How to Invest for Retirement

              Warren Buffet defines investing as the delay of consumption today for greater consumption tomorrow.  Think about that for a moment.  Instead of buying something today for $100 dollars, if I wait a year at a 10% annual return, I will be able to buy something for $110 without having to do any additional work.  Now when we invest for retirement, instead of waiting for one year, we are waiting 10 to 30 years.  This is why we invest, to have our money work for us.  Below I will offer the same advice I have given my own family members and the same investment plan that I follow.

Monthly Savings

              Periodic savings and investment are the most important step in any retirement plan.  Saving for retirement does not have to be a chore.  On the contrary, the more automatic you make your savings plan the more effective it is.  In order to ensure that you are saving you must pay yourself first.  Every month before you start spending, take money from your income and put it into savings. 

How much to Save? 

As much as you can.  Remember, your savings will have two purposes. 

1. You are delaying consumption today for greater consumption tomorrow.  
2. You are delaying consumption today in order to buy yourself the freedom of retiring early.

There are infinite ways to cut back on your budget. 

• Cut the cord and end your expensive cable bill.  Buy a monthly internet plan and stream shows.  Even better, install an antennae and watch TV for free!
• When things break in the house, fix them yourself.  Youtube is a wealth of information on how to fix things.  You will be much more satisfied fixing things yourself as well.
• Shop around for a cheaper cell phone plan.
• Reduce your grocery bill by only buying what is on sale.  I look forward to the monthly grocery store fliers as that tells us what we are eating for the week by what’s on sale.
• Drive an old car.  Buy used and keep the price of the car as low as possible.  Skip the luxury brands and focus on reliability to keep maintenance cost down in the future.  As for price, think in terms of limiting your car budget to 10% of your annual salary.
• Instead of an expensive vacation, do a stay-cation instead.  It’s who you are spending time with that’s important, not where.

Freedom Dollars

              The idea is that every dollar you save is one step closer to buying your freedom.  To not worry when you need money in a pinch such as a broken furnace or leaky roof.  The freedom one day to take a job without money being the motivating factor.  Freedom to reduce stress in your life.  Aim to save 50 to 75% of your income.  After a while the savings will become habit forming.  After more time you will realize that you are not really giving anything up.  Happiness comes from interaction with people, lower stress, reduced desire to want for more, and enjoying life.  Not take out dinners, material goods, or other expensive modern-day conveniences.  Now with all this extra money, what do you do with it?

Stop Making Credit Card Companies Rich

              The first thing to do with your cash is pay off any high interest rate debt.  A general rule is that if an interest rate is higher than what your expected return on investments is, then pay if off.  Credit cards are only good for the rewards that they offer such as cash back or travel miles.  By paying off your balance every month you are reaping all the benefits.  If you ever make the minimum payment, then the remaining balance carries forward at a high interest rate, sometimes 20% or more.  With that type of interest all you are doing is making the credit card company rich and making it harder for yourself to take control of your finances.

Take Advantage of the Tax Benefits that the Government Offers

              Next, you need to utilize tax advantaged accounts.  The government has given us many tools to invest for retirement.  You should take advantage of all of them first.  The most popular will be to max out your 401k plan at work.  Especially if they match.  The great thing about 401ks is that money comes out of your pay check before taxes.  You will have to pay taxes when the money comes out, but your money gets to earn a compound return tax free until it’s withdrawn.  A huge advantage.

              If you have more money to invest after your 401k is maxed out, then you are doing awesome!  Congratulations.  There are other ways to be tax efficient, such as traditional IRAs, Roth IRAs (which can be accessed through the backdoor Roth IRA trick if you exceed the income limits), 529 plans for college, and SEP IRAs if you have self employed income.  Now, let’s figure out how to invest the money.

Cash is not always King

              The worst thing you can do with your savings is leaving it in cash, as the rate of inflation will erode your purchasing power.  What’s inflation? Well, have you ever heard people talk about, “I remember when it cost less than 50 cents to go see a movie.”  Verse today a ticket is 10 to 30x times that depending if you pick one of those fancy theaters.  That’s inflation, the price of goods goes up over time.  In order to buy a hamburger tomorrow with the same amount of money in your pocket today, your cash must at the minimum keep up with the rate of inflation. 

Investing your Cash

              Index fund investing is by far the best approach on making your money work for you.  There are numerous funds that charge very low fees and you will guarantee yourself a market return, much better than most mutual funds or money managers out there.  There are two methods I suggest.  For the ultimate hands-off investing buy FFNOX and then contribute money to it every single month.  Fidelity charges 13bps as of 12/31/2018 and rebalances periodically between the four different funds, which are US large cap, US mid/small cap, international stocks, and fixed income funds.  Below is the allocation breakout as of 12/31/2018.

FFNOX Allocation

              For those who want higher returns that also comes with greater risk and volatility, then you should invest in a total world index fund such as VTWSX or ticker symbol FZROX if you want 100% US investments.  If you have no further interest in learning how to invest or the reasons behind it, you can stop here.  Just set up your initial investment, contribute money monthly, and only withdraw when you are enjoying your retirement.  Remember money invested today is to be view with a 10 to 80-year time horizon.  Never invest money in the stock market if you will need it within the next 5 years.

Should I Pick Stocks Myself?

              The general thesis, as presented in “A Random Walk down Wall Street”, is that it’s very difficult to beat the market.  The market is defined as the total stock market, such as the S&P 500 which is a group of the 500 largest US based companies.  A lot of time and money are spent by professionals picking stocks in hopes to outperform the general stock market, with very few doing so consistently.  In addition to being difficult to beat the market, investing in fewer than 60 stocks will increase the risk of capital loss, for example a company going out of business and its stock price going to zero. 

Beating the Market

              There are two approaches to trying to beat the market, pay someone high fees or pick stocks yourself.  The problem with paying high fees is that not only does the investment professional need to beat the market, they also need to beat the market plus the fees that they charge.  Few people can do so consistently over time, those that do are hard to identify.  When looking at historical data, Mutual funds or money managers that beat the market for a 10-year period are not likely to beat the market going forward.  Some exceptions are Warren Buffet who is past retirement age and Peter Lynch who is retired. 

              The second approach is doing it yourself.  There are two reasons to deter you from doing it yourself, the first being that if the professionals who commit 50+ hours a week cannot do it, what makes you think that you will be capable?  The second is that even if you were able to beat the market, the time and effort spent on trying to beat the market may have been better spent investing in your career.  The investment in your human capital and building your career is much more of a sure bet than the chance of outperforming a low-cost index fund.

Guaranteed Market Rate Returns

              Broad based index funds guarantee to earn the market return, which is something that two thirds of money managers cannot do on any given year.   The number of money managers that cannot beat the market consistently is far higher than two thirds.  Index funds can charge as little as 10 basis points in fees (0.10%) or less where most money managers or mutual funds will charge greater than 100 basis points (1%).  Also, the probability of losing your entire investment is virtual zero in an index fund as every stock in the index would have to go out of business. 

              By investing in index funds, you are earning market returns for minimal cost, reducing risk, and potentially investing more of your capital.  Since index funds reduce your risk of total investment loss to virtually zero, then you should be more willing to invest more of your capital.  This will ensure more of your money is working for you in generating returns.

Not for the Faint of Heart

              One thing to caution is the volatility that is involved in investing in the stock market.  On some years, markets can be down 30 or 50%.  While this is a scary event to see the value of your portfolio decline that much, it should be seen as a tremendous opportunity to invest at reduced prices.  By investing monthly, you are taking advantage of these dips. 

              Brokerage houses will allow you to set up automatic investment plans.  This is the ideal route, as it will be set it and forget it investing.  Every month your account gets debited, so you don’t have to look at your portfolio.  Not looking is important as it will reduce the temptation to invest more when the stock market is high or sell out of fear when the stock market is low.

Tax Efficiency

              Another large benefit of index investing is that it is tax efficient.  Every time you sell a stock for a gain, you will have to pay taxes if held outside a tax advantaged account.  Also, if you invest in only high dividend paying stocks you will have to pay taxes on those dividends as well, more on this later.  For those investing in tax advantaged accounts such as an IRA or 401ks this is less of an issue, but for taxable accounts, being consciousness of taxes can really add to your returns.  Vanguard has tax-managed index mutual funds that may be helpful for those in the top tax brackets, but any broad-based mutual fund and especially ETFs will be tax efficient, if you hold for 10+ year time periods.  I tend to use mutual funds solely because they offer automatic investing where you will have to place a trade every time that you want to buy or sell an ETF.

Another Downside to Actively Managed Mutual Funds

              Actively managed mutual funds will be less tax efficient on top of their higher fees.  In their attempts to beat the market, mutual funds and or investment advisors will buy and sell stocks.  Selling stocks will trigger a capital gains tax.  Not only will you be paying higher fees and most likely getting a return below the market, you will also be paying more in taxes.

How much is Enough to save for Retirement?

              The 4% rule for retirement gives you a good approximation of how much you need.  This rule implies that you should have enough savings for retirement that 4% of your savings will be enough for one years of living expenses.  Simply take your annual living cost and multiply it by 25.  If your rate of return is 4% or higher, you can live off your investments indefinitely without depleting your savings.  But I will caution that the market are not always expected to return 4%.  If so, you may want to use 3% as a safer approximation which would be your annual living cost times 33. 

To Buy High Dividend Stocks or Not, that is the Question?

              The next question is how do you extract that 4% on a yearly basis?  Once you reach retirement, an investor may want to invest in high dividend paying stocks for current income.  I disagree with this strategy.

              Let’s say that you have two baskets of stocks, simplified for ease of explanation.  Group A pays a 4% dividend and has a 0% growth rate.  Group B has a 0% dividend and 4% growth rate.  At the end of the year both groups will be 4% higher in value.  Being that the tax rate on qualified dividends is the same as long-term capital gains, one may say at a cursory review that the after-tax return is the same.  That is not true.

              Group B only gets taxed when you sell.  Let’s say your portfolio had 100% gains thanks to your long-term diligence on investing on a monthly basis.  Your 50 bucks of initial investment is now worth 100.  Selling 4 dollars’ worth (4%) is taxed on half of the proceeds, since only half of your portfolio is a capital gain.  The other half is a return of capital.  In group A taxes are paid on the 4 dollars of dividends, in group B taxes are only paid on 2 dollars.  The other big benefit is that on group B you only pay taxes when you sell.  Group A must pay taxes regardless if you buy or sell since dividends are paid every year.  Having this option of only paying taxes when you sell is optimal in your wealth accumulation years as you tend to be in higher tax brackets.

Conclusion

              Below I have listed some simple bullet points to assist in streamlining your investment plan and an allocation mix that I recommend.

1. Save as much as possible by paying yourself first.  Invest the money automatically every month.
2. Index funds are the most efficient way to put your money to work.  Invest 70% of your portfolio in US Stocks, 20% in Non-US, and the remaining 10% in a bond fund or US treasuries.  Not looking at your portfolio will reduce your stress and temptation to sell when markets go down.  Below is an example investment allocation that I recommend.
   • US (70% Allocation) – Ticker Symbol VTSAX
   • Non-US (20% Allocation) – Ticker Symbol VTIAX
   • Treasuries (10% Allocation) – Or you can use ticker Symbol VBTLX
3. Once you reach retirement, withdraw money and rebalance annually.