Scalper1 News
Summary Introduction and series overview. The basic concept of saving and building toward goals: develop a plan. Common downfalls and a recipe for adjustment. The building blocks. Summary. How I Created My Portfolio Over A Lifetime – Part VIII Introduction and Series Overview The basic concept of saving and building toward goals Common downfalls and a recipe for adjustment The building blocks Summary Back to Part VII Introduction and Series Overview This series is meant to be an explanation of how I constructed my own portfolio. More importantly, if I hope to explain how I learned to invest over time, mostly through trial and error, learning from successes and failures. Each individual investor has different needs and a different level of risk tolerance. At 66, my tolerance is pretty low. The purpose of writing this series is to provide others with an example from which each one could, if they so choose, use as a guide to develop their own approach to investing. You may not choose to follow my methods but you may be able to understand how I developed mine and proceed from there. The first article in this series is worth the time to read based upon some of the many comments made by readers, as it provides what many would consider an overview of a unique approach to investing. Part II introduced readers to the questions that should be answered before determining assets to buy. I spent a good deal of that article explaining investing horizons, including an explanation of my own, to hopefully provoke readers to consider how they would answer those same questions. Once an individual or couple has determined the future needs for which they want to provide, he/she can quantify their goals. If the goals seem unreachable, then either the retirement age needs to be pushed further into the future or the goals need to become attainable. I then explained my approach to allocating between different asset classes and summarized by listing my approximate percentage allocations as they currently stand in Parts III and IIIa. Part IV was an explanation of why I shy away from using ETFs and something akin to an anatomy of a flash crash. In Part V, I explained the hardest lesson about investing that I have had to learn: why holding cash is not a bad thing at certain times. Part VI was an explanation of why and how I sell long-held positions. Part VII was about tax efficiency to give readers some sense of what I put in which account and why. In this article, I want to dig deeper into the areas of saving and creating a plan. My own has been adjusted so many times it might get confusing and it would also expose more about myself that even I am willing to do. Thus, I will provide a version based loosely on my guidance provided to my son in January. I am hopeful that we can keep having this annual discussion in the future to help him stay on track and adjust his plan when outside events beyond his control make it necessary. The basic concept of saving and building toward goals The first thing to do is to determine a reasonable goal. If you are under 30 years of age and want to retire by the age of 65, you can assume that you will need at least $1 million to retire on (in current dollars) you have to get used to the idea that you will probably need and $2.75 million by that time. The historical average of inflation has been about three percent, so I use that number assuming we will eventually revert to the mean over time. Over a lifetime, you will likely experience much higher rates at times, but for the most part inflation should hang out within one or two percentage points of the average in most years. The environment we are experiencing today and for the last seven years is an anomaly because of artificial policy intervention by the Fed and by a major shift in demographics that is occurring in the U.S and other developed countries. Such an environment only occurs about once every 80 years or so. We should continue to experience extremely low inflation, if not deflation, for the next five years (maybe a few more) before inflation returns to normal again. That is a relatively short period compared to a full lifetime, though. But to keep things simple, I will create the basic plan in current dollars and we will only set a goal of $1 million. Accumulating more after that point is infinitely easier than getting there. That should become obvious in the illustration I am about to present. I am using a round number so that it can be adjusted accordingly, but do not get too hung up with incorporating inflation into your initial plan because it will pretty much take care of itself over time. As a matter of fact, the hardest part of getting to the ultimate goal, whatever it may be for you, is the first $100,000. That does not mean that it is easy after that, but it just gets less hard. So that is where each new investor should concentrate. I want to propose a set of milestones to help gauge how things are going. I did this with my son and it got him excited, so I hope it helps you wrap your brain around the concept as well. Here is what we talked about when we began. Start Milestones 1st 2nd 3rd 4th 5th 6th 7th Yrs. to reach 3.5 3 3 4.5 3 2.5 2 Targets $25k $50k $100k $200k $300k $400k $500k Milestones 8th 9th 10th 11th 12th 13th 14th Yrs. to reach 1.5 1.3 1.2 1.1 1 1 .9 Targets $600k $700k $800k $900k $1 million $1.1 $1.2 The years to reach the next milestone is not cumulative; it is the approximate time required to move from one milestone to the next at the average assumed rate of return. I tried to keep things conservative in the sense that this is what an average plan for the average person or couple should look like. Before I explain my assumptions, let me first explain that the reality is much more volatile than the above example. An investor can expect to have gains of 20-30 percent in some years and much lower in others. Overall, I do not expect equities to provide as high an average return as has been the case historically. In addition, bonds will not be able to provide the appreciation that has made up a good portion of the long-term return from fixed income for as much as another decade. Until interest rates rise to more normal levels of five percent or more on the 10-year Treasury note, bonds will probably underperform equities. Equity returns will likely not be too exciting either. But, if an investor sticks with a well-designed plan, the average return should make the above table very possible. Let me go through my assumptions to show how we get there. As with my son, I am assuming that the investor starts saving what he/she can each year and increases that amount over time. It is harder to save much in the beginning, but as the milestones are hit, it gets easier because you have the cash working for you earning dividends, interest and appreciation. I also assume varying rates of average growth in each different type of account: IRA – eight percent; 401K – six percent; and taxable savings seven percent. Contributions to a taxable account begins with $5,000 in year 18, increases by $1,000 per year until it reaches $10,000 per year and remains at that level until retirement. In the model, I assume zero savings going into a taxable account for the first 17 years. That is because it only makes sense to maximize savings going into tax-deferred accounts, especially a 401K (if available and the employer offers a matching contribution). I also assume that the investor begins by saving $2,500 in IRA in the first year, $3,000 in the second, and the maximum each year thereafter. Next, I assume the investor contributes ten percent of wages to the 401K every year and that the employer does not contribute. That should be conservative for most employees. I start the income low for the first two years: $15,000 in year one and $20,000 in year two. Then I boost the annual income to about $34,000, assuming that the individual has to develop some work experience before obtaining a professional job. This is based upon what my son with a degree in physics and minor in math is finding to be true. Those who start out with a higher income earlier should be able to save more in years one and two. Finally, I include annual wage growth of five percent. Mine was higher over my lifetime, even including the setbacks. Since my son was interested in becoming an officer in the Air Force, I predicated the rate of increase in annual wages on a single income of an average officer attaining the rank of colonel at the end of thirty-year career. I then assumed he would move into a similar-paying private sector job for the next ten years before retiring. My reasoning for the differing rates is relatively simple. Starting with the IRA (traditional or Roth), I assume the long-term rate of return of eight percent with little trading and a concentration primarily in equities. The 401K will have the highest fees taken out year after year, thus pulling down the average overall yield by about two percent below an IRA account. If the employer matches all or part of your contributions, it usually remains the single best investment vehicle an employed investor can find, hands down. The taxable account, I assume will be self-managed and contain either no-load funds, individual stocks or bonds (I will get into what I recommend at different stages of life in a future installment). The reason this rate is one percent lower than the IRA is to allow for the impact that taxes will have. Of course, if the investor trades in and out of the market, the return will usually be lower in each investment vehicle because of friction (primarily transaction costs), unnecessary taxes (in taxable accounts) and missed opportunities. Most people trade too much in a taxable account, so I would advise not diverting any savings into a taxable account until one has some experience under the belt to see hold the power of compound interest can work over time. If you trade that account, you are unlikely to achieve that return. If an investor is able to remain on track (very unlikely to be as smooth as portrayed), it takes about 27.6 years to reach $1 million in net worth. If one is 30 at the beginning and plans to retire at age 65, this would leave about 7.4 years to reach the final targeted goal. There is one thing to remember, though, inflation will occur in income as well as expenses. In many cases, incomes will rise much faster than inflation. If one is on a career track with promotion opportunities, as I was, one can do much better on the savings portion than assumed in the example. The important takeaway from this example, as crude as it may seem, is that it is harder to accumulate that next $100,000 at first (especially the first couple) but then it gets easier. By the time one reaches $300,000, about half of the annual growth comes from dividends, interest and appreciation. The percentage increases a little each year until the savings portion is dwarfed by the earnings from the invested capital. With your money working for you, the more you have the less dependent the outcome is on savings. But you want to keep saving consistently because there will always be down years from the appreciation portion. Consistency of savings helps to keep you moving in the right direction. Consistency is one of the four most important factors that makes such a plan work. The next two are patience (or time) and average return. By keeping the expected returns well below historical averages, I hope to make the plan more realistic. Setting a goal of achieving 12 percent annual returns can set you up for failure and disappointment. Try not to fall into that trap. You may have a couple of great years back to back and become overconfident, but you need to remember that those good years just make up for the bad years to come. And those bad years will come. The final of the major factor for success is avoiding losses. Stick with quality in all asset classes, make sure you are realizing income from each investment (or at least most) and learn how to hedge (when appropriate) once you have $200,000 or more in the equity portion of your portfolio. Common downfalls and a recipe for adjustment The problem with most people is that they do not increase savings commensurate with wage increases. We all can spend whatever we make, and then some. So the trick to amassing enough wealth to achieve financial security is to make better choices all throughout life. Again, it is most common that people do not become serious about saving and investing for retirement until they are well into their 40s, if not 50s. It just does not dawn on them that they should be putting anything away for the future. Of course, getting married and having children complicates things immensely for most folks, especially if one parent stays at home to raise the kids full time. That is a life choice and a good one for the kids. But when they get into school, even a part-time second income can help with saving for college. If you are able to meet you plan without that, good for you. We could not. My wife always had a part-time job and it was difficult with two children, even though the two were separated in age by four years (we wanted only one in college at a time). We did some things to increase income and savings that most people would not consider. You might say we got creative. The biggest thing we did was remodel the basement of our house to create a fifth bedroom with a separate entry (and we only had 1452 square feet in our house). We rented that space out to a college student since we were only a few blocks from a University. We also rented out two of the bedrooms upstairs to students. We paid our taxes on the rental income and decided not to take any depreciation since it was still our main residence. But all of the income from those three rented rooms went into savings. We lived in Arlington, Virginia at the time (1990s) and were able to get an average of $350 per room per month. The biggest downside to the arrangement was that we had a small kitchen and everyone had to share that space. Crazy, I know. But we screened the renters well and got lucky. We increased the value of our home with the additional bedroom and bathroom and we only did it for about three years until I received a significant promotion. We did it to reach our savings goals for only as long as we needed to and then became more normal again. Thinking out of the box sometimes works and sometimes it does not. Most of the work at home schemes are not for most people and end up being additional expense rather than income. I advise against anything that requires an initial investment, even for product inventory, and especially those that require selling to friends and neighbors. Unless you really love the products or are exceptionally good at selling things that nobody really needs, stay away. Find something more conventional that pays you to do something that is actually productive. Providing a service to a company and getting paid for how much you do is something that can work if you are diligent. Just be careful that there is no upfront cost to you because, if there is, the company is usually a scam trying to sell something and the potential income is usually not enough to cover that cost. If the company furnishes everything you need at no cost to you, it may actually be legitimate. Getting a part time job outside the house during the hours when the kids are at school or a couple evenings a week when you have both parents available to cover childcare is a probably the most reliable option. That is the route we took most of the time. My point to that story is that sometimes we need to be creative in finding a way to make extra money to meet our savings targets. If you can’t make sacrifices like that then you may find it necessary to reduce spending on such things as cable TV, or turn the thermostat down in the winter and up in the summer, eat out less, pack a lunch, or forego that $4 latte every day and make it more special by having it once a week instead. There are so many ways to cut back spending if one is really serious about saving. These may be hard choices, I know, but living a little more frugally now sure beats getting up every day in your seventies to be a greeter at Wal-Mart (NYSE: WMT ). My wife and I like to travel. But recently we made another major life choice. My wife decided she wanted to care for her elderly mother who is about to turn 99 next month. This is sort of a throwback to the days of our childhood. Most elderly people go live in a retirement center once they are unable to care for themselves. The children are usually too busy to take them in and provide the necessary care. Her mother tried following the traditional path and lived in a very nice retirement center for a little over a year. Her health went downhill rapidly. It was not so much the quality of care or the facilities or the available activities at the center. It was more a matter of her mom felt useless and had given up, becoming very non-social. Her rate of deterioration was shocking. So, her children decided it would be better if she could live in a house and my wife volunteered. And here we are, putting off the travel we would have otherwise been enjoying. But that is another choice; another sacrifice, if you will, that we both felt was the right thing to do. Her mother has been with us for about ten years now and I think she just might make it to 100 because of the environment. She loves being around family. We are both in good health and decided that we can travel all we want when the time comes that we are free to do so. In the meantime we are not spending as much in retirement as we anticipated so we are still in accumulation mode, though at a lesser pace. I guess the point of that story is reinforce the idea that life never works out exactly the way we plan it. Many of us will need to make adjustments to reach our goals and others will need to extend the accumulation phase (called work) of life to reach their goals. And then there are those like us. We got to retirement and took on another responsibility, putting things on hold a little longer. It will be different for everyone. But whatever you do, never give up. If you get off track for a while you can get back on track with a little effort and a few changes. The building blocks I hinted at what the building blocks are in the previous section but I want to provide the building blocks that I used in my plan and specifically what my son is using in his. Having a career path with promotional opportunities is one, but it does not need to come at the outset. I had a great job right out of college but after four years decided it was not what I wanted to do with the rest of my life. I fell back into a blue collar job that still paid well enough and kept me ahead of the cost of living with relatively regular increases to my hourly wage. I did not hit the career path until I was 40! I had to go back to college in mid-life twice to improve my options, once to get into a professional career and the second time to enhance my promotional potential. Some young people are not ready to go to college right out of high school. I tried it, but could not make the grades in my first attempt. I got drafted and served in Vietnam with a reconnaissance outfit in the 1st Infantry Division. When I got out, I was focused and ready to learn. That is where I “grew up” and decided that I wanted to find a better life for myself. As I mentioned above, it worked well for me at first, but then I ended up in a job that did not require any college for a few years. My problem was that I did not have a clue what I wanted to do. Those who come out of high school knowing what they want to do career-wise are way ahead of the game. But I am living proof that it is not the only way to having a successful and fulfilling work life. I went back to college and studied accounting. I took almost every accounting class offered in two semesters and one summer of classes. Heavy study loads with no real easy classes, but I knew that was what I wanted to do so it was much more satisfying than those general education classes that are otherwise required. I took and passed the CPA exams in my late-30s and started applying for accounting positions. I was too old to get the attention of the major accounting firms so I applied with the government and got my first job in a promising career. The rest is history. For those who cannot imagine how to pay for college these days I sympathize. But I also do not accept that as an excuse. I worked full time through my entire undergraduate studies and again while I attained my master’s degree. It is called sacrificing in the present for something better in the future. I have done it several times and have also reaped the rewards. It is worth it in the end. The other building blocks consist of taking advantage of tax-deferred accumulation of savings through individual retirement accounts (tradition IRA or Roth IRA), 401K plans offered by employers, saving in a taxable account, and (if you are self-employed) using another form of tax-deferred account such as a simplified employee pension (SEP IRA) plan. The last one is great because you can put away up to 25 percent of you wages (maximum $51,000 per year) before taxes. If you cannot afford to put in the maximum allowed at first, develop a plan to get there as soon as you can. What I did with my 401K plan (actually called the Thrift Savings Plan in the government) was to start at five percent immediately (because my employer would match the first five percent) and then I increased my contribution by two percent the next year, two again in the next year and then hit the maximum of ten percent by the end of year three. It reduced my income taxes and kept me working toward my next milestone. The differences between a traditional IRA and Roth IRA are basically twofold: contributions to a traditional IRA are before taxes and contributions to a Roth IRA are after tax; withdrawals (after the age of 59 ½) from a traditional IRA are fully taxable as earned income because the tax was fully deferred, while withdrawals from the Roth IRA are tax free. There are other differences that retirees should be aware of that can be found at Investopedia.com, irs.gov or other informative sites. My wife and I each hove one of both types of IRA. When we were younger we wanted the tax deferment. If I were to do it over again I would start with a Roth IRA and contribute as much as I could while my income was still relatively low and hold off on contributing to a traditional IRA until my income pushed me into a higher income tax rate. The early contributions, while smaller, could be worth more when you retire because of the time factor. Having the ability to make withdrawals in retirement that are tax free is really nice! When I started out there was no such thing as an IRA or Roth IRA (which came along several years later). When the IRA was first introduced, the maximum one could contribute was $2,000 per year. How things have changed! Now everyone can put away $5,500 per year and those who are 50 or older can contribute $6,500 per year. Summary To conclude, I would just say that it is never too early nor too late to develop a plan with a reasonable goal, flexible timeline and milestones to measure progress. If you are already 50 and have $200,000 saved, it is not too late to get organized and plan to succeed in providing yourself with financial security. You deserve it! In the next installment, I plan to describe and explain my son’s original plan, what it was based upon and how we modified it when he changed his career path intentions. After that I would like to explain a little about how I determine with relative confidence when the market is likely to have changed trend directions. I cannot predict a bottom or a top, but I am pretty good at determining when either has been hit. I hope you will find my observations and analysis helpful. For convenience to readers new to this series, I have created an instablog, ” How I Created My Own Portfolio Over A Lifetime ,” with links to all the articles of this series. I will usually add a link to the blog for each new article within a day of it being published. As always, I welcome comments and questions and will do my best to provide details and answers. This is one of the best aspects of the SA community. We can learn from each other and share our perspectives so that other readers can benefit from the comprehensive knowledge and experience represented here. Scalper1 News
Scalper1 News