s easy to take the nice things a spouse or friend does for you for granted.  Be mindful of when someone is doing something beneficial for you, and praise/reciprocate accordingly.

Be appreciative of random chance (or Providence, depending on your viewpoint) and remember all the good luck you receive, and try not to dwell on the bad.  Everyone can bring to mind the last time they were stuck in grinding traffic, but what about the last time your commute was a breeze for some inexplicable reason?  Did you remind yourself how fortunate you were at that moment?

Don’t be too hard on yourself

While I believe that people should hold themselves to high ethical and behavioral standards, I also think people beat themselves up over things that, when put in perspective, are actually quite trivial.  Even if you make a big mistake, it doesn’t make anything better to simply feel guilty about it.  Focus on the future instead: repair the damage if you can, cope with it if you can’t, and consider if you need to take preventative action going forward.

I know someone who has been agonizing about leaving a job they don’t like, mostly because they’ve invested a lot of time and effort into this career path.  They spent a lot on school to receive a specialized degree to go into this field.  They spent several years gaining experience on the job.  This person dislikes the job, but feels guilty about quitting because they’ve put so much into it.

The bottom line is, they can’t get back the time and money they spent for their current profession, so there’s no point in feeling bad about it.  Instead, they should focus on answering questions that matter like: will it make me happier to leave this career for a new one?  (Yes!)  How can I find a new career and avoid making similar mistakes in my next job?  Note that these questions deal with the controllable future, not the uncontrollable past.

Worry about what you can control, steel yourself against for the rest

This last suggestion is particularly apt to investing and my point about letting bad luck go.  In investing, the best you can do is make smart choices in the present with respect to your goals and needs.  For most people, low-fee stock index funds are the way to invest for distant goals, like retirement.  If you have $100,000 in such a fund for a retirement that’s 20 years away, and the fund drops by 25% the next day, should you feel remorse for your decision?  No!  When uncertainty is involved, rationally expected results should determine how you evaluate your decision-making, not actual results.  To see why this is true, imagine the following gambling scenario:

Multi-billionaire Bill Gates offers you the following proposition: You’ll flip a quarter, and if it comes up heads, you get $2 from Gates.  If it’s tails, you pay him $1.  Do you accept this flip?  (Make the decision in your head for the purposes of this thought experiment.)

Now ask yourself: if the coin comes down tails (you lose $1), does that mean you made a bad decision (before the flip occurred)?

Assuming your goal in this scenario is to make money, the answer to the first question is ‘yes, take the flip’ and the answer to the second question is ‘no, you made a good decision even though you lost.’  Let’s see why: 50% of the time, you win $2, the other 50% loses you $1, for a net average gain of $1 (= 2 – 1) for every two flips.  This is a positive ‘expectation’ (average result) of 50 cents per single flip.  With each flip you ‘expect’ to win 50 cents on average, so ‘yes’ you want to flip.

If the coin comes down tails, losing you a buck, did that change your expectation before the flip?  Of course not, you still had a 50 cent expectation.  Thus, even though you lost, you made the right decision in terms of maximizing your expected profit.  Similarly, your expectation for future flips is still a positive 50 cents, so you should offer to keep playing with Bill no matter how many times you lose (or win.)  (If you can flip fast enough and/or get Bill to raise the stakes, you’ll eventually bust one of the richest men in the world.)

This example can be applied to life, albeit with less clarity.  If you made a decision that seemed like a good one based on your rational evaluation of the information you could get, that’s the best you can do.  In the investing example, since market movements are impossible to predict with any accuracy (run from, or punch, anyone who tells you otherwise), there’s no point in kicking yourself if the market dives unexpectedly.  (The same goes for congratulating yourself on your wise intelligence if the market soars.)

Instead, be emotionally prepared to cope with the misfortune that is sure to come to everyone in greater or smaller amounts in life.  Counting the positive things in your life will help.  (I remind myself of my wonderful wife, friends, family, ridiculously good looks, and the existence of microbrewed beer whenever I’m feeling down.)

If your decisions repeatedly turn out badly, you should reexamine your thought process to make sure you’re really making rational decisions based on good information.  (This is because similar repeated outcomes suggest that luck is not the reason for them.)   Ask your friends or family to check your logic.  They should be quick to tell you if, say, you’ve dated obvious jerks in your last three relationships and need to stop kidding yourself about your ‘bad luck’ with love.

I’d love to hear comments from folks on how they’ve dealt with choice, and their thoughts on what I’ve written above.  Good luck implementing the above in your own life!

Working for yourself: how to get started as an entrepreneur

As a financial advisor who launched his own business, I have a strong interest in entrepreneurship.  Contrary to what you might think, no huge life-changing leap is required to start your own business.  I still kept my ‘day job’ while doing what I’m really passionate about during the other waking hours of my life.  In this post, I’ll discuss why you might want to work for yourself, the typical barriers that keep people from doing this, and how to discover what you can make money at.

Motivation

As a physics student in college, I had a kindly old professor that would start every lecture with what he called, in a funny Russian accent, ‘moh-teee-vaaaayyy-shun’, or why what we were about to learn was going to be valuable to us.  To me, the two key reasons for starting your own business are 1) freedom to do what you want, when/how/where you want and 2) money.

The first reason, freedom, is multi-faceted.  If you work for yourself, you get to set your own hours, write your own job description, pick your office space, and work in a way that makes the most sense to you.  The second reason, money, means that a side job can allow you to do things financially (retire sooner, pay off debt, plate yourself in gold) that you might not have been able to do otherwise.  Your own business can even eventually replace or surpass your current income, if that’s your goal.  Some schlub toiling away at a box factory isn’t likely to get rich, but many (though few per capita) hardworking entrepreneurs have.

Overcoming barriers to starting your own business

Many reasons, also known as ‘excuses’, are cited as making entrepreneurship difficult.  Some are valid, but others are just rationalized laziness (mental and physical.)  Because it’s fun to blame people, let’s start with the nonsense:

“I don’t have enough time to start a side business!”

I have a general premise that if you really want to do something, you can make time for it, regardless of how ‘busy’ you are.  The trick to good time management is to eliminate activities to make room for more important ones, and to focus on getting one important thing done at a time.  There are a number of good books and blogs on ‘personal productivity’. One book that I highly recommend everybody read (not just the entrepreneurs) is ‘The Power of Less‘ by Leo Babauta (he also has a blog.)  Tim Ferris also has some great posts on controlling your time and getting important things done.  His book, ‘The Four Hour Workweek‘, is already a classic treatise on how to live an accomplished life (however you define it.)

Let’s say you spend 50 hours per week at your full-time job (including lunch.)  Let’s also assume it takes you 45 minutes to commute each way, 5 days a week.  That’s 7.5 hours per week + 50 = 57.5 hrs for work.  Add in 8 hours of sleep per night (56/week), and that brings the total to 113.5.

There are 168 hours in a week, leaving you with 54.5 hours to do what you please.  Of these, maybe 3/day go to personal stuff like eating, bathing and getting ready for the day.  That leaves 33.5 hours.  Spending 2 hours per day with family & friends leaves 19.5 hours.  Even if you give yourself an hour of free time each day to read, watch TV, surf the internet, etc, that leaves you 12.5 hours.

So, even if you work more than 40 hours, have a long commute, spend lots of time with family & friends, sleep a full 8 hours, take time for meals, and sit on the couch an hour each night, you have at least 12.5 hours per week to spare, and nearly 20 if you cut out free time spent alone (be honest; you’re getting some of that web-surfing time in at work anyways.)

This is more than enough time to get a part-time freelance project going.  I started my business while working full-time and pursuing a graduate degree in business in the evenings.  Did I do this by cutting contact with family & friends while simultaneously stressing myself out?  No!  I still saw family & friends for a few hours at least once per week, got plenty of sleep, read, cooked, and got all my homework done.  I even took an awesome 11 day trip to the Czech Republic while on break from my MBA classes.

I DID make a conscious effort to set and complete small (written) goals each day that would get me closer to where I wanted to be.  These might have been designing a page of my website, filing my sole proprietorship business license online, or contacting & meeting with potential clients.

What I DID NOT do is just as important:  I didn’t spend much free time browsing the internet (when I was on the internet, it was to get something specific done), watching TV, playing video games or just lounging around.  I stopped going to the monthly meetings of an organization I had joined (and let everybody in the group know that I had to be firm on that.)  In a nutshell, I prioritized getting important things done at the expense of letting small things slip (I use this strategy at my ‘day job’ too; see the above-linked Tim Ferris articles for more on this idea.)

Even though I made sure to see friends & family, especially on weekend nights, I hung out with them less than I would if I had all the time in the world.  If you have something important you need to finish, you have to learn to say ‘no’ to requests for your time.

“I don’t have any money”

While it’s true that certain types of businesses require large upfront capital expenditures (like manufacturing), many can be started with no more than a phone, computer and some office supplies.  I have a friend who started a bakery in Seattle without investing much upfront by renting kitchen space by the hour (including the expensive equipment) and selling wholesale.  If, like me and many other people, you’re going to supply a service, you really don’t need much to get started.  If you do need cash, finance your venture out of your (non-retirement) savings or income, hit up relatives or friends for loans, or start saving a bit each month to get what you need.  Avoid buying anything you don’t absolutely need for the business.

Focus instead on generating cash from customers.  Ramit Sethi, my favorite personal finance blogger, recommends getting paid by at least 3 customers (1 could be a fluke) as a sign that your venture is viable.  Start marketing your services to friends, family, co-workers and the acquaintances of these folks, build a simple website, and stay focused on taking action towards your goals.

“But I don’t know what to do?”

After setting aside time and money (or lack thereof), many would-be entrepreneurs are stymied by not knowing what services or products to offer.  Sethi has posted a great video about this discovery process.  In general, you want to come up with a business venture that combines three things: 1) Interest – what you’re passionate about, 2) Skill – what you’re good at (you don’t have to be an expert), 3) Marketability – what people will actually pay for.

Digest Ramit’s video and start setting your entrepreneurial goals today:  ‘How to figure out what to do’ video

Here’s another video from Ramit on entrepreneurial goal-setting.

Another reason to love Vanguard: lower brokerage fees

You may already know that I’m a HUGE Vanguard fan.  Their rock-bottom index fund fees, selection, online account features, and investment philosophy just can’t be beat.  Well, there’s another reason to celebrate them: as of May 4th 2010, Vanguard has significantly reduced its brokerage trading fees.  (See THIS for more details.)

For stocks, commissions are $7 if you have $50,000 – $500,000 in assets (and a ludicrously low $2 per trade if you have more than $500K.)  Even if you have less than $50,000, you still get 25 trades per year at $7, then $20 per trade after that.  For many buy-and-hold investors still a long ways from retirement who hold only a few individual stocks (like me), 25 trades per year could be fine.

AND here’s the kicker: Vanguard’s ETFs can all be traded FREE!  This means you can buy any of their indexes as ETFs instead of funds (garnering yourself even lower annual expense ratios versus buying Vanguard’s funds.)  You can have 25 trades per ETF per year before Vanguard imposes a 60 day waiting period to prevent frequent trading.  This means that you could even dollar-cost-average into these funds twice-monthly.  (That said, if you do frequent dollar-cost-averaging, just using Vanguard’s standard mutual fund services may be better and easier.)

When things you love come together

I love my wife, and I love personal finance.  If my wife suddenly developed an all-consuming passion for, say, investing…, my god.  To me, that’s what Vanguard offering superior online brokerage service is like: when two things that you love come together (Vanguard + inexpensive online brokerage), it’s just beautiful.  It will likely be only a matter of time before I get around to transferring my Scottrade assets over to Vanguard.

What to look for in a broker

If you’re looking for an online broker to open (or transfer) an account to, consider Vanguard.  Compare its features and prices with other online brokers to make the best decision for yourself.  Especially look at trading costs (should be around $10 or less), other fees, usability of the online interface, and online features (I hate paper.)  Also, if the broker offers free dividend reinvestment (Vanguard does, as does ING Direct’s Sharebuilder; Scottrade doesn’t 🙁 ), that’s a plus.

Asset allocation rules of thumb

“Asset allocation”, or the percentage of your assets (usually just financial ones) that you put into different types of things (stocks, bonds, cash, real estate), has been shown to determine a very large portion of a person’s return.  It is also the key determinate in how much volatility your portfolio undergoes.

[UPDATE 12-21-2010: HERE is a very good, quick (5 minute or less), easy-to-use questionnaire from the good people at Vanguard that can be used to estimate your personal asset allocation.  It might be a bit conservative for my taste (too heavily weighted towards bonds instead of stocks), but it’s an excellent starting point to get a ballpark stock-to-bond split.]

While there many ways to arrive at a recommended asset allocation, it often helps to have some simple rules of thumb.  The general idea is that the older you are or the sooner you need the money, the safer your investments should be.  So while a 100% stock retirement portfolio would be great (in my opinion) for a 30 year-old with 30+ years until retirement, it would generally NOT be advisable for a middle-income retiree.

The following rules of thumb that I will discuss assume that the asset allocation is for RETIREMENT, and that the average person won’t be tapping into it until they’re between 60 and 70 years old.

120 minus your age

To simplify between all the different types of assets, people often just make the distinction between stocks and bonds.  For people that own homes and keep some petty cash in their savings or checking accounts, I think just talking about stocks and bonds works well for most people.  One such stock-to-bond ratio rule of thumb is this:  from 120, subtract your age.  The remaining number should be in stocks.  For example, if you’re 60, this rule would tell you to put 60% (= 120 – 60) of your assets into stocks, and the rest (40%) into bonds.

This rule is definitely simple, and reasonably useful.  (It used to be 100 minus your age, but that was when people didn’t live as long.)  My criticisms of it is that may tend to put too much of one’s assets into bonds, especially prior to age 60.  Historically, stocks have out-performed bonds in almost every 30 year period.  Of course, this is no guarantee that they will continue to do so, but it suggests a high probability.

In general, if you have more than 5 – 10 years to go before you need some money, it could be in the stock market.  Thus, I tend to recommend that people who still have 10-20 years to go before retirement put all of their money into stocks.  This assumes that most people will have some fixed income anyway (like social security.)  It also assumes that the person will only be using a small portion of their retirement funds per year (like 4 – 5% of the total account balance.)

Some alternatives

Since I prefer a slightly more aggressive rule of thumb than the above, I came up with the following asset allocation formula: Put 2 times the difference between your age minus 50 into bonds.  I.e.: % in bonds = 2*[Your age – 50]

So, if you’re 50 or under, you put nothing in bonds.  At 60, you’ll have 20% in bonds (= 2*[60 – 50]), and 80% in stocks.  At 70, you’ll have 40% in bonds, 60% in stocks, and so on.  This has the virtue of keeping a 100% stock portfolio until you’re 10 – 20 years out from retirement.  It also ‘catches up’ to the more conservative allocation by increasing the percentage of bonds in your portfolio by 2% per year after age 50.

Another option might be to just use a fixed allocation like 60-40 or 75-25 stocks to bonds.  You might choose to gradually switch from 100% stocks to this fixed allocation over a period of, say, 10 years, like from 50 to 60, or starting 10 – 20 years prior to your target retirement date.

Lastly, you could adjust my 2*[age – 50] formula above to take your target retirement age into account: use % of bonds = 2*[ Age – (Target retirement age – 15) ].  If you’re going to retire at 65, this works out to just 2*[Age – 50] (since 65 – 15 = 50.)  But, if you’re going to retire earlier or later, your recommended asset allocation will adjust accordingly.

Conclusion

Asset allocation is important.  Within each asset class, always diversify as much as you can.  Pick stock and bond index funds with low expense ratios that sample the entire market.  (Large cap and small cap, domestic and international for stocks.)

In general, I like 100% stocks as an allocation for retirement portfolios that still have 10 – 20 years until you start tapping them.  Then, gradually switch to something more conservation using one of the above rules of thumb, or something more exact like a financial advisor or William Bernstein’s “The Intelligent Asset Allocator”.

The financial media makes me laugh out loud

On the heels of my look-back at the stock market decline of 2008 – 2009, the financial troubles of Greece sent shudders through equity markets today.  While I try not to pay too much attention to the emotional swings of “Mr. Market” or his reporters, I read a quote from a trader that I couldn’t help but share:

” ‘We did not know what a stock was worth today, and that is a serious problem,’ said Joe Saluzzi of Themis Trading in New Jersey.”

Understandably, for a guy that trades stocks every day for a living, this is important.  But for this to be featured in the ‘front page’ of Yahoo! Finance suggests that it is of paramount importance for average investors and web surfers to know what their stock prices are at every instant of the day.

Well guess what?  It’s not!

If you’ve read any of my articles on investing, you know that I believe investing in stocks with a short-run focus is dumb.  Stock portfolios should be held for long-term gains and savings goals like college or retirement.  Because of this, it is pointless, time-consuming and emotionally draining to worry about the day-to-day changes in stock prices.  It can be hard to resist the temptation to check daily on your portfolio (I have the same problem), but we must resist the urge!

Super-investor Warren Buffett has been quoted as saying that a person should choose investments such that they don’t care if the stock market closes for 10 years, rendering them unable to trade or check its market price during this time.  As with many of Buffett’s simple statements, there’s a lot of wisdom in this one.

What you should do

Investors should structure their portfolios with the appropriate mix of stocks, bonds, and cash (‘asset allocation‘) and buy highly-diversified, low-fee index funds and plan to hold them up until they need the money (for at least 5 years; the longer the better.)

If you haven’t done this, give your portfolio a checkup and make sure you have an appropriate portfolio given your age and needs.  If you’ve done this, then forget about the market’s daily throes and do something more enjoyable with your free time.  Turn off CNBC and avoid the financial media’s sensationalist ‘news’ that’s designed solely to make you worry over things you shouldn’t and consume more of such stories.  Instead, sleep soundly at night, knowing that you’ve structured your investments such that they require only occasional maintenance and review.

To see if you might benefit from the help of a professional financial advisor, check out my website at greenlakepartners.com.

Hindsight: Looking back on the 2008 – 2009 recession

On October 2nd, 2008, I wrote an article called ‘What do do (and what NOT do to) in today’s turbulent financial markets’.  My main message urged investors to stay calm, and simply assess their financial situation as they would in any other type of market.  Then, I told folks to ‘do nothing’ in terms of changing their current investment plan.  I urged people not to pull their money out of the market, and to continue contributing regularly as they would under any other circumstances.  (I also suggested that now might be a good time to start investing as well.)

Now that the stock market recession appears to have passed (leaving 10% unemployment and several bankruptcies in its wake), let’s take a look at my advice and what the market has done since:

Roughly one and a half years has elapsed since I wrote the article (as of this writing.)  From that time period the total stock market (represented by Vanguard’s VTSMX, the blue line above) is up about 10%, with the S&P 500 (large cap stocks, the red line) up about 7-8%.  If we assume dividends were about 2-3% per year during this time period, the total market return was probably about 15% since then.

During the next 6 months after my article, things continued to get WAY worse, and then improved dramatically from a low in about March of 2009.  Of course, I had no idea which way markets would go in the short-term when I wrote my article (and don’t believe anyone who says they did), but history has demonstrated that after long periods of time, stocks tend to do fantastically well compared to other asset classes.

Academic studies show that investors are terrible at timing the market.  They tend to pull money out when prices dive, and put money in when prices skyrocket (think 1999.)  Obviously, this is contrary to the difficult-to-follow-but-oft-quoted Wall Street adage ‘buy low, sell high’.  Such studies have also shown that the investors who trade the most perform the worst, partly due to excessive trading fees as well as bad timing.

When you combine this information it is clear why a policy of regular stock market investment (‘dollar cost averaging’) into stock market index funds tends to outperform other more active investment strategies.  Perhaps an even greater benefit of this approach is a huge reduction in mental burden on the investor.  Investors who stuck to regular investment plans would have purchased a lot of shares on the cheap during the market decline, profiting immensely during the subsequent rise.

Conclusion

I wrote this look back at the recent recession not to say ‘I was right’.  (For the several months following my advice, stocks plunged!)  For all I knew, the recession could have lasted much longer than it did (or it could have been shorter.)  Stocks could still be below where they were when I wrote the article.

The important takeaway is that sticking to a well-thought-out investment plan makes sense even in times of severe market fluctuations.  A key part of this is making sure you’ve planned out your financial future enough to put things on semi-autopilot.  Start by following these four simple steps to wealth.

(If think you might benefit from professional advice or investment management, send me an email at Ward.Williams@greenlakepartners.com for a free consultation to see if I can assist you.)

Smoking is bad for your wealth: Quit today!

Today, everyone can repeat the Surgeon General’s warning that smoking is terrible for your health.  Given the high costs in terms of everyday spending, insurance rates, quality of life, and other effects, smoking is also extremely harmful to your wealth.

Direct costs of smoking – the high price of cigarettes

According to a 2002 study, the average smoker smokes 13 cigarettes per day.  If we assume that a pack is 20 cigarettes, and the average pack costs $5, that’s $3.25 per day (= 13/20 * $5) or $1,187 per year.  Obviously, the more you smoke, the more it’s costing you.  With the federal tax per pack having been raised to over $1 combined with many state taxes at $2 (including Washington’s), the cost of cigarettes seems to only be going up ($6.33 per pack in Washington state as of this writing.)

For reference, a person in the 15% tax bracket could quit smoking their 13 cigarettes per day and contribute nearly $1,400 per year (pre-tax) to a 401k.  If this person quit smoking at age 30 and retired at age 65, their 35 years’ worth of cigarette savings would’ve grown to $206,000 (in real dollars) given historical stock market returns of 7%.

Indirect monetary costs of smoking – insurance, job prospects, resale values

In an article on the high costs of smoking, MSN Money “pulled some online quotes on 20-year term life insurance (a $500,000 policy) for a healthy 44-year-old male … The lowest quote for a nonsmoker was $1,140 in premiums per year; for someone smoking a pack a day, the lowest price more than doubled to $2,571 per year.

[…] According to eHealthInsurance.com, the monthly premium for a policy from Regence Blue Shield with a $1,500 deductible for a 44-year-old male nonsmoker is $552 more a year [for smokers].

A few state governments also charge their employees extra for health insurance if they smoke, and others are gradually joining the trend.”

Additionally, home owner’s typically receive a 10% discount for being non-smokers, tacking on about $85 per year for smokers, given average home insurance premiums of $850.

“Numerous studies find that smokers earn anywhere from 4% to 11% less than nonsmokers. It’s not just a loss of productivity* to smoke breaks and poorer health that takes a financial toll, researchers theorize; smokers are perceived to be less attractive and successful as well.”

Add on higher dry cleaning bills, lower resale values of homes and cars (or money shelled out to clean them), and perhaps the occasional teeth whitening service, and you’re looking at a few to several thousand a year to smoke.

[* – I should note that in fairness to smokers, I’ve read assertions that other than early death, there are no appreciable losses in job productivity attributed to smokers.  However, if employers believe there are anyway, smokers will still receive lower salaries, everything else being equal.]

Indirect non-monetary costs of smoking

Besides bad breath, yellow teeth and smelly personal effects, smoking seriously reduces one’s quality (and length) of life.  The average smoker dies 7-8 years sooner than a non-smoker.  In addition, they are way more likely to live an unhealthy (and therefore uncomfortable) old age, suffering higher incidences of various cancers, heart diseases and strokes:

“The number of people under the age of 70 who die from smoking-related diseases exceeds the total figure for deaths caused by breast cancer, AIDS, traffic accidents and drug addiction.”

There are other side effects as well due to reduced blood flow: “For men in their 30s and 40s, smoking increases the risk of erectile dysfunction (ED) by about 50 per cent.”  For both men and women, smokers’ skin develops more wrinkles and looks paler.

The sooner you quit, the better

The benefits of quitting become immediately apparent (including more cash in your pocket):

From Wikipedia: “The immediate effects of smoking cessation include:

  • Within 20 minutes blood pressure returns to its normal level
  • After 8 hours oxygen levels return to normal
  • After 24 hours carbon monoxide levels in the lungs return to those of a non-smoker and the mucus begins to clear
  • After 48 hours nicotine leaves the body and taste buds are improved
  • After 72 hours breathing becomes easier
  • After 2–12 weeks, circulation improves

Longer-term effects include:

  • After 5 years, the risk of heart attack falls to about half that of a smoker
  • After 10 years, the risk of lung cancer is almost the same as a non-smoker.”

While quitting is difficult due to the addictiveness of nicotine, there are several methods that greatly increase your chances of succeeding.  Try to surround yourself with those who have quit smoking, or are non-smokers:  “A study found … that smoking cessation by any given individual reduced the chances of others around them lighting up by the following amounts: a spouse by 67%, a sibling by 25%, a friend by 36%, and a coworker by 34%.”  So if your significant other, friends or coworkers smoke, try to get them to quit too.  You’ll both help each other succeed.

The best approach using pharmacological aids seems to be use of “[t]he Nicotine Patch plus [as needed] use of gum or spray” which “increased quit rates to 36.5%, the largest quit rate reported.”  In addition, joining a social ‘support’ group seems to help.  “Programs involving 8 or more treatment sessions can double success rates.”  Use support lines like 1-800-QUIT-NOW (1-800-784-8669), to talk to an expert and increase your likelihood of success even further (live IM chat is available too.)

Despite all these methods, it often takes people more than one attempt to quit, so keep at it if it doesn’t work out the first time.  Set a date to quit, then use the above resources to stick to it.  You can get started by tossing your cigarettes & buying some nicotine patches and gum.  Then, check out this free quitting guide at smokefree.gov.

Good luck, your bank account and body will thank you!