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Retirement?!? Why should 20-somethings be worried about retirement? Because of the miracle of compounding interest. Let's say you invest $500 per month starting at age 30 until you retire at age 65. Let's say you earn 6.5% (a number we'll justify later) on this investment. When you retire, you'll have over $750,000 waiting for you. Not bad. But what if you had started at 25? You'd have $1.1 million! Those first five years, just 13% of your investment career, increased your return by over 40%! Even if you only put away $50/month, those 5 years alone will still grow to over $32,000 when you retire. So try to save if you can – 40 years is a long time for yields to compound.
There's a slightly specious story you sometimes hear which makes this point another way: Twins graduate college and one starts saving for reitrement right away, then stops after 7 years and never puts in another dime. The other doesn't start saving until age 30 but dutifully contributes for the rest of his life. Because of the late start, the late-saving twin NEVER catches up.
Also, saving now will build habits and knowledge that will come in very handy in 5 years when you start making real money and will want to start saving even more.
Finally, now that we've hypothesized that you can be a millionaire if you start now, consider just how much $1 million really is. If you put it into a bank account that earns just 3%, the interest alone would be more than you make now – and you can certainly, safely do much, much better than 3% with $1 million.
So, how do you make that magical 6.5%? Warren Buffett famously said, “Diversification is a protection against ignorance.” This means that if you don't know which stocks or properties or bonds or currencies or commodities are going to be worth more in the future, then buying all of them will hedge your bets. By buying all the biggest companies' stocks and holding them, you piggyback the average 10.2% growth of the US economy since 1930. So why use 6.5%? That's 10.2% adjusted for inflation. 6.5% is the number to use if you're thinking in today's dollars, which we have been, implicitly.
Conventional wisdom says that you can do better if you pick good stocks and avoid bad ones instead of grabbing them all. The less-famous second half of Buffett's quote is “… It makes very little sense for those who know what they're doing.” There are plenty of people who have made their fortunes on the market by buying the right stocks at the right time, but trying to do so takes time and energy – time and energy you could be spending making money as a poorly-paid scientist or enjoying the fruits of your undervalued labor. But be warned! If you find you have a knack for this financial stuff, rumor has it that astronomy and physics PhDs are highly sought-after and well-compensated in the financial world: 6 digit starting salaries with plenty of room for growth. You might be on a path for a career change!
So, given that you're not going to pack up for Wall Street just yet, how do you buy a little bit of everything and aim for 6.5%? Here are two easy ways:
- The really, really easy way: Get a retirement mutual fund like Vanguard's Target Retirement 2045 or T. Rowe Price's Retirement 2045. These funds are not only diverse and composed almost entirely of of low-cost stock index funds, but their balance of funds slowly changes as you age, so that when you're 65 they're full of bonds and money-market funds which produce income for you to live on for another 25+ years. They're designed to be the only retirement investment tool you'll ever have to buy.
Note that many funds require a minimum initial installment of $3000. T. Rowe Price allows you to start an IRA with no initial installment if you sign up for automatic monthly payments, which is a great way to get started. Once you have more than $3000, you can switch your money over to another company, if you want.
- The merely easy way: Roll your own. There are more complex ways to diversify, but this combination will come close to minimizing your risk while maximizing your returns, and does it with only 2 funds:
For instance, you might hold Vanguard's Total Stock Market Index and Total International Stock Index. The Total Stock fund is “the market” — the 6.5% you're aiming for – and is composed entirely of low-cost index funds, so you won't get soaked by fees. The international fund is there because the rest of the world is growing, too! Volatility with the international stocks can be higher than the domestic funds, but as long as investment horizon is very far away that's OK,and this extra bit of diversification will actually lower your portfolio's volatility (because its price changes are not strongly correlated with the US market). In addition, the international fund is a hedge against a (very unlikely) US market or dollar collapse (if the dollar plummets, the value of this fund in dollars will go through the roof). Most advice says invest 10-30% internationally, which mostly means Europe and Japan. There are also “emerging market” funds for places like Brazil, China, and India.
The above portfolios are “passive”, meaning you regularly invest in them, occationally balance them, and otherwise ignore them. It's important with index investing to reinvest all capital gains and dividends. The 6.5% real return generated by broad index funds includes the compounding effects of these dividends. This is why the market has historically returned 6.5% after inflation, even if the value of the index itself hasn't increased at that rate.
Picking Good Funds
When choosing a mutual fund, look for an index fund with a very low expense ratio (<0.7%), and no loads or commisisons. Most mutual fund companies will charge you a flat rate of $10/year or so per fund, so keep the number of funds down, too. MorningStar is a good, free, independent source for these numbers, which can be hard to find on some companies' websites (usually a bad sign). Check any funds you're thinking about by typing the fund's ticker symbol in the “Quotes” fox at the top or browsing the “Fund Families” in the pull-down menu at the left of the page, and don't take their star system too seriously.
One thing not to get too hung up on is the past performance of a fund, which is what Morningstar rates with its star system. That warning about past results not being a guarantee of future gains is no platitude: chasing performance by buying last year's hot fund is a great way to buy high and sell low. The difference between "growth" and "value" funds is mostly style, not long-term performance. Focus on fees, diversification, and convenience.
One tantalizing alternative to index funds that does not require a lot of time or expertise is to purchase “actively managed” mutual funds, where you pay loads or high expense ratios to a fund manager to beat the market for you. Virtually all funds without “index” in their name (and even some with that word) are actively managed. The higher expense ratios may seem worth it if they mean higher returns, but very few funds reliably beat the market over decade time scales, even before the managers take their fees. And even though a 2.5% expense ratio seems small, it can still take a HUGE bite out of your retirement savings (nearly 80%!). A nice example of how things like expense ratios and active trading can hurt your returns is discussed here. The bible of the passive investor is A Random Walk Down Wall Street, a classic book which describes why it's effectively impossible to beat the market this way. And for retirement, forget getting rich quick – the tortoise wins this race. Here is a nice statement of investing philosophy for investing for retirement.
Getting Rich Quick
If you'd like to try to “beat the market” and earn more than 6.5% by going after other investment opportunities you can. After all, Warren Buffett and Peter Lynch famously beat the market year in and year out (but they aren't hobby investors, of course, they're (more than) full-time professionals investing other people's money). Some popular resources for outperforming the market are The Motley Fool (which will tell you which stocks to buy, for a monthly fee), that Rich Dad, Poor Dad guy (who will tell you how to think about investments and spot opportunities, especially in real estate), and the wild-and-crazy stockpicker Jim Cramer (please don't take advice from Jim Cramer). But remember a Forbes family motto – there's more money in giving advice than in taking it!
So keep this in mind: For every investor who beats the market, there is another who gets beaten, because the average of all investors' returns is, well, the market average (minus brokers' fees, of course – Warren Buffet has a nice metaphor about this principle. Collectively, Americans spend $100 billion per year trying to beat the market – and, on average, failing). So if you're going to be one of the ones that outperforms the market, it's because you're either luckier or better at investing than the average investor (and “average” here is dollar-weighted, so think brokerages, hedge funds, pension funds, and endowments, not Joe Shmoe chasing tips on some website). Anyone who tells you than you can reliably outperform these average investors in your spare time is uninformed or selling something.
If you decide that you're going to try actively managing your own investment by picking stocks or actively managed funds, or gold, or real estate, or whatever, keep track of your rate of return, and remember to include all fees, commissions, and loads. If you're day-trading, these fees can add up very quickly. If you're moving money around a lot, also remember to include the return you get on your money that's sitting in a short-term account waiting to be invested. At many brokerages your return on cash in these accounts is near 0% — if you were a passive investor, this money would be fully invested, not sitting in a low-yield savings account. Compare your overall rate of return on all of your money after all fees to that of an index investor investing the same amounts at the same times to see how well you're really doing. If you really want to be fair about it, you should factor in the value of your time, as well (even 2 hours a week at $60/hour is over $6000/yr – which, as we've already established, will grow in an index fund to over $1 million by the time you retire).
The bottom line is, make sure you really know what you're doing and why before you commit large amounts of money to “active” investments. It's probably best to treat stockpicking or other speculation money like gambling money – only spend money you can afford to lose, and start with a pre-set limit on how much you'll put in.
Is investing in the stock market risky? In the long run, on average, index funds aren't risky because the economy is always creating wealth and the overall market will reflect that. What is risky is trying to time market fluctuations or putting all your eggs in one basket. Any given company can get suddenly hit by a fatal scandal (Enron, anyone?) or disaster (the airline industry), so investing in individual stocks is risky. Investing in a broad array of stocks that tracks the US economy is safe. Even the risk of market crashes doesn't matter if your investment horizon is sufficiently far away – the tech crash that followed the dot com boom only hurt those who bought individual stocks high and sold them low. Thirty years from now a NASDAQ index fund will have made you a lot of money, even if it was purchased the day before the crash (of course, it would have been better if you had bought it the day after! Remember that – the best time to buy is when the market is doing poorly.)
A note about the term “risk”. Counterintuitively, in the financial world the term does not refer to the chance that you will lose money, it refers to the short-term volatility of the holding. Thus, stocks are high-“risk” not because their price might drop permanently, wiping out your portfolio, but because their daily, weekly, and monthly prices vary a lot. If you only care about the price 40 years from now, not next week, or if you're looking for dividends and not capital gains, these variations are irrelevant and you are immune to this “risk”. The equities that have the best returns, stocks, also have the highest “risk”, and the least volatile investments, bond funds and money-market accounts, have some of the lowest returns.
As you approach your investment horizon (that is, as you approach retirement for a retirement account, college for a college fund, etc.), you should reduce this kind of risk. If you need the money on Tuesday, and the market crashes on Monday, you've lost all of your years of gains right when you needed them. The generally accepted strategy is to slowly change from a portfolio of mostly stock to mostly bonds (which are very low “risk”) in the last 5 years of your investment career. Another version of this rule is that the percentage of your total portfolio in bonds should be equal to your age – so a 25 year old should hold 75% stocks and 25% bonds. This rule is extremely conservative – the chances that a dollar invested in bonds today will, in 40 years, be worth more than an dollar invested in stocks is virtually nil. Having bonds does make it easier to stomach rough patches in the market, though, so if you want a smoother ride and can still meet your retirement goals, it's not a bad rule.
Jeremy Siegel has a nice column explaining why the market is a safe, 6.8% bet if your investment horizon is long.
Portfolio apportionment and balancing
The 100% stock portfolio discussed above is not for everybody. When (not if) the market has a bad day, month, or year, it can be very difficult to watch your savings dwindle and years of gains vanish. If you have stocks in your portfolio, you must be willing to live through the rough patches and recognize that the market will recover. The more stocks you have, the stronger your stomach lining needs to be. Remember that the worst possible time to sell investments is when they're worth the least.
In fact, when they're worth the least is the best time to BUY them. If you invest a fixed amount in fixed proportions every month, you automatically buy more shares of what's cheap and fewer shares of what's expensive among the various components of your portfolio. As long as the market, on average, goes up, you'll take advantage of undervalued funds and buy less of the overvalued ones. This is called “dollar cost averaging” and it reduces volatility.
If the 100% stock portfolio is giving you heartburn and you can't help but fiddle with which funds or stocks you own every few months, or if your investment horizon is only, say, 5 years away, you should probably invest in some bond funds as well for your own sanity and financial well-being. The target date retirement funds listed above start with 5-10% bonds, and increase the fraction as their target date approaches. An oft-recommended split for medium-term investing is a 60/40 stock/bond ratio. This will keep your portfolio more stable and insulate you from volatility, but it will also depress your long-term returns. This balance between high returns and mental health is sometimes called the choice between “eating well and sleeping well.” Make sure you're doing both.
As markets vary you'll notice the fraction of your portfolio dedicated to the portions doing well increase. Every year or so you should “rebalance” your portfolio by selling the well performing funds and buying the others to get back to your target balance. If you have a 60/40 stock/bond split, you'll see that split vary as stocks and bonds appreciate at different rates. If stocks do well, then at the end of that year you'll sell some and buy some bonds to get back to 60/40. In the above stock portfolio, if the international stock fund does great, you'll sell some and buy more domestic fund to get back to the 70/30 split. There's no need to do this too often – once a year at most, and even then only if your balance is off by more than a few percent. As a young investor, if you are dollar cost averaging you probably won't need to do this at all.
Here are some useful interest rate formulae, whose derivations are left as excercises for the reader.
The standard interest rate formula says that the principal, P, grows as one plus the yield, y, to the power of the time invested, t, to a value,
|V = P(1+y)t|
The so-called “rule of 72” is a way of estimating this without a scientific calculator: it says that the product of the doubling time and the yield is 0.72 years. So for a yield of 8% the doubling time is 9 years: after 36 years $1000 becomes $16,000.
OK, maybe you knew that. Here's a better one: for small yields, long times, and an annual contribution P, the final value of your investment is
|(P/y)(1+y)t = V/y|
Very handy. Thus, $1000/year for 36 years at 8% will grow to $16,000/0.08 = $200,000.