Since the Great Recession (2008-20XX) salaries have stagnated, the job market has not rebounded and government debts have piled up leading many to question what kind of retirement income will the state be able to provide (not just in the US, but in most of the developed world)? Add to this, historically low interest rates, extending at least well into 2013, and you are likely to see more of your family and friends with a case of the holiday blues. Some strategists, including Bill Gross at the worlds’ largest bond fund, are describing this as a wealth transfer from the people to the banks or from the savers to the borrowers. For those in retirement or close to retirement, who have probably de-risked and hold more of their savings in fixed income this problem is particularly acute. For those of us who are further away from retirement there are a few things we can do to improve our odds of retiring on time.
The Boring Part
First, you need a plan to figure out how much you need to retire on; include all income streams (don’t necessarily count on receiving the same amount from the state that current retirees do) and subtract your estimated expenses. Subtract 10% from your estimated income and add 10% to your estimated expenses and realistically assume that you will live to 100 (if you move on early you can leave something to your family or favourite charity). Oh, and don’t forget to subtract taxes from your income streams!
Be Real No Nominal
When discussing real vs nominal we are differentiating between an amount that takes into account inflation and one that ignores it. For instance a dollar in 10 years will buy less than a dollar will today, although in both instances the nominal amount will be one dollar. I have a friend who upon graduation from high school started a small business (a single person proprietorship). The first year he lost money, the second he broke even and ever since he has run a profitable business. Initially he took the advice of his banker and invested the profits in various bank-originated mutual funds. However, after losing money following the dot.com bust and then the attacks on September 11, he withdrew all his savings from the funds and instead invested them in a “high” interest savings account and various short-dated certificates of deposit (CDs). I am sure many readers have been (still are) or know of someone in a similar situation.
Unless you are earning more than the inflation rate you are actually losing purchasing power and the longer this condition persists the more devastating the results. This problem becomes more acute a few years out when inflation returns due to all the additional liquidity that central banks have been pumping into the system. As an example, if you are 35 years away from retirement and have $10,000 to invest, leaving this amount in a savings account or other short-term investment vehicle with a 1% return will grow it to $14,166. However, a 7% annual return, a reasonable estimate for a conservative based portfolio, will grow it to $107,766. If we assume a 3% inflation rate over this time the real growth will be considerably less and actually negative for the first example. As can be seen in the chart, the bank account will have less than half of its purchasing power in 35 years, but the portfolio with the 7% return will be able to purchase 4 times more than the initial $10,000 investment. The other important thing to notice from the chart is the power of compounding; the longer you allow the money to accrue interest the larger your nest egg. Compounding for 35 years instead of 25 years, at 7%, will double your capital.
(click charts to expand)
Note: I have assumed that this money has been invested in some type of a national tax-free savings account and therefore has been allowed to grow tax-free during these 35 years.
The Psychology of Staying Invested
As we commence a new year, the strategists are calling for another up year as they seem to do each and every year (the consensus according to Bloomberg is for the S&P 500 (SPY) to finish up 6% to end the year at 1338). On an annual basis this is not a bad bet, since 1950 the S&P has advanced 73% of the time. Trying to predict whether the market will advance on any given day is considerably trickier as the probability is only 52.8%, a probability that is very close to that of flipping a coin.
If you are a passive investor, you are better off not checking your portfolio on a daily basis. Consider that over the past 52 years the S&P 500 has closed down 46.4% of the time on a daily basis versus only 27.4% on an annual basis. Psychologically, it is more difficult to stay invested over the long term if you are watching your portfolio daily and see it dropping almost half of the time versus closer to a quarter of the time on an annual basis. In 2011 the S&P finished almost exactly where it started the year (down 0.4%), although it was a volatile year. The market swung over 20%; at its high the market was up 8%, toward the end of April and at its low down over 12%, in October. By being slightly more detached from your investments you are less likely to make emotionally driven decisions based on short-term market volatility.
S&P 500 Daily, Weekly, Monthly, Yearly Price Changes
Control The Things You Can Control
In investing there are only a handful of things you can actually control, controlling these few things will result in huge benefits to your portfolio over time:
Invest early: As can be seen from the chart the power of compounding works best over longer periods of time. As an extreme example if you had received a penny from a Roman in the first century and invested it at a compound rate of return of 3% per annum, today that penny would worth more than the combined economic wealth in the world.
Seek low fees: ETFs generally have lower fees than mutual funds. An ETF is an investment fund that is traded similar to a stock, but generally tracks an index. For example the SPDR S&P 500 Trust ETF (ticker symbol NSYE:SPY) tracks the S&P 500 and has an expense ratio of 0.09%, for comparison purposes most mutual funds will have an expense ratio of above 1%.
Tax efficiency: Maximize your contributions to tax-free savings vehicles (these will vary depending on where you live, but a few examples include: 401K, IRA, Roth IRA, RRSP, TFSA, ISA) additionally many companies will match or add “kickers” to money that you invest.
Diversification: As with most things in life it pays not to have all your eggs in one basket. In 2011 financials performed poorly, while Utilities, Healthcare and Bonds had great years. In 2012 the reverse could occur. The point is nobody knows what the future holds; therefore it is best to hold a variety of investments in your portfolio to mitigate unsystematic risk. At a minimum, you should hold an ETF on US equities, such as, the aforementioned SPY. Another ETF that focuses on other developed markets, e.g. iShares MSCI Canada Index, which carries Morningstar’s top rating (EWC). One for developing markets, e.g. iShares MSCI Malaysia, which is actually Pacific/Asia Ex-Japan and carries a 4-star Morningstar rating (EWM). One concentrating on commodities, such as, Rogers International Commodity ETN (RJI). Finally, a bond fund that includes corporate and sovereigns in both developing and the developed world, as an example I would suggest the King of Bonds, Bill Gross’s/Pimco’s Total Return Fund, which carries a 4-star Morningstar rating.
Timing: Although timing the market is next to impossible there are times when the market appears under or over valued. Today with the market trading at close to 12X forward year’s earnings it appears to be more or less fairly valued. Historically, 12X forward earnings is inexpensive, however, with all the uncertainty coming from a European existential question, to a potential Chinese hard landing, to political deadlock in the US it is difficult to say with any confidence that the market cannot go lower.
Let your savings work for you, leaving all of your money in a bank account will lead to a lower purchasing power than it has today. You need to exceed the inflation rate over the long term. If you do not have the time or the inclination to spend a considerable amount of time analysing and following the markets you are probably best investing in ETFs and not looking at your financial statements on a daily or weekly basis. Invest early, minimize fees, make use of tax efficient vehicles, diversify and do not invest in an over-valued market.