On January 29th, I wrote this article asking the question of whether or not we are over-saving for retirement.  It was based on a fairly interesting New York Times piece on January 27, 2007 on the topic.  Since then, I’ve seen this topic appear fairly often in the personal finance press.

As a reminder, this graphic sums up the issue: spending in retirement is not level, so planning for a steady “80% of your pre-retirement income” may be overly conservative for many.  This graphic does a fair job outlining the issue:

Anyway, Vanguard has recently posted their take on the issue, and it’s worth reading.

Look, you could be cynical and say that Vanguard has every incentive to encourage people to over-save.  After all, they make money on the amount you have saved with them.  However, given Vanguard’s reputation for low costs and history as a staunch consumer advocate for savings, that’s an unlikely scenario.

Vanguard’s response to this issue is really basically the following:

• It doesn’t take a significant savings rate to accumulate significant retirement wealth
• It is better to over-save than to under-save, all things considered

It’s the second point that I really believe is the most material.  Look, I wish we lived in a country where everyone had been acting like good little ants, storing away food for the winter.  But that just isn’t the case.  The average retirement account has approximately $56,000 in it, and that isn’t going to cut it.

The WWII generation had three legs to their retirement system – social security, pensions, and savings.  Social security is evolving to a cash-starved system that will only really be there for people with modest means.  Anyone with significant savings will see their social security benefits means-tested and taxed at fairly high rates.  Pensions are also gone, for the most part, largely because the only institutions that can afford them are governments who don’t have to do proper accounting.

So that leaves saving.  As a result, I’m inclined to think that while the argument that common financial planning goals are too conservative might be interesting in theory, it sends the wrong message at the wrong time.  It’s like we’re telling an addicted gambler in Vegas that whoops, we made a mistake, and their savings account isn’t totally tapped out yet.

Wow. Who knew cartoons from 50 years ago were this educational?

Many thanks to Get Rich Slowly for this one.

Here’s a 1957 cartoon about the virtues of stock market investing from the New York Stock Exchange (NYSE). Fred Finchley is a family man with a good job, a lovely wife, two rambunctious children, and all the conveniences of modern life. What he doesn’t have, however, is enough money to pay for his dream vacation.

When Finchley’s boss gives him a raise of $60 a month, he faces a dilemma. Should he use the money for savings? For a couple of nights on the town with his wife every month? The NYSE suggests that Finchley put his money to work in the stock market with a “monthly investment plan”.

“Working Dollars” does a good job of explaining how dollar cost averaging works. The cartoon makes a case for small, regular investments. Investing isn’t just for tycoons — using a monthly investment plan, even the average family can begin to acquire wealth.

It may not seem like it, but this cartoon was extremely well thought out, and the personal finance advice it offers is just as applicable today. Of course, I’m not sure how excited anyone would be with a $60/month raise right now, but I’m pretty sure the point is made with $600/month or more.

The most interesting subtlety is highlighted well by Get Rich Slowly, and I couldn’t agree more. The biggest danger in personal finance is lifestyle inflation, the tendency to increase expenses with any increase in income. The danger is, of course, that income is hardly reliable, but once you get used to a certain lifestyle, it’s incredibly hard to dial down expenses. This is particularly topical for people who work in high risk/high volatility jobs, like technology and sales. Even if you have steady pay, retirement often involves a shock to the system in terms of income.

A neat find.

I haven’t posted a lot about personal finance lately, and I’ve been meeting to get back on the horse soon.  In the meantime, this is a fun one for those of you who may not have heard it before.

When investing for a long term goal, like college or retirement, it’s often very useful to be able to quickly determine how long it will take to double your money.

Enter the Rule of 72.

Now, the Rule of 72 is shorthand, and not completely accurate.  But it’s accurate enough to be immensely useful.

The Rule of 72 says that if you divide 72 by the rate of return on an investment, you’ll get the number of years required for that investment to double.

So, if you find an investment that returns 8%, 72 / 8 = 9, so the investment will take 9 years to double.

I learned this rule about 15 years ago from my grandmother, and I’ve been using it for quick shorthand ever since.

For example, let’s say I want to know how much a $50K 401K might be worth over time.  Assuming an 8% rate of return, I can quickly determine that it will double in 9 years, quadruple in 18 years, octuple in 27 years, and be worth $800K in 36 years.

This also works, unfortunately, for loans, but in reverse.  If you take a student loan out at 7.2% for 10 years, well, you can expect to end up paying double what you borrowed in total.

I’ve also used this rule in business environments, especially when you are looking at compounding growth rates for business metrics like sales, revenue and costs.

Once again, the rule is really a shorthand, and not completely accurate.  Obviously, a 72% return doesn’t double in 1 year.   And a 1% return doesn’t double in 72 years.  However, it’s surprisingly accurate in the middle ranges, which apply to most situations.

This article in Get Rich Slowly has some variants that are fun. But for me, the basic Rule of 72 lets me quickly an easily assess what a return will really mean to an investment, in those rare moments when I’m away from Excel.

So enjoy this tidbit, and I’ll get to some meatier topics this week.

It has been quite a while since I’ve posted as part of my personal finance education series, but it hasn’t been for lack of desire to do so. This is the first post that starts getting into topics on investing, and as a result, it has taken me a bit of time to collect my thoughts.

If you haven’t had a chance to review the previous two posts on Saving and Emergency Funds, please do so. It only makes sense to start talking about investing for the long term when you have the basics of good financial hygiene in place. It makes no sense to own stock in Google or money in an exchange-traded fund if you are having trouble paying off your credit card.

Of all the chapters to come in this series, however, this one is probably the most important to take to heart as you manage your own long term investments.

It turns out that the most important decision for your investments is not trying to find the next hot stock nor trying to find the savings account that pays the highest rate. It’s not finding the best new type of bond to own, and it’s not finding the lowest expense ratio. These are all important, but most likely not the biggest determinate of your investing success.

It turns out the most important decision you make with your investment dollars is how you divide your assets between different types of investments. This one decision tends to explain the majority of success and failure that people see in their investment portfolios.

Let me explain, at a high level.

It turns out that there are many different ways to invest your money. These different types of investments have different characteristics. Some people over-simplify this to whether one type of asset is “riskier” than another, but it turns out that risk comes in many flavors.

Some investments have returns that are very unpredictable in the short term. Others are extremely predictable. This is sometimes referred to as volatility.

Some investments require your money to be locked up for long periods of time. Others provide you easy access to your money. This is sometimes referred to as liquidity.

You have probably heard the names of a lot of different types of investments thrown around:

• Cash
• Bank Accounts
• CDs
• Money Market Funds
• Bonds
• Stocks
• Mutual Funds
• ETFs
• Gold
• Timber
• Real Estate
• Commodities
• etc…

There are no shortage of different types of investments out there. Each has its own characteristics; its own strengths and weaknesses. What makes it even more confusing is that some types of investments, like mutual funds and ETFs, are really just structures that invest in other types of investments (like stocks & bonds).

The whole idea behind diversification is a reflection of that age-old advice “don’t put all of your eggs in one basket“. By spreading your money around to different types of investments intelligently, you increase the chance that when one of your investments goes down, another will be up. This smooths out the ups and downs, and makes it much more likely that you’ll hit your investment goals.

For most people who don’t have truly large sums to manage, there are only three types of assets that are applicable to most savings goals like retirement or college. They are:

• Cash
• Bonds
• Stocks

Cash investments can take many forms. Some people keep their case in bank accounts or money market funds. Historically, cash investments tend to barely return any money after inflation, which means that they pay interest rates that increase roughly at the same rate that prices increase. They are the definition of liquidity, typically offering you access to your money easily and on extremely short notice.

One of the common mistakes that people make when investing for long term goals is keeping too much money in cash. Because of the low returns, over long periods of time, cash can act like a big anchor on your portfolio, limiting your ability to compound your returns over time.

Assuming you have an emergency fund of three to six months in cash, the purpose of cash in your long term portfolio is really just for three things. First, it cushions downturns in the market, since your cash portion never goes down. Second, it provides you with extra money to invest when other assets become relatively cheap. Third, it provides you with liquidity. It’s terrible for your returns to be forced to sell other assets when they are down, just because you need the money. Cash is always there for you, protecting you from yourself, making sure you don’t end up buying high and selling low.

Bonds come in many different flavors, but fundamentally all a bond is a loan. If you need to borrow a large amount a money, one way to do it is to sell bonds. For example, a company can easily “borrow” $1 Billion by selling 1 million $1000 bonds. The buyers of the bonds get a piece of paper that promises them their money back, sometime in the future, plus interest.

Bonds have been around a very long time, and as a result, there is every imaginable variety. You can find bonds from governments and companies, bonds based on mortgages or utility revenue. There are bonds that pay interest every 6 months, or only at the end of the term.

Historically, bonds have returned an average of about 1.7% above inflation, so while you will see your money grow, it won’t grow quickly. This number, of course, is a horrendous average – there are many varieties of bonds with their own histories and returns. Fundamentally, however, most people turn to bonds when they want to see higher returns than cash, and they are willing to sacrifice liquidity to get it. By locking up your money for a longer period of time, you hopefully will see higher returns.

Bonds have a lot of unique risks. There is the risk that the company will default on the bond, and never pay it back, known as default risk. There is the risk that interest rates will go up, making the bond you bought at a low rate less valuable, known as rate risk. There is the risk that inflation will grow, effectively erasing the value of your bond interest, known as inflation risk. If you want to get fancy, there is even currency risk, since your bond will tend to be denominated in only one currency.

Right now, the interest rates available on cash investments are so high relatively to bonds, that some people advocate not putting any money in bonds right now. Most financial planners, however, will tell you that keeping a set mix of stocks & bonds will smooth out your long term returns significantly, and lower the risk that you’ll end up missing your investment goals. Historically, there have been long periods of time where bonds outperformed stocks, and having money in bonds can ensure that when stocks are underperforming, your portfolio will survive to fight another day. Ben Stein captures this really well in his recent book, which I reviewed here.

Personally, I tend to group cash & bonds together in my asset allocation, since I find it useful to think of cash as just another type of bond that happens to have very high liquidity, and relatively lower returns. Sometimes, however, cash can be the best place for the “fixed income” portion of your portfolio at times. Right now, it’s hard not to like the 5.05% you can get at E*Trade or EmigrantDirect on a bank account with no minimums and liquidity.

Stocks are the most common basic investment in modern personal finance for achieving long term investment goals. Historically, they have returned approximately 6% over inflation, meaning that they are one of the few asset classes to aggressively grow your spending power over time. Stocks are really just pieces of paper that give you part ownership in a business. When a company like eBay has 1.7 Billion shares, each share is like owning a little piece of the overall business.

Stocks are incredibly liquid, and are now freely traded world-wide. Stocks are also incredibly volatile, with prices moving up and down every minute, every day. Because of this, stocks have a reputation for being risky. If you have all of your first house down payment in stocks, it is possible for that account to drop more than 20% in a single day, and that’s bad news if that’s the day before closing.

In the long term, a diversified portfolio of US stocks has been an incredibly rewarding investment. As a result, people have a hard time balancing the short term risk of stocks with the long term risk of not owning stocks.

For most people, even those in retirement, a significant portion of your portfolio likely belongs in stocks. However, it is extremely important to balance that investment with other assets, and to be realistic about how much volatility your investment goals will allow for.  Most Americans have too much of their long term savings in cash, and too little in stocks.

There are over 9000 public stocks in the US alone, and there are many different kinds of stocks.  There are giant companies like General Electric & Microsoft, and tiny companies you have never heard of. As a result, having a diversified portfolio of stocks is likely the most important aspect of this asset class.  I’ll post a whole separate chapter on this topic.

This has been an extremely long chapter, and we haven’t even scratched the surface on some of these topics.  There is one last topic I want to illustrate, and that is the benefit of rebalancing your portfolio based on an asset allocation strategy.

Let’s take a hypothetical portfolio of $10,000 broken down as:

• 10% Cash:  $1000
• 30% Bonds:  $3000
• 60% Stocks:  $6000

Let’s assume that the Bonds and Stocks are represented by broad, cheap index funds from Vanguard.

Let’s say that Year 1 is really bad for stocks, and mediocre for bonds and cash.  Stocks return minus 10%, and bonds return 4%, and cash returns 5%.  Your portfolio becomes:

• $1050 Cash
• $3120 Bonds
• $5400 Stocks

No question, it’s bad news.   Your portfolio is now worth only $9570.  However, if you had been 100% in Stocks, you’d be down to $9000.   The Bonds & Cash cushion the blow of a bad year on the market.

Since your goal is a 10%, 30%, 60% split, you want to rebalance your portfolio once a year.  This means moving your money around so that you now have:

• $957 in Cash (10%)
• $2871 in Bonds (30%)
• $5742 in Stocks (60%)

Basically, you move money from the assets that did well this year, into the assets that did poorly.  This may seem counter-intuitive to those who believe in going with their winners and selling their losers, but this single act encapsulates one of the most practical benefits of a good asset allocation strategy:  it forces you to sell assets that are high, and buy assets when they are low.  Assets tend to regress to their average performance, so this rebalancing has been proven to be a winning strategy to avoid the very human mistake of buying investments when they are high, and selling them when they are low.

Let’s look at what happens in Year 2, assuming that an “average” year happens.  Cash returns 3%, Bonds return 5.5%, and Stocks return 10%.

• $986 Cash
• $3029 Bonds
• $6316 Stocks

As you can see, by moving money into Stocks after the down year, the portfolio is set up for better performance when stocks do, inevitably, recover.  This wouldn’t be possible, however, without having money in different asset classes.  It also assumes extremely good diligence and fortitude to rebalance every year.

Whew!  Long chapter.  A lot of great topics.  For those of you waiting for more detail on each asset class, I plan on having the next few chapters focus on individual asset classes and investment goals.

This is just a reminder that tomorrow, Tuesday, April 17th, 2007, is your last chance to fund an IRA for the 2006 tax year. After tomorrow, you will have lost the chance forever to make your contribution for 2006.

You can contribute up to $4000 in 2006 towards an IRA if you are under 50. If you are 50 or over, you can actually contribute $5000 in 2006.

Many people don’t realize that even if you have a 401(k) or 403(b) plan at work, you can still qualify to contribute to an IRA.

Assuming that you are not opening an IRA for your partnership or business, there are four IRAs to be aware of:

• Deductible IRA. This is what most people think of when they think of an IRA. This is a retirement account where you get to deduct your contributions for the year off your income on your tax return. The problem? You can’t deposit into this type of IRA if you have a 401(k) or 403(b) plan at work, and people over a certain income are disqualified.
• Roth IRA. The hero of the hour. This is the IRA that everyone is talking about. You don’t get a tax deduction this year, but you get a better bonus down the road. All gains on this IRA are tax-free, forever, as long as you withdraw them after the age of 59 1/2. Problem? You can’t contribute to this IRA if you make more than $110,000 as an individual, $160,000 as a married couple filing jointly.
• Rollover IRA. You can’t contribute to this type, but this is a great place to move your 401(k) money from your old company. It keeps the tax status of the old 401(k), and it usually gives you access to a much wider variety of investment options. Better yet, you have the option of either converting this IRA to a Roth IRA, if your income permits, or you can roll it into a future company 401(k) if you’d like.
• Non-Deductible IRA. This is the over-looked gem of the IRAs. Anyone can contribute to these in any year, regardless of income. You will owe taxes on the gains when you withdraw them in retirement, but they get to compound tax free until then.

There are several good reasons to consider an IRA contribution this year, even if it’s non-deductible:

• You never get the chance to go back and make contributions for past years. You lose your option to make a 2006 contribution tomorrow, forever.
• You can now make IRA contributions for a spouse that does not work, up to $4000 for a year.  A great addition if you are in a one-income household, and you are concerned that your retirement savings are limited.
• In 2010, thanks to the 2006 budget, you will get the ability to convert a non-deductible IRA to a Roth IRA, regardless of income! Check out my post on the 2010 Roth IRA Conversion Loophole for more information.

Reasons not to make an IRA contribution for 2006:

• You can’t afford the drop in liquidity of having your money locked up for potentially decades.
• You forgot about the April 17th deadline, and read this post too late.  🙂

Opening up a new IRA is extremely low cost, if not free. E*Trade offers free IRAs. Vanguard offers IRAs for only $10. You can open them online, with a transfer direct from your checking account.

Happy Saving!

One of the blogs I read regularly is The Finance Buff.  This past week, he has posted four times on the topic of inflation-protected bonds, TIPS and Series I Savings Bonds.  As a result, I thought I’d post some pointers and comments here.

First, as I mentioned in my personal finance series, Series I savings bonds are an interesting option for an cash emergency fund.   Series I savings bonds have the following advantages:

• After 12 months, you can cash them in at a moment’s notice.  Great liquidity.
• You can buy up to $30K of them in any year.
• You can buy them direct from the government with no fees at the Treasury Direct website.
• You owe no income taxes at all until you sell them.
• You never owe state or local income taxes on the gains, even when you do sell them.
• You won’t owe federal income taxes on the gains if you use the money towards a qualified educational expense, like college tuition.
• Your money is guaranteed to grow above the rate of inflation, re-adjusted every 6 months, for the next 30 years.  You are given a fixed rate above inflation, measured by the CPI-U index, which measures inflation in urban areas.

Right now, Series I Savings Bonds pay 1.4% + inflation.  Given that historically, money market funds have basically matched inflation over time, and bonds have only beaten inflation by about 1.7%, that’s a pretty good deal, by historical standards, for something that is at least as liquid as a 1-year note.

In any case, the Finance Buff doesn’t like the Series I Bond rate.  In fact, because inflation is so low, he sold his Series I Bonds in November, taking the 3-month interest penalty.

Instead, the Finance Buff likes TIPS, which are the inflation-protected version of normal US Government Bonds.  TIPS are offered in terms of 10 years and 20 years, and right now they are paying a whopping 2.63% over inflation!  Given that the historical return of bonds is below that amount, I can see why he likes them.

Unfortunately, TIPS do have a down side or two:

• While you are paid the interest every year, the inflation value accrues every year to the bond principal.  What that means is that you owe taxes on the inflation gain every year, but you don’t get the cash to pay the taxes.
• TIPS are only available in high dollar amounts.
• TIPS, like other bonds, can be sold before maturity.  However, there is no guarantee of the price you’ll get if you sell them before they mature.  To guarantee your return, you have to hold them the full 10-year or 20-year period.

Here is a great post from the Finance Buff on TIPS.

I have to post this great snippet from his follow up article on pricing TIPS.  It’s fairly complex, but I love seeing the hard math posted for some reason.  Check it out:

I tip my hat to you, sir, for posting that.  🙂

In any case, I had to think about why I’m still such a fan of the Series I Savings Bonds.  I think it is because of the context that I use them – as a cash-equivalent emergency fund.  I’m not looking at them as a bond investment, but as a form of cash.

As I stated, cash equivalents, like money market funds, over time have returned an average of 0% over inflation.  So the idea of getting better than that on my “safety money” appeals to me.

That being said, the rates on high yield internet savings accounts, like Emigrant Direct, are well over 5% now.  With inflation as low as it is, that’s a serious yield also.  With no risk, money available at any time.  Government protected, even, up to $100K!  Hard to argue with that.

The problem is, there are penalties around selling Series I Bonds too early, and there are significant tax advantages to consider.  Interest on a bank account goes on your 1040 every single year, and is taxed at federal and state levels.  There is also no guarantee that these type of high-yield savings accounts will be around forever, although they’ve been pretty consistent over the past 5-7 years.

I’m lucky, because the Series I savings bonds I purchased in 2002 have a 2.0% premium over inflation, so they are paying a higher rate that the bonds you can buy today.  As a result, I’ll be keeping mine for a while.  Sometimes, like this period, they pay less than 3% interest.  Other periods, they have paid almost 8%!  In the end, to be comfortable with them, you have to be comfortable with earning a fixed amount over inflation over time, and leaving it at that.

You can find out more about TIPS and Series I Savings Bonds on the Treasury Direct website.