Legal disclaimer. I am not a financial advisor, and don't have any special training in what I am talking about. Not knowing what I am talking about has never stopped me before, so if you read on, you have been warned - proceed at your own risk. However, as we near the end of our working life, we have ended up in an enviable financial condition - far better than most expensive financial advisors claimed they could do for us.
As you read below, a key part of our success was taking the small risk of the stock market in exchange for the far higher returns on our investment - often 3 or more times as much return as just buying Certificates of Deposit or other "totally safe" investments. If you are not willing to take any risk at all, as one person I spoke with recently, no need to keep reading.
One kind of savings is for retirement or major purchases like the down payment on your first house. Another kind is saving for a vacation or a car (yes you can pay for these without a time payment plan after the purchase). But the most important type of savings is to cover your living expenses if you suddenly are without a job. You might be laid off because of business circumstances, but more important for professionals, is to be able to say to your boss, "I don't feel what you are asking me to do is right (legal, ethical, moral, decent, whatever), so if you insist, I quit." Does that ever happen? Yes. There have been multiple times when we were ready to quit, but things worked out or we found a different job before just walking out of our current job. But there were a couple times when one of us had to pull the trigger and actually quit.
How much do you need in the "go to hell" fund? Your first job may not pay very much, and a replacement job is probably fairly easy to find - if you lose your job parking cars, McDonald's probably will hire you, even though the tips are lower. Cash to cover expenses for a few weeks is probably enough. As my career advanced, my salary increased, as did my mortgage and other fixed expenses. And the time to find a comparable replacement job rose as well. First we had to plan on a few months, then 6 months, then a year or more. That doesn't mean you have to have a full year of gross salary saved, but you need enough (now it is a smaller amount of after tax money) to cover your necessary expenses (no vacation, no eating out, no parties, no memberships, etc.) for the year.
Each time I changed jobs, I figured "I gave up my old job, but what if the new job doesn't work out? How long could we last?" By my last job change, in my 50s, the answer was a revelation... we could last forever. I wasn't retirement age, and I wouldn't like to live the rest of my life at the level our savings would support, but we would survive without my job. So you could say that my last job - the last 10+ years of work - was to improve our lifestyle for the last 35-50 years of our life. That was a wonderful feeling.
One of our self-imposed rules was that we wouldn't let our basic expenses exceed what either one of us could cover... we didn't do anything that required both of our salaries. If one lost their job (or returned to school or got sick) the other could cover our expenses with minimal change in our style of living - the savings in the "go to hell" fund would still be there if needed to cover a problem in the second person's job.
It would be nice to save enough that your kids or grandkids could go to the college of their dreams without worrying about money, but if you have to choose between college for them or retirement for you, choose retirement.
Why am I being so harsh on the kids? There are lots of ways to finance college, even loans at reasonable interest rates. There is no way to finance your retirement. And early savings towards retirement has much Much MUCH more impact on the total than late career attempts to save. If you can keep a good retirement plan going, and can help the kids, great. If they have to borrow money, and you can help them pay it off, great. But your retirement has to be top priority.
In my first job, my boss called me in, and said "You aren't putting any money in your retirement plan (what today would be called a 401k, but they hadn't been invented yet)." "Of course not," I replied, "I live in a cheap basement apartment with Salvation Army furniture, drive a ratty $95 car, and have a ton of college debt." I don't know what he said next, but before I left his office, I had signed up for the retirement plan. 50% of the money went into interest based investments - at pretty respectable but not great interest rates. The other 50% went into equities - stocks.
Over the next 12 years, working at two different Universities, I continued the plan. The total amount I invested over those 12 years was well under $10,000. The low University salaries were supplemented by other benefits - they did contribute a to my retirement in addition to what I did. The total amount invested by me or my employers (40 years ago) wouldn't buy a decent car today, but has grown tremendously over the years. That early investment grew to almost a million dollars. We could survive on just those funds - not a comfortable retirement from only 12 years work, but enough to live on. Lesson 1: Invest early in your career. The earlier the better.
Lesson 2: Diversify. Not knowing any better, I split the investment 50%-50% between fixed income and stocks. I was really tempted to move the money from stock to fixed income during the period when interest rates skyrocketed and home mortgage interest reached 21%, but I held firm. During each stock market boom, I was tempted to move money from fixed income to stocks, but I held firm. Forty years later, the money had grown to ¾ in the stocks, ¼ in the fixed income accounts. The volatile and slightly risky stock investments made 3 times as much as the "safe" investments. General advice, when you are young and aren't going to withdraw the money soon, put more in stocks - despite the ups and downs, the long term trend is up, far more than conservative investments. When you are closer to retirement, if you need more stable income, gradually shift the investments to the more conservative, less risky, less volatile choices.
Lesson 3: Don't panic. We lost a ton of money when the dot com bubble burst. We were patient, left our investments in place, and more than recovered in remarkably short time. Then we lost a ton of money in each of the subsequent recessions (market dips). We have more than recovered from each dip. Our savings are back above the boom-time peak. They are over three times the level they were when we moved to Austin 15 years before the first version of this article (and the detailed chart below), and have continued to rise.
How much do you need when you retire? You can survive on Social Security, but you won't like it, and at some point Social Security will run out of money. Many years ago, businesses provided a retirement plan for their employees, that coupled with social security made a fair retirement, but those plans are now extremely rare. A rule of thumb as I was planning was each person needed about $1,000,000 in savings ($2 million for a couple) to retire comfortably. With inflation that figure may be low.
How do you save $1 million? If you save $300 per month from the time you are 25 until you are 65 (monthly for 40 years) and earn 8% on your savings (investments), you will have just over a million dollars. But if you make excuses and don't start until you are 35, you will have just over $450,000 - less than half as much. And starting at 45 you will only have $178,000. Start saving early really pays.
This is how our net worth (everything we own, minus everything we owe) has changed over 25 years. It grew both from investment income and from our extra savings after our house and cars were paid off, and as our income increased over our careers. It started low - we were poor and had college debt, there were no big inheritances. We lived frugally and saved consistently, but most of the money is the result of investments like IRAs and those started with that retirement fund with my first job.
The several year peak about 60% of the way up the curve was the dot com boom. The dip after that peak was the dot com bust - little more than giving back the gains of the boom. There are a couple smaller recessions moving up the curve - each followed by a recovery that put us back on track. Don't be afraid of the market!
If stocks are so good, we must have all our money in the stock market. Since we need little or none of our savings to live on, most of our investment is actually still in stocks, to leave a larger inheritance. If we were living on our retirement savings we would have gradually moved to more conservative investments.
I generalize that there are several ways people invest in stocks.
Many years ago we used our 300 bps dial up modem to automatically call every 15 minutes to pick up stock prices that we were following (The available prices were also delayed 20 minutes in those days). We had some custom analysis programs that could spot trends, and were able to make a significant amount of money trading stocks. Some stocks we held for days, most for weeks or months. We were "Traders". People would ask what stock we recommended, then would say they wanted to think about our suggestion and might buy the stock next month. Sorry, as traders, our recommendations might have been valid for a few hours. With today's high speed communications and lots of professional traders, by the time you spot a trend, somebody else has already used it to their profit, and the price or market has changed. It is hard to stay ahead of people who do this full time. We don't recommend being a trader any more.
In those days, there were people who bought and sold stocks after they had held them a few hours rather than days or weeks. Using borrowed money, they would buy very large quantities of stocks, but sell them before the end of the day (so they had the money to pay back their loan). More frequent trades, larger numbers of shares in each trade, so a change in price of a few cents could be profitable. In general, these "day traders" did not hold any stock at the end of the day. Their business was to buy and sell within the day. There were a few times that we sold the stock the same day we bought it, but that was not our plan. With evolving technology and computer triggered trades, the day traders now hold stocks for minutes... or seconds. (We know someone who did this kind of trading, and with large volumes of stock can make - or lose - hundreds of dollars in minutes or seconds, many times per day. The net gain was not worth the stress, and he no longer does it.)
As an "investor", you buy a stock in a specific company. Generally you should choose that company because you understand it's business, because you believe they have a solid business plan, good management, that there is a market for their product or service, that they have a competitive advantage - their product will be more attractive than some other company entering the field. In other words you need to thoroughly study the company and it's management. You should be more concerned about the company than about what the stock market thinks about that company on any particular day - if the stock price drops 10% you should rejoice that you can buy more at a bargain price, not panic that you have lost 10% of your investment. With the amount of research you should do before buying a stock, investing in 10-15 different stocks is a large number. We may buy one or a few shares of stock to watch closely before it becomes one of our primary holdings, but generally we look at holding at least 100 shares of each stock. If you are looking for a stock tip from us, as an investment, look at Berkshire Hathaway. BRK.B .
With frequent fluctuations in stock prices, it may be tempting to wait for a low to buy and a high to sell. This is called "market timing" - it has lost money for us, more often than it has helped. The real experts speak very harshly about trying to do market timing - they insist that it doesn't work. It hurts me to agree that it doesn't work.
If you don't want to be a trader, and it is a lot of work to be an investor, how can you get into stocks? Mutual funds. There are countless types of funds, from those that focus on a mix of fixed income investments (Money Market Funds) to tax exempt municipal funds (often Bond Funds), to European business, to worldwide manufacturing to gold and gold mining equipment... and more. Instead of picking a single business, you pick the market segment or investing approach that interests you. For example:
There are mutual funds that focus on growth of value with minimal risk of loss. They shuffle the stocks that are part of the mutual fund portfolio to refine their goals. This shuffling adds management cost, so they often also work to minimize management cost which comes out of the fund's profits. Ten or more years ago, you could buy a mutual fund that was "Actively Managed" by a wizard who could handle short term investments (trading) and make money. Of course the fund operating expenses (deducted from your profits) were higher to pay for the wizard and staff, but if it made enough more money to cover their cost, who cares! As the funds became large, the investments became large - one fund we like has over $13 Billion invested, typically about $250 million in each company whose stock they hold. Active management can no longer move quickly to change their holdings - buy or sell ten million shares of a company's stock without impacting the stock price. The actively managed funds are far less active than they were years ago. Therefore it now pays to look at the long term performance, in a fund with lowest operating expenses. Some mutual funds have a fee to enter or leave the fund, or a penalty if you only hold the fund for a short time (We avoid those funds). If you want a mutual fund recommendation from us, we like Vanguard Funds, especially the Windsor series of funds.
Many people just hope to match the overall performance of the stock market. The Dow Jones Industrial average is a historical index of market performance, but is only based on 30 stocks. The Standard and Poor's 500 index (S&P 500) is based on 500 of the largest and most stable companies, and is considered a better gauge of the overall stock market. Therefore there are mutual funds that hold the specific stocks included in that index (called "index funds"), to match the market performance as measured by that index. One disadvantage is that occasionally companies are added to (and removed from) the list. That means that each index fund must quickly buy or sell stocks to keep their holdings in line with the index, even if it is not the most advantageous time to buy or sell.If you are interested in a specific industry, such as semiconductors or steel or gold (mining, refining, and mine equipment is usually included in good funds for example) there are mutual funds with that focus. Your interest may be based on the belief that it will beat overall market performance. You need to actively manage that decision because it may change unexpectedly.
There are mutual funds that focus on social issues such green energy. The overall performance will be less than the options above. If the performance were equal to the regular funds, everyone would invest here!
Mutual funds use the market closing price (4 pm in New York) to calculate the total value of the shares held, then divide by the number of mutual fund shares issued, giving the price-per-share of the mutual fund. Those prices don't change during the day - it is a calculation done each evening. If you deposit money in a fund, the number of shares you get will be calculated that evening. If you want to "redeem" shares in a fund, the value will be determined that evening, changing either the number of shares redeemed or the amount of money. Money market funds work almost the same way, but they try to keep the value per share at $1. Gains (and losses) are accumulated and paid periodically as if it were interest earned on the holdings. If you buy or sell these funds through the fund company, typically there is little or no sales charge.
Waiting for the end of the day to sell a mutual fund or determine it's value bothers enough people that a new product has emerged, called an ETF, or Exchange Traded Fund. These are like mutual funds whose shares are bought and sold throughout the day (traded on the stock exchange). The value of the ETF is calculated frequently, based on the market price of the holdings of the ETF - sometimes figured multiple times per minute. Transactions occur throughout the day, based on the value at that moment, not waiting for market close. An ETF is traded like a stock, so you can sell short, buy on margin, give a stop-loss order, or other trading techniques. The stocks included in an ETF do not change as frequently as in a mutual fund. Therefore the expense ratio is lower than a regular mutual fund. ETFs are bought and sold through a stock brokerage, perhaps with a sales charge similar to buying or selling an individual stock (although the actual fee is often zero).
Hedge Funds are somewhat like mutual funds, but take higher risks in the hope of achieving higher gains. They are far less regulated (allowing the risky investments) but may only be sold to accredited investors - basically those wealthy enough that they can afford to lose their entire investment. They cannot be sold to the general public. We do not invest in these.
How do you make money when the stock price is falling? Lets say company XYZ is selling for $100 per share, but you don't want to own it since you are convinced it will soon be selling for only $80 per share. If your credit is good, you could tell your broker to sell 100 shares even though you don't own them. (Short sales are done in units of "contracts" which are 100 shares of the stock in question.) You get $10,000 (less fees) but you have only borrowed the shares that you sold. You receive the cash from the sale of the stock, but you are "short" the stock. If the stock later drops to $80 as you predicted you buy 100 shares, paying $8,000 plus fees. You "covered" your short position (gave back the stock you borrowed) and pocket about $1,950 ($2000 less fees). Of course if you were wrong and the stock price rises, you eventually have to buy the stock to cover your short, perhaps at $11 per share, costing you $11,000 plus fees, less the $10,000 you got from the short sale. If your bet was right that the stock would fall, you pocket almost $2,000 without any investment on your part. If your bet was wrong and the stock rises, you only lost about $1000., but still no investment. Note that if you had actually owned 100 shares of XYZ, you would have had a $10,000 investment and lost or gained comparable amounts.
If selling a stock you don't have is called a short position, what do you call buying a stock (that you do have). You got it. You will hear analysts talk about being long (owning) a stock, or say that they are long 500 shares of XYZ.
In addition to selling stocks you don't own, you can (for a fee) promise to buy a stock in the future at a given price, sell a stock you do own in the future at a given price, etc. This is called options trading. The amount invested is far less than owning the stock, and with good managemement the potential earnings are higher. Great results but the amount of training and work required is huge.
An IRA - Individual Retirement Account - is an account that you can "deposit" money for your retiremenet, and it will grow without being taxed. There are limits in the amount you can save each year, but you will do extremely well it you can reach those annual limits. If you withdraw money before retirement age, you pay a penalty as well as taxes on the amount earned. After retirement age you must take an RMD - Required Minimum Distribution - based on your account balance and life expectancy - and pay taxes on the earnings. A Roth IRA allows you to pay tax on the money deposited, and withdraw it later tax free. In most cases there are minimal or no management fees.
A 401(k) is a similar tax deferred retirement plan, but it must be arranged by your employer (who may choose to contribute as well). Self employed people can establish their own 401(k) plan. When you leave an employer you can typically roll your retirement account from that employer into a personal IRA without creating a taxable event.
Buy an Annuity and in many cases you are guaranteed a fixed income for life... no matter how long you live! What could be better? In fact, an annuity is a type of insurance policy - the insurance component covers your payments if you live too long, and makes a big profit if you die soon. Of course, the agent that sold you the annuity also makes a very healthy commission on you purchase, in addition to the usual management costs associated with insurance (see below). I was forced to take an annuity to get out of a retirement plan (so it took me 9 years to get my money out.) Jenny was talked into buying an annuity and has regretted it for decades. If you can manage your money, you are better off with mutual funds, using an IRA to delay taxes.
If you need a professional to help you select and manage your investments and to nag you to save more money, you can hire a financial advisor. This is, in fact, a profession - "Certified Financial Planners" who are licensed (and required to work for your advantage, not just sell you securities for which they receive a commission). Some charge an annual or hourly fee, but most common is a percentage (¼% to 2%) of your total assets under their management (AUM). Hopefully you have a couple million dollars to invest for your retirement, so a CFP could easily cost you $10,000 per year. If you need a professional guide, fine, but we have done very VERY well without one.
Buy your home. Pay it off as soon as you can. Don't buy more house than you can easily afford (no tiny down payments, or loans that bet on the value of the house increasing, or count on being able to refinance someday). The argument that a home mortgage is good because the interest is tax deductible is weak - the tax savings are far less than you think. You may be paying a few percent on the mortgage, but only earning a fraction of a percent on your cash (but could be making 5-15% on investments); the tax savings are generally far from enough to cover that difference.
There is another reason to own your home (or car) without a mortgage. If you have an insurance claim, the insurance company pays your mortgage company - they need to have the house fixed, and have to be sure you don't just pocket the money and disappear, leaving them with a broken house and no cash to repair it. The bank's promises of how quick and easy they will make the process of repairing your home may disappear if they are swamped by a disaster.
Hurricane Sandy devastated the Northeast coast a few years ago. One homeowner was interviewed on TV - just back in his home 4 month after the storm. Yes, he had insurance, and was paid the full amount almost immediately. Actually the bank was paid. Contractors were scarce - many took on too many jobs, and "did one screw per day." The homeowner finally found workers to fix his house, but the bank wouldn't pay, based on his receipts. With so many cases, they required bids (even if the homeowner was ready to proceed), and would choose the low bidder, then send the money direct to the contractor. Of course the bank was swamped, so bidding and payment took a lot of time. As the homeowner said, "If my contractor requires a box of nails, do I have to get three bids, wait two weeks for the bank to choose Home Depot, then get Home Depot to send the bank a bill so I can pick up the nails a week later?" If he had owned his home without a mortgage, he would have gotten the check, not the bank, and been able to manage the contractors and materials himself. Streamlining the bank's bidding process, his house would have been fixed faster, and perhaps more cheaply without the contractor facing the hassle of formal bidding.
For years we liked investing in rental properties. There were tax advantages (largely because you could depreciate the house, and if the value of the house increased over time, what would have been taxable "ordinary" income became capital gains, taxed later, and at a lower capital gains rate). However, the laws to protect the tenants have become so biased in favor of the tenants that it has become a risky investment... just try to evict someone who hasn't paid the rent. And if they don't pay the rent, do they have money to pay for the damage they can do to the house on the way out? Been there, done that, no more.
If you are a senior level employee and have to move with your job, and it isn't a good time to sell your house, it may be okay to rent your high end home to an arriving businessman with a similar problem, but buying a house just to rent as an investment is not in our future.
If you house burns down or is blown away by a tornado, do you have the cash to replace it without impacting your retirement savings or "Go to Hell" (emergency) fund? Probably not, so it pays to have homeowner insurance.
If you hit someone with your car, and that person is crippled and will need lifetime care, do you have the funds available to pay? Guess you should have auto insurance.
You sign up for Medicare, and as the TV ads say, "it sometimes only pays 80% of the cost." Can you afford a 20% co pay on your doctor visits? Hint: the reason they want to sell you a Medicare supplement policy for $100 per month is that your co pay, covered by their policy, is likely to be far less than the premiums. I just got an ad for this insurance, "Basic rate $1,600 to $2,000 per year (but it could be higher)". In the past 12 months it would have probably covered the $227.94 that I had to pay. You don't need that insurance if you manage your money well enough that you have the cash available to cover the co pay.
As you get old, you may need someone to prepare your meals, clean your room, etc., generally called assisted living. A nice place will probably cost over $100,000 per year (a recent example was $9,000 per month). If you have a few million in savings, you don't need to buy a frightfully expensive long term care policy that may pay a lifetime limit of up to a million dollars. Instead of a retirement home you can go on a cruise, or multiple back-to-back cruises, with free meals, free housekeeping, free basic medical care, free entertainment, that likely costs less than $100,000 per year. Doesn't that sound better than long term care insurance paying your tab in a nursing home? One cruise line recently offered a shipboard cabin with services for a lifetime (no matter how long you lived) for a one-time payment of $500,000.
If you were to pay someone to live in your home, fix your meals, be sure that you take your pills, etc., you could pay them $25 per hour ($50,000 per year) plus room and board, and live at home, rather than in a small room (cell) in a $100,000 per year assisted living facility.
The dirty secret. Insurance companies have expenses that they call the underwriting expense ratio, that is the cost of advertising, selling you a policy, issuing the policy, sending you bills, adjudicating your claims, answering the phone when you call, and so forth. It is expressed as a percent of the premiums they collect. That expense ratio is typically 20% to 30% of the premium that you pay. So they only have ¾ of the money you sent to them to pay for your losses. If you can manage your money so you can handle those expenses without help, you are far better off without insurance.
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