Wednesday, December 12, 2007

Money: how to acquire and keep it, in one lesson

The world is full of advice on money, and is about to acquire a bit more. Let's begin with two crucial points: there is definitely such a thing as too little money and there is definitely such a thing as too much money. One seems comically obvious, the other perhaps bizarre. Let's consider them.

First off, when I speak of "money", I mean what is otherwise called "wealth"--that is, money (or its equivalent in assets) as lumps, not as cash flow. The two things are of course related: more cash flow can get you more money and vice-versa (though they often don't without some prudence). There are some for whom money is an end in itself, more or less a counter or score in a game they fancy they are having with life, or with their fellow beings, or some such thing. The technical term for such folk is "insane". I am addressing myself here to those sane folk for whom money is an enabler, a means to an end.

If you think about that, you will understand my opening remark. If you don't have enough money to reach your desired end, you have too little; but if you do have enough, more is needless, and seeking more at that point turns you into one of the insane for whom there is no such thing as "enough". Those who have gone on past the point of sufficiency have too much money. Why is it "too much" money? Because it embodies time (time is money, and--my point here--vice-versa) out of one's finite life wasted on the unnecessary (and usually unpleasant).

Were I to speak at appropriate length on the designing of a personal life-style plan, I'd never get on with my main topic, which is enabling your plan. Just keep in mind that your plan should not be determined in any way by other people. Assume neither popular desires that you yourself do not really have, nor a particular "conventional" retirement age. Just lay out everything you truly need for satisfaction and determine the needed cash flow. Remember that the unexpected isn't: there are always one-time expenses whose nature you cannot predict, which is why they're "unexpected", but whose arrival in some form you can be assured of. Consider everything from disability to death.

Now, presumably, you have a cash-flow figure. If you have ceased actively stalking money, which is the idea, you have to be getting that cash flow as a return on investments. And now we come to the meat. How do you select investments, and how much can you reasonably expect to make from them? The answers obviously determine how much money you need.

Before we go on, a word about getting that money. It is drummed into us from early childhood (or at least it used to be) that it is crucial that we save, save, save. Well, it is. You cannot have money unless you have saved that money. Mind, as you save it, you need to be putting it right from the outset into the same place, or sorts of places, as you will keep it in after you have stopped acquiring and saving; that way, it can multiply itself to the maximum safely possible as you go along. The person who "saves" by putting his or her money into pedestrian places like savings accounts at banks will have a very, very hard time ever retiring from the money chase.

How much you should be saving is one of those matters on which everyone has an opinion. The old rule of thumb is 10 percent of your income, but no one knows just whose thumb the rule is supposed to be measuring. The short form is to save as much as you possibly can. It is, of course, the old tussle between immediate and delayed gratification: a Mediterranean vacation now and another year or two working? Only you can make those determinations.

On the one hand, you are only young once; on the other hand--which tends to get forgotten a lot--you are only old once. When you are old, or even middle-aged, making money is, for almost everyone, something they'd sooner not do than do, had they a choice. When you are 65, would you rather look back at the expensive flings you had in youth, or on the past 10 years in which you were not working? Think about it. And do remember that it is usually a lot easier to have fun on little money when you are young than when you are older. But the one principle to be honored above all else, no matter how much or little you decide to save, is to be religious about your saving: as the cliche goes, always pay yourself first. Never skip a pay period or "borrow from yourself", because that way lies failure. Saving: just do it.

What is the best place you can put your money? That's a no-brainer: the stock market. The long-term average growth in the market has averaged 11 percent a year. I emphasize averaged not because the pace has been highly irregular, which it has, but because it means that many stocks did much better (and, of course, as many did much worse). The only plausible alternative is real estate, for which the ultimate maxim for success remains John Jacon Astor's classic Buy on the fringe and wait. It works, quite well if you have the patience to follow Astor's adage. But real estate is chancy, because not everyone can easily and reliably determine what fringes the center is moving toward, as against moving farther away from. Perhaps the next-best advice concerning real estate is buy a house as soon as you possibly can. That is because, as a matter of a long-entrenched national policy of encouraging home ownership, the tax code provides an immense break for homeowners, in that your interest (which, for a long time after purchase, is nearly all of your monthly mortgage payment) is fully tax-deductible. If you don't own as much house as you can reasonably afford, you're not taking advantage of the rules.

Note that word cropping up again: reasonably. Especially right now, with all the stink about lousy mortgages over-sold to those who could not in fact reasonably afford them, advice to be reasonable may seem needless. But there is another point about reasonableness. You want to tax-shelter as much of your income as you can, but a house is not usually the best investment available. What you want to tax-shelter in your home is what you spend on housing, not as much of your income as possible. The more you spend on a house, the less you have available to save in more focussed money-growing investments--so just stick to buying as much house as you (again reasonably) need for comfort at your current income level.

Your savings investments should also be tax-sheltered if possible, but I am not here going to essay the complexities of tax-sheltered investment techniques--IRAs, Roth IRAs, 401(k) plans, and that ilk. With such plans, you usually trade off some flexibility in choosing your investments for the particular tax benefit that this or that scheme offers.

Note carefully as well that the IRS is never to be denied, and that the tax benefits all work by shifting the time of the taxation; that means that their benefit is based on the assumption that your income cash flow once you retire will be significantly less than it is when you are contributing--or, more exactly, that the marginal tax rate on your income will be lower then. For people not struggling to make ends meet in retirement, that may not be a plausible assumption. Unless you are making a lot more while chasing money than you will take from that invested money in retirement, the benefit in tax-sheltering it may not be great. If, as is sometimes the case, the tax-deferral scheme in question does not give you sufficient flexibility in your choice of and handling of your investment vehicles, you need to think carefully.
The stock market is the best investment vehicle available, but, as is famously known, you can also lose your shirt there. There are seemingly countless numbers of people who believe that they can pick winning stocks. The term "winning" is not lightly used: what such folk are doing is essentially gambling. Just as with roulette or craps or any casino game, each of the punters is convinced that he or she has a "winning system". Casinos love gamblers with systems, because (saving, once upon a time, blackjack) none of them work. Consider that managers of mutual funds are very highly paid folk with about as much expertise as you can have about the stock market, who are supported by large research staffs almost equally expert, and that they spend practically all their waking hours working on selecting stocks for their funds' portfolios; then consider that 4 out of 5 of them fail to beat the overall-market average in growth with their picks. And you think you could do better than they do?

The conservative approach to stock-market investing is what is called an "index fund". That is a mutual fund whose holdings exactly mirror one or another of the "market Indexes". By investing in an index fund, you are essentially investing in whatever index it is modelled on. If you select an index modelled on one of the popular broad-based indices (such as the S&P 500), you will in essence be investing in the stock market as a whole.

A note here: mutual funds are the way to invest, and I'll have more to say about them in a moment. But tattoo this to the inside of your eyeballs: Never, ever buy a "load" fund. Always buy only no-load funds. (Beware also hidden fees, no matter their name: purchase fee, redemption fee, exchange fee, account fee.) Loads and like fees are simply highway robbery. Don't be a victim.

If you want to be a hair more adventurous than the most conservative approach, use a narrower index that tracks some segment of the market. The number of indices, and their underlying logic, is astounding, so some selectivity is wanted if you choose this path.

There is, however, a method arguably better, arguably much better, than simply following an index. An index fund is an unmanaged fund--that is, it's constituent stock holdings are not determined by anyone's judgements but simply by the make-up of the underlying index. A managed fund, the more common sort, is a fund whose make-up is determined by judgement, normally the judgement of one person alone, the fund manager (however well supported by his or her research staff). Did I not say a little above that 4 out of 5 managed funds don't even beat the overall market? Yes; but that leaves the other 20% or so.

But how does one find a well-managed fund? The same way one chooses a good batter or pitcher in baseball: their consistent track record. What have they accomplished? OK, then how does one sort that out from all the thousands of mutual funds that exist?

One uses the Morningstar mutual-fund web site. Morningstar exists to rate, rank, and otherwise evaluate mutual funds; it makes money by selling "premium" services to investors who play mutual funds the way others do stocks themselves. But most of its "basic" services are available free, including the all-important Fund Screener. That is a tool allowing you to enter a set of criteria and get a list of all mutual finds meeting those criteria. (Note, though, that the Screener never delivers more than 200 fund names for any search.)

Let's take an example. Let's impose criterion limits on only two things: show only no-load funds, and show funds with historically high returns. Let me amplify that second: we'll ignore year-to-date and one-year returns (because short-term numbers aren't as important as sustained ones), but require that the 3-year return, 5-year return, and 10-year returns all be equal to or greater than 20%. That at once reduces the universe of funds to a mere 15. If we now further require that the minimum investment needed to buy into a fund be $10,000 or less, that 15 reduces to a mere 11 funds. If we further require that the one-year and year-to-date returns (by now almost the same thing) also be at least 20%, we reduced to only 8 choices.

Does that mean that each of those 8 funds is guaranteed to make you at least 20% a year returns? Of course not. But it does say that each of those funds has done awfully well for quite a while now. The investment mantra that the SEC insists every investment vehicle chant to the punters is "Past performance is no assurance of future performance". That's a half truth. It's not an assurance, but it does indicate a strong likelihood, unless (obviously) something drastic has happened to partly or mainly vitiate the significance of past performance (the most obvious possibility being the successful fund manager who ran up those numbers leaving the fund for any reason).

If, for example, one looks at the current list of 8 returned by those search criteria, one notices that fully half of them are "precious metals" (read gold) funds; a fund focussed on such a narrow segment is prone to sharp swings in performance, especially as the value of precious metals is more a reaction to other financial happenings than to the actual performance of any industry. Interestingly, of the remaining four funds, two are "emerging markets" funds (Latin America for one and Eastern Europe for the other) and the last two are managed by the same person.

If I'm looking for places to put my money (which I am), I'd say to myself, "Self, let's take one of the two under the same manager, both of the emerging-markets funds (since they're in very different markets), and maybe a little of the best gold fund." And I will.

Now let's look at the major caveats. I'll do them as questions and answers:

That seems very superficial--what do you know about the underlying investments in these funds? Squat. (Not really, but it might as well be.) Knowing about those is what the fund manager gets paid for. If I thought I knew as much as those people, I'd be doing their job. These funds are not like penny stocks or something: they've all been around for years (at least 5, else we wouldn't be interested in them). What I know is that whatever makes up these funds has given a whacking great return for a good number of years.

What about diversification? You're talking about only 3 or 4 funds! That's a half-valid point. "Diversification" is made altogether too much of by some investment people; on the whole, they are the people who make more and more money as you buy and sell more and more investment vehicles. If you diversify sufficiently, you end up holding everything, and you could save the time and trouble by buying an index fund. The whole idea here is to do better than average. You cannot do that by averaging out. Still, there are prudent limits. Note that I suggest, in the particular example to hand, not buying both funds runs by the same manager, because suppose he goes off the rails some day? Nor do I consider it prudent to invest in multiple gold funds even though half of the top performers are gold funds; in fact, I like only a modest exposure to something that really doesn't have fundamentals but rather a derivative value. This is all what I'd think is sheer common sense.

What about risk? What is the alpha, the beta, the SD? Technicians of investing put a lot of store by various often-abstruse technical measures. Good for them. There's no question that volatility is an issue with any investment beyond a bank account. The crux is to be invested so that you are relying on returns, not on needing some large chunk of the money back at some particular time. If I were putting money by for, say, a child's future college costs, I would be a lot more concerned about volatility and risk, because on the day I had to have that lump of money, the fund might be at a low point. But if you're leaving the lump alone and just taking small or modest bits out every month, you can stand big swings: the ups will cancel the downs plus some. The little bites you take as events flow along don't influence the long-term outcome by much, if at all.

Perhaps I should have emphasized this earlier, but that last answer brings it out: we look for high-return investments, but even if, as we hope, we have them, we don't overuse them. That means take only a modest amount out as you go. That is important when you are doing your initial figuring of how much you need. You may expect to see, say, 20% returns on your money as a long-term average, but even so you'd be mad to take out 20% a year. First off, you need to allow for the silent thief, inflation, who sneaks in and takes maybe 3% or 4% of your money away every year, and no locks will keep him out (least of all the putzes on the Federal Reserve Board). Next, you need to provide a buffer against the possibility of short- or medium-term downturns, meaning that when times are good you let the extra accumulate to offset any rough times. So if you thought you could get 20%, you might actually take out something like 5% or 6% a year (which would need to periodically adjusted up as inflation devalues the worth of money). That's another way of saying you probably need to have saved about 20 times the amount you feel you need per year to live decently on. (And don't forget to figure in taxation, though most of your investment income ought to be taxed at the capital-gains rate.)
OK, OK, if you're courageous, and have been getting 20% or--as is possible--a good bit more reliably for a few years, you could dare a higher take-out percentage. There really aren't any rules (though the "financial advisers" like to use 4% to 5% annually, they are basing that guideline on a conservatively performing portfolio).
Note well that that does not mean you need to have put in 20 times your retirement income, because what you put in month by month and year by year while you are corralling money will itself be growing at a healthy rate, in effect like compound interest. There are lots of calculators available on line that can give you a handle on the actual numbers (here's one). Just to give you a scale, if you started out with nothing at age 20, and put a mere thousand bucks a year into a fund that averages 20% a year returns, by age 40 you'd have--wait for it--over $224,000. OK, that's deceiving, because $224,000 in 20 years won't be worth what it is today owing to that silent thief. Indeed, using a 3½ percent inflation rate (a tad high, and so conservative) shows that the money in 20 years will be worth about half its face value in today's dollars. Still, consider: one grand a year for 20 years and you've got well over a hundred grand in real money.

Let's look at the bigger picture. Say you want to retire in 20 years from now and have zero saved so far. Say also you reckon that to live comfortably the rest of your life, you need about $60 thousand a year before taxes (again, mostly the lower capital-gains taxes). You'd need an investment of $1.2 million in today's dollars, or $2.4 million in dollars then. You'd need to begin saving around a thousand dollars a month, starting now. Sound tough? How about a hundred dollars a month, but for 35 years? That works, too. As you see (and as the calculator can show you), the key elements are, as always: contributions (how much a month?), return (how many percent a year?), and time (how many years?). Any two of them determine the third, so stash away as much as you possibly can and look for the maximum return you can get. Stick to established mutual funds with established track records (use mainly the 3-year and 5-year numbers to judge).

That's it. Oh, no, not quite: remember to do a new fund screening every year without fail. You need to keep your investments in any given fund for at least one year to get capital-gains tax treatment if you need to remove the funds and move them elsewhere, so don't go fund-hopping on the short term. But if one of your funds goes doggie, try to see why (every fund will have a down year, at least relative to its established pattern, every once in a great while), and consider giving it more time. But never ride a loser, a term that includes funds that are merely under-performing what you expect from them.

Happy retirement.

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