Spreading your investment eggs among several baskets is only one of the many strategies to maximize your long-term returns. Starting early, investing passively, and capitalizing on tax advantages are some additional basics to secure your financial future.
For the past few years, the evening news has been peppered with stories of longtime industry giants who will not be able to honor the pension programs their employees have spent decades accumulating. Many other companies are either reducing the benefits they extend to employees or converting to 401(k)-type “defined contribution” plans, which cost significantly less and carry no future liability. This is scary, given that the average head of household ages fifty-five to sixty-four has a retirement account savings of just $60,000.1 Couple these developments with the looming shortfall in Social Security funding, and people have every reason to fret about the future.
Today only 24 percent of workers in the U.S. private sector have defined benefit plans, which obligate a company to provide a predefined level of benefits. In addition, no new defined benefit plans are being started.
The public sector is also facing its own pension crisis. While 90 percent of its employees are still covered by defined benefit plans, BusinessWeek recently reported, “The 125 largest public-pension plans are short $278 billion, a gap created by underfunding, poor stock market returns, and costly hikes in benefits.”
Increasingly, individuals will need to lean on their own foresight and planning. The solution for tomorrow’s retirees and others building a nest egg lies in understanding some common principles of investing that apply at every stage of life. Some simple guidelines that can greatly increase your chances for financial stability include:
- Maintaining a diversified portfolio
- Starting early and staying the course
- Investing passively
- Enrolling in tax-advantaged savings vehicles
MAINTAINING A DIVERSIFIED PORTFOLIO
The first principle, portfolio diversification, explains why you shouldn’t put all your eggs in one basket. The asset classes and amount you invest in each are vastly more important decisions in determining your long-term investment returns than either market timing or specific stock and bond selection. In fact, asset allocation choices are responsible for more than 90 percent of performance for long-term investors.2 The goal of asset allocation is to maximize return and minimize risk. When investing, you should diversify both across asset classes and within each asset class.
Diversify across Asset Classes: Asset allocation is the ultimate protection if things go wrong in one investment class or sector, as is likely from time to time. Asset classes include broad categories, such as stocks and bonds, and narrower categories, such as domestic vs. foreign and growth vs. value stocks. As Chart 1 illustrates with five common classes, investments are characterized by their level of risk and return.
The goal of asset allocation is to maximize return at what the investor feels is an appropriate or manageable amount of risk. Harry Markowitz introduced the concept of an efficient portfolio, one which has the smallest attainable portfolio risk for a given level of expected return (or the largest expected return for a given level of risk). Just as there are investments that may offer a 100 percent return with little or no security, there are investments that can guarantee the safety of your principal but with little or no return. Markowitz pointed out that risk is reduced by diversifying. For example, when stocks are doing poorly, bonds could be doing well.
As investors diversify across classes, they should choose a mix that corresponds with the amount of risk they are willing to bear and the number of years before those funds will be needed. Money needed in two years for a down payment on a house should be invested more conservatively than money needed in thirty-five years. A conservative asset allocation would include a lot of money in the money market and bond asset classes.
In contrast, if you have a long time until retirement, your asset allocation should be more aggressive. Stocks become less risky as your time horizon increases. For instance, in any one year the standard deviation (or variability) of a diversified stock portfolio’s returns dating back to 1871 is about 19 percent. But if the holding period is increased to five years the standard deviation decreases to 8 percent. During a twenty-year period, that number decreases to 3.5 percent. There has never been a twenty-year period in U.S. capital market history where a diversified portfolio of stocks lost money.
The reality of investing is that the stock market will go up and down. Investors who begin early and stay in the market have a much better chance of riding out the bad times and capitalizing on the periods when the market is rising. Diversification across asset classes is extremely important. If your investment horizon is short, allocate a lot to conservative or low-risk asset classes. However, when planning for a distant retirement, consider placing more weight on stocks.
Diversify within Asset Classes: Diversifying a portfolio within asset classes is likewise crucial. A portfolio that includes one U.S. stock, one international stock, and one municipal bond cannot be considered appropriately diversified despite allocating money among different asset classes.
There are two distinct types of risk in stock investing:
- Systematic risk (nondiversifiable)
- Unsystematic risk (diversifiable)
First, systematic risk is the risk associated with investing in the stock market. From week-to-week or year-to-year, the market as a whole (the “system”) can move up or down—there are no guarantees. All investors bear systematic risk—those who own a diverse collection of mutual funds as well as those who merely own one stock. For example, if the economy goes into a recession the entire market will be adversely affected.
Second, unsystematic risk comes from specific events that impact individual companies but not the whole market. The good news is that diversified investors don’t need to worry about firm-specific risk. As the number of unique stocks in a portfolio increases, the amount of unsystematic risk (diversifiable risk) decreases. For instance, if a portfolio consisted of shares of just one company, and that company went bankrupt, the holder would lose his or her entire investment.
If a person invested in only one randomly chosen stock, the standard deviation (a measure of risk) is nearly 50 percent, meaning one shouldn’t be surprised if the stock went up or down by 50 percent in a year. The thought of losing 50 percent (or more) of an investment is scary. However, as Chart 2 illustrates, for a portfolio of ten randomly chosen stocks, this risk is cut nearly in half. The measure of risk drops below 20 percent in a portfolio with thirty stocks.
STARTING EARLY AND STAYING THE COURSE
When it comes to long-term investing, time is your best friend. Time enables the “miracle of compounding” to work its magic. Compounding means that interest on your money earns interest and is added to your principal. In that way, future returns are calculated on a larger and larger base.
For example, let’s say you invest $2,000 a year starting at age twenty-five in a tax-deferred account that earns a 10 percent average annual return. At age sixty-five, you’ll have accumulated a total of $885,000. But, if you had waited to begin saving until age thirty-five, your nest egg would total only about $329,000. That $20,000 you didn’t save ends up costing you $556,000!
A little money and a lot of time equal a fortune. Two caveats are in order—the benefits of time can be destroyed by bad market timing and borrowing. The safest course is to decide early in life to be a committed long-term investor. Do not tap into retirement accounts before retirement for any reason other than the most dire of emergencies. Withdrawing from such accounts before retirement not only caries a hefty 10 percent tax penalty but also does irreparable damage to what Albert Einstein called the “eighth wonder of the world—the miracle of compound interest.” You will never again have the chance to replicate the years of diligent allocation to a formal retirement program once the funds are removed.
INVESTING PASSIVELY
One key to success in long-term investing is to reduce the amount of money your portfolio loses each year as a result of transaction costs and other fees. Passive investing seeks to mirror a market index and does not attempt to beat the market. By investing passively as opposed to actively, expenses are minimized and long-term returns are maximized.
There are fees that must be paid each time a trade is made, including transaction fees and the bid/ask spread. In addition, taxes are higher when investment gains are realized in the short term through active management. Active-managed funds pay taxes earlier, when an investment is sold, and thus miss out on the benefits of compounding. And actively managed funds typically pay the higher ordinary income tax rate as opposed to the lower capital gains tax rate.
Passive mutual fund investors also avoid the high fees professional fund managers command. Experienced fund managers typically charge between one and two percent of the value of assets under management as their annual fee. Fortunately, it is easy to avoid the time, transaction costs, tax disadvantages, and management fees associated with actively managed funds. Two cost-efficient ways to passively invest in the stock market are index mutual funds and exchange traded funds (ETFs).
Index funds and ETFs seek to provide investors a return that passively mimics that of a specific market index (such as the NASDAQ or S&P 500) while charging minimal fees. This compares with the professional fund manager’s promise that an actively managed fund can earn you enough additional return (or “alpha”) to more than cover their additional fees. With ETFs and index funds, transaction fees and taxes are minimized because portfolio turnover is low, since most indices change their composition infrequently. Academic research indicates that the average actively managed mutual fund, after expenses, fails to match the performance of a comparable index fund.3
The main difference between the index funds and ETFs is that an index fund is an actual mutual fund—individuals pool their money and a professional buys and holds a basket of companies in proportion to their respective market capitalizations. In contrast, an exchange-traded fund is traded on the market and can be purchased as simply as any share of stock. Both allow a novice investor, with little by way of capital, to inexpensively invest in a diverse portfolio. There are index funds and ETFs that track broad market indices in addition to specific industry sectors, regions, and asset classes.
Another argument in favor of passive investing for most investors is, mathematically speaking, your performance will be better over the long term. While it is true that many fund managers outperform the market each year, the percentage that can outperform consistently over at least ten years is miniscule. A recent study of the performance of 171 large-cap equity mutual funds during the past twenty years published by the Journal of Financial Planners4 came to the following conclusions:
- The longer the investment time frame, the more difficult it was for active managers to outperform the index fund.
- The percentage of funds that outperformed the index fund during a twenty-year period was 10.59 percent.
- The distinction between returns based on growth, value, and blend styles faded as the investment time frame lengthened.
This same study found that mid-cap mutual fund performance was even more abysmal—only one out of eighteen funds outperformed the index during a fifteen-year period. In addition, these results don’t account for what index fund pioneer John C. Bogle, the founder of Vanguard, termed “survivor bias,” meaning a twenty-year study can only be done on funds that have been around for twenty years. Funds that went out of business—most likely due to underperformance—can’t be factored into the results. Thus the performance of the “average” mutual fund compared to the index fund during the twenty-year study period was likely even worse than the grim study results.
The study also confirmed one well-known investing caution—that past performance is no indication of future results. That isn’t to say that there aren’t some mutual funds that will outperform over the long term. The study simply demonstrates that it is hard to predict which funds will be the stars of the future and, mathematically speaking, the best place for the average investor to invest their money during the past twenty years was in a low-cost index fund.
Stock Picking as a Disadvantaged Player: So far this discussion of investing strategy has ignored would-be day-traders who make their own trades on individual stocks. With the background already established that, over time, most professional fund managers can’t keep up with average market returns, let’s examine the likelihood that a nonprofessional fund manager can do as well or better than an index.
A casual stock picker is a disadvantaged player, a player who underperforms on average, because their expertise is in something else, and they’re investing against fund managers who do nothing but study the market.
A disadvantaged player increases the chance of reaching a positive outcome by decreasing the number of trials (that is, by increasing the sampling error or risk). But this is also a key reason why casual stock pickers lose over the long haul. Such an investor may be able to make one quick profitable stock trade, but each additional trade makes it more likely that they will lose overall. Even the average professional mutual fund manager could be considered a disadvantaged player in the long term, because each manager had only a 10 percent chance of outperforming the index during the past twenty years.
Of course there are individuals with the insight, training, and skill to be successful. But this group is much smaller than most casual stock traders would like to believe. If you don’t think you could earn a living—long term—solely based on your stock trades, it may be time to find a less financially risky hobby (like skydiving or bungee jumping) and park your money in an index fund. If you can consistently make money over the long term, maybe you should quit your present employment and trade stocks full-time. The talent to replicate success in stock investing is rare.
ENROLLING IN TAX-ADVANTAGED SAVINGS VEHICLES
Now that we’ve focused on starting early and investing a large percentage of your retirement money in passively managed stock index funds, there is still one last important lesson regarding where to keep those investments. Housing retirement money in investment vehicles that include matching and/or tax advantages is a no-brainer.
One great benefit of a 401(k) is the “out of sight, out of mind” principle. Money is deducted from your paycheck before you ever see it, eliminating the need for setting aside funds. A 401(k) shouldn’t be considered a usable asset until you enter retirement.
The feeling that an employer will take care of his or her employees in their golden years is rapidly being replaced by one of personal responsibility. By depositing money in a defined contribution vehicle like a 401(k), your employer is forcing you to decide how and how much to invest for retirement. This is both a challenge and an opportunity. Under the “defined benefit” system, actuaries make a series of complex estimates and projections to approximate how much money a company must budget yearly to make good on promised retirement benefits. Snatch the Match: If your employer offers to match your contribution to a retirement program (401(k), 403, SEP, Keogh, or SIMPLE), be sure to take advantage of it. This is about as close as you can come to a “free lunch” in investing. Surprisingly, almost 25 percent of employees don’t contribute enough to their 401(k)s to qualify for their full company match. In essence, those employees are turning down free money. But remember that your employer’s contribution is merely a poor substitute for the defined benefit plan they might have offered a generation ago. The 401(k) match actually costs them less than what they would have spent under most previous defined benefit plans.
Avoid and Delay Taxes: The federal government wants you to save for retirement and encourages this by giving some tax breaks. Using tax-advantaged investment vehicles like IRAs and 401(k)s to build savings is crucial to retirement planning. Your pre-tax contributions to these accounts can grow unfettered until drawn upon and taxed as ordinary income. With a few exceptions, money withdrawn from retirement accounts before age 59½ will face an additional 10 percent penalty.
Currently, employees can contribute up to $15,000 annually to a 401(k) and $4,000 to an IRA ($5,000 for those fifty and older). There are two types of IRAs: traditional and Roth. A traditional IRA is funded by pre-tax dollars, and taxes are paid in the future as you make withdrawals. Contributions to Roth IRAs are made after taxes, but future withdrawals are then tax-free (if certain guidelines are followed). One way to think about which IRA is right for you is to consider your current tax bracket and the bracket you expect to be in as you enter retirement. If one expects to be paying less in taxes in retirement, a traditional IRA is more appealing. Conversely, if your tax rate increases or stays the same, a Roth IRA would be recommended.5
CONCLUSION
When I entered the Marriott School fresh from three years trading equities at Goldman Sachs, I listened politely and silently disagreed while some of my professors preached the benefits of passive investing. Having learned several hard lessons on my own, I now subscribe to the wisdom they espoused. The benefits include knowing that during the long term, odds are that I will do better as a passive investor than those who think they can game the system and come out ahead.
By maintaining an appropriately diversified portfolio, starting early, investing passively, and taking advantage of tax-advantaged investment vehicles, you can set the stage for financial self-sufficiency.
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Article written by Brian Baker
Photography by Bradley Slade
ABOUT THE AUTHOR
Brian F. Baker earned his MBA from the Marriott School in 2004, where he was also named a Hawes Scholar. Baker works for Zions Bank Public Finance, where he helps local government entities finance capital projects. He previously worked for Goldman, Sachs & Co in U.S. equities. The most important current investments for Baker and his wife, Erlyn, are their four children.
NOTES
- Boston College Center for Retirement Research.
- Gary P. Brinson, Brian D. Singer, and Gilbert L. Beebower, “Determinants of Portfolio Performance II: An Update,” Financial Analysts Journal, (May/June 1991).
- Steven R. Thorley, “The Inefficient Markets Argument for Passive Investing,” marriottschool.byu.edu/emp/SRT/passive.html. (teaching notes, Marriott School of Management, Brigham Young University), September 1999.
- www.fpanet.org/journal/articles/2006_Issues/jfp0206-art6.cfm.
- Walter Updegrave, “The Joy of Tax-Free Retirement Income.” Money Magazine, (1 August 2006).