Final Four–Asset allocation v. Index mutual funds

Basketball hoop

Welcome to the first game of the Final Four of my investing strategies tournament.  Here we have Asset allocation taking on Index mutual funds.  In the first round, Asset allocation blew out Diversifying mostly due to the higher returns that younger investors can get by investing more in stocks early in their investing career.  Index mutual funds upset Free money on the strength of lower management fees that can apply throughout an investor’s career and across every account type.  As always, check out the disclaimer.  With that out of the way, let’s see who wins.

bracket-game 4

Reasons for picking Asset allocation:

Last round we saw how being too conservative with Asset allocation can really reduce the returns of younger investors who aren’t as heavily invested in stocks as they should be.  If you go to the other end of the investor’s time horizon, when he or she is older and nearing retirement, you can make equally harmful mistakes.

On one end of the spectrum older investors can become way too risky.  As the years tick by and people get closer to retirement, they begin to take stock (pun intended) of where they are probably a little more closely than they did in their 20s or 30s.  If they aren’t quite where they want to be, knowing that on average stocks have higher returns than bonds, one natural response is to allocate more of their nestegg to stocks to “catch up”.  According to generally accepted investing theory, this is the exact wrong thing to do—as we get closer to retirement you should be reducing your allocation of stocks to lower your risk, not increase it.  Here you’re stepping away from the world of investing and into the world of gambling.  Maybe you’ll get lucky and ride a bull market up to get your portfolio back to where you want it, but you’re definitely putting yourself at risk of hitting a market pothole and putting yourself further behind.

On the other end of the spectrum, they can become way too conservative.  Some people have the natural instinct to want to get completely off the investing train in retirement because they don’t want to have any risk, so they put all their money in bonds or cash.  This is understandable because they’re going to be depending on that nestegg, so it’s got to last.  But the problem is that even in retirement, many people still need the higher returns that stocks provide to balance out the relative safety of their bonds.  This is especially true in a world where people are living longer and it’s not unreasonable to expect retirement to last a few decades or longer.  And actually, that time element also makes the case for stocks being a significant part of your retirement portfolio—you have time to ride out the storms, just not as much time as you had before.

These are what make Asset allocation one of the harder investing strategies to get right, because it’s changing over time and there are shades of grey (at least 50 shades of grey).  Other strategies like Diversification and Free money are much simpler because your strategy is absolute.  Diversification—you should be diversified at all times.  Free money—you should get as much of it as you can at all times.  But with Asset allocation, the right thing to do gradually changes from being mostly in stocks during your early years, and then slowly switching to more bonds and cash as you start to near retirement, but never shifting completely to bonds.

There’s no strict rule on what your Asset allocation should be at different stages of life, but I always look at Vanguard target retirement funds as a bit of a guide (although I’ll write about some of my issues with these types funds in a future post).  With 40 years until retirement, right around when you’re first starting out, Vanguard suggests about 90% stocks and 10% in bonds.  Once you hit retirement Vanguard suggests 40% stocks and 60% bonds.  Notice that even in retirement a very significant portion is still in stocks.

Vanguard target date funds % in stocks % in bonds
2055 (40 years to go) 90% 10%
2035 (20 years to go) 85% 15%
2025 (10 years to go) 70% 30%
In retirement 40% 60%


So what does that all mean?  Well early on Asset allocation done properly can get you higher returns over the long run, historically about 3-4% higher than if you completely screwed it up.  Later on, it’s going to help protect you from any market crashes, market corrections, or general market zaniness that occurs.


Reasons for picking Index mutual funds:

We know from the Elite Eight round, that one of the major advantages of Index mutual funds is their lower management fees, which are on average about 1% less than actively managed mutual funds.  We also know from The power of a single percentage that saving 1% of your portfolio year after year can lead to some serious ducats (I’ve decided to use as many slang terms for money over the next few posts, so prepare yourself).  But we’re in the Final Four now so we need something more than that.

Not above a little chicanery, Index mutual funds is going to steal a page from Asset allocation’splaybook.  Often with actively managed funds, they keep a significant portion of the fund’s assets in cash so they can buy an investment when the opportunity presents itself.  Of course we know from above that holding cash over the long term leads to lower returns than holding stocks.  Index mutual funds are able to be almost 100% invested in stocks (or whatever asset class you want) because they aren’t picking investments so much as just following the index.  Just doing some simple math, if actively managed funds have 5% of their assets in cash, and over the long term stocks return 6% more than cash let’s say, that comes to a long term benefit of about 0.3% (5% x 6%).  That’s not going to change the world, but even those little bits compounded over decades can make a huge difference.

Index mutual funds is also copying Tax optimization.  When your mutual fund sells shares there are tax implications on that (death and taxes, baby).  That’s why you get that statement every year from your mutual fund telling you what you need to report to the IRS. The more frequently your mutual fund trades stocks, the more likely it is that you’ll have short term gains which are taxed at higher rates.  But with Index mutual funds, trading is minimized because the fund is only following an index like the S&P 500 which doesn’t change that often.  That leads to lower taxes which we know can add up to some serious cheddar (see, I did it again).

There are also people who argue that Index mutual funds do better than actively managed funds because they take the human element out of it.  This is pretty controversial, and if you believe in the theories from A Random Walk Down Wall Street, which I unabashedly do, then shouldn’t active managers do just as well as a passive index?  Hmmm, that sounds like fodder for another post.  People debate this all the time and I’m not convinced that this really drives the needle.

The final major benefit of Index mutual funds is that they’re super easy, especially compared to some of the more difficult investing strategies like Asset allocation.  You can go to a place like Vanguard (that’s where the Fox family’s money is) or Fidelity or a dozen other places and sign up for one of their index funds, then as Ron Popeil says, “you set it and forget it.”  That means you’re getting pretty incredible value for a relatively small amount of work.


Who goes on to the championship game?

Index mutual funds pulled out all the stops, but in the end Asset allocation was just too strong.  Index mutual funds will definitely help build your nestegg, probably juicing your returns 1% compared to actively managed funds and maybe even 1.5% if you’re feeling charitable.  That’s nothing to sneeze at, but we’re talking about punching your ticket to the Championship round here, people.

Let’s say you completely abandoned the idea of Index mutual funds and went totally with actively managed funds.  How bad would that be?  It wouldn’t be ideal (just my opinion and one not shared by my good friend Mike), but you’d be fine in the end.  Actually this is what millions of people do all the time and it tends to work out.

Compare that worst-case scenario to Asset allocation’s and you see why they won.  Screwing up early on and investing too much in bonds and cash instead of stocks can cost 3-4% on your returns.  That dwarfs what Index mutual funds bring to the table.  Screwing up closer to retirement can put your whole financial plan at risk.  Ask near-retirees who were to heavily invested in stocks before the 2001 or 2008 crashes what they think.  In the immortal words of Winston Zeddemore “I have seen s%$t that will turn you white.

bracket-game 5

With Asset allocation the stakes are just too high.  I have Asset allocation pulling away, 68-59.  Be sure to come back tomorrow to see who they take on in the final, either Savings rate or Tax optimization.

First Round: Starting early versus Tax optimization

Basketball hoop

We’ve made it to the last contest of the first round, and this one is a doozy.  Yesterday we saw Savings rate take down Mortgage.  Today we have a true Kentucky versus Duke-style clash; this is a match of the real bluebloods of the investing world.  As always, check out the disclaimer.  Let’s go to the game.

bracket-game 3

Reasons for picking Starting early:

Starting early is one of the sage pieces of wisdom everyone gives, and for good reason.  The earlier you start investing, the more time you give the incredible power of compounding.  In this way, Starting early is very similar to Savings rate which we saw won the last game.  Because of the compounding the numbers seem to act “funny” (not funny “ha ha,” but funny as in not a way you would expect unless you are an expert in exponential algebra).

So let’s say Mr Grizzly just got his engineering degree at age 22 and wants to retire with $1 million on his 60th birthday.  Similar to the previous examples his starting salary is $50,000 and it gradually increases to $100,000, and he can get a 6% return on his investments.

If he starts saving at age 22, he will need to save about 9% of his salary to get to the $1 million mark by 60.  However, let’s say he can’t start right away, and instead he starts saving at age 30; now to become a millionaire by age 60 he needs to save about 13% of his income.  Wow!!!  By delaying a measly 8 years early on, he has to increase his savings rate about half again what it was.  If he puts it off until he’s 40, he needs to save 25%–that’s doubled his savings rate compared to starting at 30!!!  And if he delays starting until he’s 50, it will require he save about 67% to become a millionaire by the time he’s 60.

Starting age Savings rate to become millionaire by age 60
22 9%
30 13%
40 25%
50 67%


Clearly the earlier you start, the easier it is.  9% of your income isn’t trivial, but it certainly seems manageable.  On the other end of the spectrum, it seems just plain unrealistic to be able to save 67% of your income; even 25% would be a tall order for most.  So everyone can agree it’s better to start earlier rather than later.  Done deal.

But the problem with these types of analyses is saving more comes at a cost.  That $4500 you saved at age 22 (9% of your $50,000 starting salary) meant you couldn’t spend that.  Perhaps that’s not so bad if you were wasting it on clubbing and mani-pedis, but who am I to judge?  But maybe clubbing and mani-pedis are what makes life worth living.  Broadening that out, nearly all of us are making less early in our careers, so how realistic is it for us to be saving right away?

Also, early on you actually have higher expenses like repaying student debt, buying furniture for your new place, buying a work wardrobe, and just kind of experiencing life.  That’s not to say that people can’t be disciplined about those things, but there’s got to be a balance.  I personally started saving about 30% when I first started working and I think maybe I should have traveled a little bit more and enjoyed that time of my life (I was living right outside of New York City after all).

Nonetheless, Saving early is a tremendously powerful force if you can afford to do it.  There’s no doubt in my mind that the Fox family is at a comfortable place right now in large part due to the fact that I started squirreling money away so early.


Reasons for picking Tax optimization:

Taxes are a tremendously important part of investing.  It is a dominant force like Shaquille O’Neal on those LSU teams from the early 1990s.  Taxes impact every facet of investing—whether you’re young or old, no matter the type of account you have (401k, IRA, brokerage, Mortgage).

Shaq in college

Obviously taxes take a chunk out of nearly every financial transaction you do.  What makes Tax optimization so important is that during your earning years, that chunk can be in the 30-50% range, obviously depending on a number of factors like your income and the state you live in.  However, in retirement when you’re income is lower, that tax rate might fall to 10% or even less (of course, as my good friends Rich and Mike pointed out, no one knows what future tax rates will be—I am just assuming that tax brackets remain the same as they are today).  Many of the Tax optimization strategies to some degree involve finding ways to not pay taxes at the higher rate when you’re working, but rather pay when you’re retired and your rate is lower.

Just how big of a deal can taxes be?  Let’s look back at that example from The tax man cometh.  Mr and Mrs Grizzly are ready to save $1000 per month, either in a taxable account like a brokerage account or a tax deferred account like a 401k.  Using a regular brokerage account after 30 years (let’s assume a 2% dividend and a 5% stock increase) they have about $815k—certainly nothing to sneeze at.  However, had they invested the exact same amounts in the exact same stocks but instead in a tax deferred account, they would have had $1.12 million.  That’s almost $300k more, just for Tax optimization!!!

2015-02-16 deferred taxes graphic (qd)

The only difference is when they paid taxes on the money and at what rate.  In a taxable account they were paying taxes on the $12,000 each year at their high-income tax rate (34%) and they were paying taxes on qualified dividends (thanks Rich) at a pretty high rate too.  In the tax deferred scenario, they were paying taxes on the money after they were retired which I estimated at about 2% because at that time their income is only what they are spending.

That’s just one example, and there are tons just like that where Tax Optimization can really add up to tons of money.  There’s no such thing as a free lunch, but this gets pretty darn close.  When you put your money in a tax deferred account, it gets more difficult to access if you need it right away, but that seems a pretty small price to pay compared to the massive benefits of tax deferral.


Who wins?

This clash of the titans was super close.  In the end I have Tax optimization winning on a Christian Laettner-esque (sorry to all my Kentucky friends) miracle shot to push it to the Final Four.

To me I think this comes down between something that is not very complex but involved sacrifice (Starting early) and something that is fairly complex to pull off but doesn’t involve a lot of sacrifice (Tax optimization).  Ultimately, when Starting early you’re taking money that could have been spent on something else and started investing it.  So long as you weren’t planning on setting the money on fire, that will involve a sacrifice.  Conversely if you do Tax optimization you really aren’t foregoing anything, except a little bit of liquidity.  All it is is being smart with taxes and setting up the right accounts.

There are a lot of pretty easy Tax optimization maneuvers like 401k, IRAs, etc., that only take a few hours to figure out and then you’re set for decades.  So you’re getting those huge benefits without a lot of effort.  But Starting early is requiring a fairly significant sacrifice in your early years that could cause quite a sting.  Put all that together and I have Tax optimization coming out on top 83-82.  I have to confess though, I think Starting early would have beaten a few of these other strategies if it had lucked out a little bit in the draw.

Well, that was a wild first round.  I hope you enjoyed this and we’ll see you tomorrow for the first match of the Final Four, Asset allocation versus Index mutual funds.


bracket-game 4

First Round: Mortgage versus Savings rate

Basketball hoop

After a thrilling contest between Index mutual funds and Free money yesterday, we are now pitting Mortgage against Savings rate.  As always, I am not an expert on these matters.

bracket-game 2


Reasons for picking mortgage:

For most families, their Mortgage payment on their home is the single largest expenditure they have.  Also, due to its nature as a commodity, it’s also one of the easiest places to really save a lot of money pretty painlessly.  For a lot of products there’s a trade off between price and quality.  A BMW 325 owner could pay $20,000 less and drive a Honda Civic, but there is a trade-off, either real or perceived, between those two cars.  Sure you’re saving a lot of money, but you’re also getting not nearly as nice a car.

Mortgages are very different because money is a commodity, so there’s no difference.  If you get a Mortgage from Bank of America it acts pretty much identically as the Mortgage you get from Roundpoint (incidentally, the Fox family used to have our mortgage with BofA and now we’re with Roundpoint).  Money is money so here you want to go with whoever can give you the lowest rate (there are some features that might be important like prepayment penalties or ability to refinance within a certain period of time, but in my experience those are pretty rare).

Here we’ll use the Grizzly family as an example; they owe $400,000 on their home.  One of the easiest ways to save money on a mortgage is by refinancing when interest rates go down.  In the past few years, rates have been at historic lows and that means Mortgage interest rates have been similarly low.  Let’s say the Grizzlys got their mortgage 8 years ago with a rate of 6%, but now they can refinance at about 4%.  That alone would reduce the interest payments over the life of their mortgage about $175,000!!!  That’s an incredible amount of money for going through a process that takes maybe a month from beginning to end, and probably about 5 hours of work on your part.  As easy as this is, there are millions of homeowners out there who haven’t done this yet.

You can move a little up the difficulty spectrum and save even more.  Some Mortgages are sold with “points” which is basically prepaying interest; for example you might pay an extra $5000 when you get your loan and for that you would have an interest rate of 3.5% instead of 4.0%.  Points aren’t very well understood and because of that a lot of people tend to stay away, but if you are planning on staying in your house for a long time, they can be the best money you ever spent.  Using that above example, paying the $5000 to get the lower interest rate would net you a savings of about $35,000 over the life of the loan.

Kind of the opposite of points are adjustable rate mortgages (ARMs).  Instead of a 30-year fixed loan (the interest rate stays constant for the 30 year life of the loan) you could get a 5-year ARM where the interest rate is fixed for the first 5 years of the loan and then adjusts based on market conditions for the remaining 25 years.  The benefit of these is ARMs tend to be about 1% less than fixed rates, but the major concern is that rates could rise after the 5 years is up and that could increase the cost of your Mortgage.  In my opinion ARMs make sense if you don’t think you’ll be in your home for very long.

In fact the Fox family got a 5-year ARM when we relocated to North Carolina.  In the here and now we enjoy a rate about 0.8% lower than if we got a 30-year-fixed (our rate is 2.2% and it would have been about 3% with a fixed).  That’s worth about $300 each month.  Rates have been rising, so in 2020 when the ARM starts to float (rates can move) we can either pay a higher rate (remember, we’re still ahead of the game so long as rates stay below 3%), refinance to a fixed mortgage and pocket five years of monthly $300 savings, or just pay off the entire mortgage.  We’ll see.

  What it does?
Refinance Take out a new loan at a lower interest rate to decrease the amount of interest you pay
Buy points Pay more in closing costs to get a lower interest rate
ARM Get a lower interest rate that is fixed in the beginning but then becomes adjustable (usually after 5 years)


So all these seem to be pretty big numbers, especially since you aren’t really giving anything up to achieve them.  But they aren’t going to be quite that big because interest on mortgages is tax deductible, so saving $100,000 in interest on the life of your mortgage may only put you ahead $60,000 because of the tax deduction.  On the other side of the spectrum, you might end up with significantly more if you took those savings and invested them.  Either way, your Mortgage is a great way to pad your nestegg.


Reasons for picking savings rate:

Savings rate is probably the most fundamental element of investing.  You can’t really invest until you have saved some money to invest with (Gee Stocky, thanks for that tremendous insight into what we already know).  And certainly, the more you save, the more you can invest, and the larger your nestegg will become.  But how much can saving more really move the need?

savings rate

The impact can be pretty staggering.  Over a 38-year period, from 22 when most of us enter the workforce, until we turn 60 and hopefully retire, if you invest $100 per month (assume a 6% return) you will end up with about $175,000!!!  It’s not that $100 isn’t a lot of money (it definitely isn’t chump change), but that seems pretty incredible that such a modest amount every month can lead to such a large number at the end of the run.  Over those 38 years, you would have invested a total of about $47,000, and because of investing returns you would have ended up with about 4 times that amount.

And the math works so if you save $200 per month, you end up with about $350,000; $1000 per month, you end up with $1.75 million.  Ladies and gentleman, say “hello” to the power of compounding.


Who wins?

Mortgage gives it a good fight, but in the end Savings rate is able to generate numbers that are so much bigger.  Also, while refinancing at a lower rate is a pretty sure-fire way to save money with your Mortgage, the more complicated maneuvers like buying points or using an ARM do entail some risk which could cost you serious dollars if you move too early or too late.  On the other hand, there is really no way that saving more can hurt your nestegg.  In the end Savings rate crushes Mortgage 65-51.

Come back on tomorrow to see the final match of the first round, Starting early against Tax optimization.


bracket-game 3

First round: Free money versus Index mutual funds

Basketball hoop

After a thrilling first day where we saw Asset allocation blow out Diversification, we are now on to day two where Free money will face off against Index mutual funds.  As always, I am not an expert on these matters.


bracket-game 1

Reasons for picking free money:

Free money is . . . well . . . FREE.  And obviously the more money you can contribute to your portfolio the closer you’ll be to retirement, the better you’ll be able to ride out stock market downturns, and the more financial flexibility you’ll have generally.  I’m not telling you anything you don’t already know.

In the US, by far the most common opportunity for Free money is the company match for your 401k.  Of course, credit card rebates are another nice source of free money, but let’s stick with 401k’s.  Typically it looks something like they will match $0.50 for every dollar you contribute up to 6% of your pay.  And there are some companies that are even more generous; Medtronic has historically matched about $0.90 for every dollar up to 6% of your pay.  Do the simple math and your average 401k match comes in at about 3% ($0.50 * 6%).  Ever since I started working in 1999 I have always contributed at least enough to get the entire company match.

If you do a quick calculation (assume you work from 22 to 60, with a salary that starts at $50,000 and rises to $100,000 over the years, with a 6% investment return), the value of that match is about $350,000.  That’s not what your whole 401k would be worth, that’s just the value of the match!!!  Not bad considering the median nestegg for a 60-year-old living in the US is about $160,000.

So who says no to this?  Sadly, about one-third of employees who have access to a 401k plan are “leaving money on the table” by not contributing up to the amount that their employer will match.  This is some really low hanging fruit that is going unpicked.  I get that there is only so much money to go around, but man, every dollar you’re putting in gets you another $0.50 of FREE MONEY.  That’s a guaranteed 50% return; there are a lot of investors who would give their first born for something like that.


Reasons for picking index mutual funds:

Index mutual funds are mutual funds that mimic an index like the S&P 500, Barclays Bond index, FTSE Global Cap, or the MSCI US REIT index.  That may sound confusing—the point is these mutual funds find an index already established in the market and do their best to copy it exactly.

Index fund advocates, and I count myself among them with probably about 95% of the Fox’s nestegg in Index mutual funds, believe that these funds actually perform better than actively-managed mutual funds (an actively managed fund is one where the mutual fund manager picks individual stocks or bonds that he or she believes will out-perform the general market).  I personally think the data here is mixed to slightly favorable for index mutual funds (mostly because of tax implications), but that is a pretty deep discussion probably for another blog post.  For this analysis, I’ll assume that actively managed mutual funds and index mutual funds return the same amount.

The undeniable advantage of Index mutual funds is their lower management fee.  Like all things, mutual funds charge a fee for their services; it is a percentage that the fund managers skim off the top to pay for managing the fund.  For actively managed funds that fee averages to about 1% with some higher and some lower.  This goes to paying for all the research done, salaries for the different teams, brochures and disclosures, travel to different conferences, etc., and it tends to be a pretty decent chunk of change.  For Index mutual funds, you really don’t need all that because all the team is doing is tracking a pre-existing index; because of this management fees tends to be fairly low—in the 0.05% to 0.2% range.

Remember The power of a single percentage?  We actually called out mutual fund management fees there as ripe for a 1% coupon.  Running the numbers using the same scenario we just used for Free money (assume you work from 22 to 60, with a salary that starts at $50,000 and rises to $100,000 over the years, with a 6% investment return), that 401k account using a index mutual fund with a fee of 0.2% would leave you with about $990,000.  An actively managed account with a fee of 1% would leave you with about $820,000.  That a difference of $170,000 in your 401k over the course of your investing career.

But that’s just for one account.  Index mutual funds can be used for pretty much all your investing accounts—401k, IRA, 529, brokerage.  Also, they can be used throughout for investing career, from the time you open your first account as a youngster all the way through the end when you shuffle off this mortal coil and leave some cash to your loved ones (more cash than you would otherwise because you were paying lower fees).


Who wins?

This turned out to be much closer than I anticipated.  At first I figured that Free money would win this going away, but Index mutual funds definitely came to play.  Free money has a power effect (about 3% of your salary on average), but that is generally limited only to 401k accounts, only to the first 6% of your compensation, and only while you are working.  Even with all those limitations, it makes an enormous difference over your investing lifetime.  Index mutual funds have a smaller impact but a much broader application.  You can use them on every account, with every dollar invested, for every year you’re investing.

In a game that came down to the absolute wire, I think Index mutual funds barely edges out Free money in a Bryce Drew-style miracle finish.  The final score, Index mutual funds 70, Free money 69.  Ultimately I think Index mutual funds and that lower management fee will save more of your money in every corner of your investing portfolio, and that will ultimately lead to a bigger impact on your nest egg.  I hope to see you tomorrow when your Mortgage takes on Savings rate.

bracket-game 2

First Round: Asset allocation versus Diversification

I’ve got my tickets to the Regionals in Charlotte, thanks to my neighbors Mr and Mrs Nittany Lion.  In honor of that I am kicking off the investing strategy tournament to determine which is the single best investing strategy if you could only pick one (which fortunately isn’t the case–you can pick all these).  As always, I am not an expert.  So without further ado, we’ll start with the contest between Asset allocation and Diversification.


Reasons for picking Asset allocation:

Asset allocation is picking the right mix of stocks, bonds, and cash which maximize your investment returns while also limiting that chances that you hit a bad patch of time which cripples your portfolio beyond recovery.  The basis of the concept of asset allocation is the fact that as your expected investment returns increase, so does its volatility.

So for example, cash (or money market accounts) are the least volatile investments around where the chances of you losing money are nearly zero, but they also offer the smallest return at about 1-2%.  On the other end of the spectrum are stocks which historically have averaged about an 8% return, but where about one-third of the years you lost money.  Bonds are between those two, both in terms of returns and risk of losing money.

In my experience screwing up Asset allocation, especially among young investors, is one of the most common missteps.  The conventional wisdom is that you want to take more investing risk when you’re younger because you have more time to “recover” from any market downturns (as was the case with me in 2001 when I was just starting out).  That means that typically (and of course, each individual is different) younger people should allocate more to stocks than bonds or cash.  However, so often I talk to younger investors who have a significant chunk of their 401k in bonds or worse yet, cash.

Why is this so bad?  Well, over a period of decades, the investment horizon when you’re in your twenties or thirties, you end up leaving a lot of money on the table.  Using historic averages, if the 25-year-old you invested your 401k in stocks and your twin invested in bonds, when it comes time to hang up the spurs, it’s no contest—you’re so far ahead of your twin.  Remember that historically, stocks have returned about 8% while bonds have returned 5% and money markets (cash) have returned about 2%.  Just doing some really simple math, the historic difference between stocks and bonds has been about 3%–that adds up to huge differences over an investing career (remember from “The power of a single percentage” how big a difference 3% can make?).  Who knows if it will be like that in the future, but based on history that could lead to hundreds of thousands or even millions of dollars over time.

Of course, you probably read A Random Walk Down Wall Street, so maybe you’re saying, “but when you invest in stocks you’re only getting a higher return because you’re talking on more risk.”  There’s no such thing as a free lunch, and right you are.  That argument is exactly why Asset allocation is so important.  If you were 60 years old and getting ready for retirement, it probably wouldn’t be a good idea to risk losing a big chunk of your portfolio by investing the majority of your money in stocks.  But if you’re 20 or 30 years old, then you can invest in stocks to get the higher return knowing you’re at less risk of a catastrophic loss because you have three or so decades to ride out any storms.


Reasons for picking Diversification:

Diversification is the strategy of picking multiple investments so that you can reduce the volatility of your portfolio.  When some of your investments are down, others will be up.  This is really Investment 101 stuff, and I don’t think you’ll find many legitimate investors who would not say it’s a good thing.  But if you think about it, how much is Diversification really doing to help you achieve your financial goals?

The fact of the matter is that Diversification does not increase your investment returns, on average (“on average” is a critical phrase here).  If that’s true, then why does everyone make such a big deal about Diversification?  Because by diversifying with several stocks you even out the highs and lows that would occur with a single stock.  As an example let’s look at investing in an S&P 500 index mutual fund which is considered highly diversified, and compare that to investing in a single stock.  Here I picked Catepillar because from 1980 to today, it and the S&P 500 had largely the same performance (they were both up about 2300% over those 38 years).

Over that time both investments had their ups and downs, but the difference was that Caterpillar’s ups were much higher and its downs much lower.  Since 1980 (38 years), the S&P 500 index had eight negative years with its worst year being 2008 when it was down 39%.  It also had 13 years where it had a return of 20% or better with its best year being 1995 when it was up 39%.

Now compare that to Caterpillar over the same time, remembering that over the entire 38 years they both had total returns fairly similar to each other.  Caterpillar had 17 years with negative returns, the worst being 2008 when it fell 55%.  On the other side, it had seven years where returns were over 55% (16% better than the best year of the S&P 500 index), with the best year being in 2010 when it increased 90%!!!

So think about that.  If you decided not to diversify and put all your money in Caterpillar back in 1980, you would have ended up in pretty much the same place as your twin who diversified with the S&P 500 index, but you would have had a much crazier ride.  2008 would have sucked for both of you, but much more so for you than your twin.  Also, almost half of your years would have been negative (15 out of 34 years) where it was only about 7 out of 34 years for your twin.  Of course, that would have been offset by some real “bumper crop” years (I had to get a farming analogy in) like 2010 when your portfolio would have almost doubled.  No one is complaining about a year like that, but it that a good thing?

Even recently, with Caterpillar you would have had 2014 and 2015 which were down over 10%, but that was made up in 2016 and 2017 which were both up over 60%.  Meanwhile, the S&P 500 was trudging along at double digit gains.  Holy Cow!!!

How do you plan for something like that?  Pre-2010 you were probably figuring you’d have a moderate retirement, and then 2010 rolled around and life all the sudden got a lot sweeter.  Exact same story after 2015.  Just look at the graph—far and away the most common annual return for the S&P 500 index was the 0-20% bucket; for Caterpillar the returns were all over the board and the most common was -20% to 0%–a loss!!!

And of course, I picked Caterpillar because over the 38 years it was pretty close to the S&P 500.  Remember that if you picked a single stock randomly from a broad index like the S&P 500, you would expect the stock to do just as well as the index, because the index is just an average of a bunch of those stocks.  And it’s true that on average a single stock will do as well as an index, but what if I randomly picked United Airlines which went bankrupt just like many, many other companies do every year (there’s no real chance that the value of the S&P 500 would go down to zero in a similar way)?  Or if I picked Medtronic (one of the greatest companies ever) which outperformed the S&P 500 some 8x?

My personal preference with investing is that I want as much predictability as possible, and that is even tough to come by when you’re highly diversified; when you aren’t diversified, there’s no chance.  Maybe if you like those types of thrills that putting everything into a single stock brings, you may want to think about BASE jumping or free diving.

But assessing it honestly, Diversification does not lead to higher returns on average.  It just reduces the crazy swings up and down.


Who wins?

Asset allocation wins this one pretty easily, 86-59 (I just made that up to look like a basketball game score, but it seems about right).  Diversification definitely helps smooth things out, but Asset allocation can undeniably increase your returns which translates to real money.

bracket-game 1

So Asset allocation moves on to theFinal Four.  Make sure you come back tomorrow to see Free money take on Index mutual funds.

Top 5—investing moves when you’re just getting started

A week ago, my Uncle Lynx passed away.  At the funeral I was chatting with some distant family members (my cousin’s wife’s nephew).  He and his wife are a super cute couple.  They are in their early 20s and just getting started on this crazy journey called adulthood.

As we were chatting, the subject veered towards personal finance (me talking about personal finance . . . imagine that).  This couple’s ears perked up and then seemed genuinely interested; I suppose it’s possible they were just really polite, but I think it was something more.

It got me to thinking about what are the most important things to do in the world of personal finance when you are just getting started.  Here is my Top 5 list:


5. Figure out your debt situation: If you’re lucky, you won’t have a lot (or any) debt.  For most of us there is some out there, and that isn’t necessarily a bad thing.  List out every debt you have (student loan, mortgage, credit card, car payment, etc.), the balance, and the interest rate.

On a spreadsheet (see #4) rank them in order of interest rate.  As a general rule I use a cutoff of about 6%.  If your interest rate is above that pay those off right away, starting with the highest interest rate debt first.  If your interest rate is below that, that might be okay to keep that debt and just make the normal monthly payments.

If you have any debt (especially credit card debt) at any rate higher than 10%, that’s a “debt emergency”.  Really look at every purchase you make—if it’s not critical to your survival (food, shelter) then pass that up until your debt is paid off.  The only exception to this is #1—funding your 401k.

You can get creative with your debt by consolidating high interest rate cards onto a lower rate card or one that offers a low teaser rate.  That could save you a ton of money, and you should probably look into that, but ultimately, you’ll need to pay that sucker off.  So just hitting the grindstone of paying off your credit cards is a must.


4. Make a budget on a spreadsheet: Take a spreadsheet and put a quick budget together that includes your income, your expenses, and the difference between those two.  This can be simple at first (and it should be simple at first).  Over time, you’ll add more and more sheets to the spreadsheet for things like your mortgage, investments, kids’ education, and other things.

But at the beginning, you need to get a sense of where your money is going.  The budget will give you an aspirational view of this.  After your budget is done, you can track your spending with a website like  This two-step process lets you figure where you want to spend your money, and then also look at where you actually spend it.

Of course, this is an iterative process, and as you close a month and look at your expenses, you can see if you’re spending more than what you budgeted.  This isn’t a time to beat yourself up (being too hard on yourself is a sure way to stop looking at your finances closely, and that’s a REALLY bad thing), but a time to ask yourself why you spent more and if it was worth it.

As an aside, using a spreadsheet is a really good skill in general.  I was really good at spreadsheets and it’s hard to overstate the incredible impact it had on my career, as well as the incredible wealth those skills gave me and my family.  And really, my experience with spreadsheets started in college when I was creating a financial budget.


3. Educate yourself on investing: At a young age, educate yourself on investing.  Obviously, this blog is the universally acknowledged best place to learn about investing, but I have heard rumors there are others. is a great website that looks at personal spending and his early posts had a tremendous impact on my outlook.  A Random Walk Down Wall Street is a book on investing that really defined my investing strategy; I read that as a 19-year-old and still think about its insights today.

There are a lot of websites written by millennials about spending and personal finance that might resonate even more.  A few are:,, and  Most are about reducing spending and budgets and that sort of thing, but there are some on the nitty gritty of making investing choices.  You’ll want perspectives on both.

The whole point is that you need to know what you are doing here.  Spending 20 hours early in your life to figure out basics like asset allocation, tax avoidance, and fee minimization as well as a general attitude towards saving early can easily lead to hundreds of thousands or millions of dollars.  That comes to about $50,000 per hour—not bad.


2. Start an IRA with $1,000: This is as much about the experience gained as it is about actually investing your money.  Vanguard lets you start an IRA with $1,000 as the minimum amount.

You’ll navigate through their website, figure out how to make choices (like Roth or Traditional IRA—go traditional).  You’ll pick your investments, and then you’ll have something to look at every once in a while to see how it’s doing.

So many people are just at a total loss when it comes to setting up accounts for their investments.  That becomes a real problem once you hit 30 or 40 and you’re starting to get behind the 8-ball; you know you need to do something but are kind of clueless on where to start.  Doing it now lets you get your toes wet in this world and makes the next accounts you need to set up (529, 401k, brokerage, etc.) all the less daunting.


1. Get the company match on your 401k: #2 was more for experience than for investment.  Here is where you should start walking down the path for investments.  At a minimum, contribute the match and take the free money.

This is so important for a couple reasons.  First, you’re getting that free money.  Second, you’re making your first “asset allocation” decision.  When it comes time to pick which fund to invest in, unless you have very unique circumstances for an early-20s person, I would definitely go with a 100% equity index fund.

Third, your 401k is a really powerful tool.  If you had no other investing tool, you could still grow a 401k to well over a $1 million during your working career.  That is enough to fully fund your retirement.


BONUS—Stay poor:  Too many young adults make a huge mistake of trying to mimic the lifestyle their parents provided, once they (the young adults) get out of school.  That first paycheck of $2,000 is going to seem like a ton of money (and it is).  It’s really tempting to decide to buy a new car or go on a kickin’ vacation or upgrade the furniture.  Resist the urge.

Your parents took 25 or more years of working (with pay increases and investment returns) to provide the house and cars and vacations you enjoyed your senior year of high school.  It’s not realistic to think you can have stuff at that level of niceness so early.

A car is a really good example.  In general, automobiles are horrible investments.  To the degree you have a car that can get you from point A to point B, keep it.  A new car will be nice and cool and make your friends gawk, but it’s a horrible use of money.  A couple hundred dollars a month for a car, plus insurance, and maybe $50 for a gym membership, $50 for cable, and $80 for four dinners at a restaurant—those numbers add up.  Those alone could fund your savings in the early years.

Your early 20s are a time when it’s still okay not to have the best and nicest of everything.  If you can embrace that, even when you do have the money, and put that extra money to work in investments you’ll build a very strong financial foundation that will afford you many more opportunities are you reach your 30s and 40s (remember, I did that and I retired at 36).

Investment returns on our solar panels

If you are a loyal reader, you’ll remember that two years ago this month we made a 5-digit purchase.  Foxy and I installed solar panels on our new North Carolina house.

Two years later, let’s look at how that “purchase” has performed as an “investment”.  To save you the suspense (Hey, I appreciate you’re busy and may not have the time to read this whole post), I’ll give the investment a solid mediocre to slightly below mediocre—about a 4% return.


Sweet, free electricity

We bought an array of twenty 265-watt solar panels.  At the time, when we were talking to the sales guy and we factored everything in—the number of sunny days in our area, the pitch and direction of our roof—we thought we were going to be getting about 550 to 600 kWh each month.  As it turns out, we’ve averaged slightly less than 530 kWh per month.

That’s a bit of a miss that translates to real money.  With our electric utility in North Carolina (Duke Energy), when you factor in taxes, fees, and everything we pay about $0.10 per kWh.  Quick math shows you our panels save us about $53 each month.  However, that’s 20 to 70 kWh less than we thought, and that translates to about $2 to $7 less per month that we are getting than we expected.

That said, we’re generating a lot of “free” and green electricity each month.  As you would expect, our electricity varies widely with the seasons—higher in winter because of the furnace and summer because of air conditioning and lower in spring and fall.  If you average everything out, we use 1,100 kWh each month, so those panels are addressing about half our usage.  That actually seems pretty decent.


By the numbers

But you know me—words like “pretty good” and “decent” don’t cut it when we’re talking about real money and investments.  Let’s dive into the nitty gritty to see how this works has an investment.

The whole set up cost $17,700, however our net cost was significantly less.  For paying in cash we got a $1,100 discount.  We also played credit card roulette, and that knocked our price down another $1,400.  Finally, the biggest discount was the federal tax credit; solar panels allow for a 30% tax credit so that knocked another $5,700 off (we only got that when we filed out taxes the following year).  Net all that out, and our panels cost $9,700.

For a $9,700 “investment” we got our electricity bill reduced by about $53 each month.  If you do the math, that’s right at 4.0% return.  If you’re curious, without the $1,400 credit card roulette the return would have dropped to 2.8%.

A 4% return isn’t very good.  It’s a far cry from the 20%-ish annualized return the stock market has blessed us with these past two years, so that’s a bit of a miss.  However, that’s not entirely fair to compare something like solar panels to the stock market.

Probably a better comparison would be a bond—we pretty regularly use electricity and those solar panels pretty consistently generate 530 kWh each month (the highest we get is in June at about 800 kWh and the lowest is in January at about 200 kWh).  That 530 kWh is worth $53 each month, so that “feels” a lot more like a bond.  Given the warranty on the solar panels is 25 years, I think it’s safe to assume we’ll continue to get that electricity generation for a really long time.

So we bought a $9,700 bond that pays us a monthly dividend of $53—a 4% return.  That’s where I’ll give it a solid “decent”.  In this market, 4% is a fairly decent return for a government or corporate bond: long-term Treasuries are yielding about 2-3% and investment grade corporate bonds maybe 4-5%.  We’re right in that mix, so that’s okay I guess.  Of course, I would have liked more (and thought we were going to get more), but that’s the way it is.

There is a bit of an ace in the hole that makes this a bit brighter.  That 4% assumes that electricity rates stay at $0.10 per kWh, which is where they’ve been the past two years.  Electricity rates have historically risen in the 2-3% range (although they didn’t this year specifically, I believe, because I invested in solar panels and the investing gods wanted to humble me).  If you assume a 2% electricity rate inflation that return bumps up to 5.6%.  That seems a little bit better.

As an aside, when I run for government office I am going to propose a nice little tax break financed solely by increasing electric rates.  Between solar panels and LED lights, we can definitely reduce our electricity usage with minimal sacrifice.  I cringe when I see incandescent light bulbs at someone’s house or in a store.  A 5-watt LED bulb can generate the same brightness at a 60-watt incandescent bulb.  Over the 20 life of an LED bulb, there is a electricity savings of about 1,000 kWh ($100).  In case you’re curious, that’s a 251269% return (I’m not kidding, that’s a real number) on investment just changing your old bulbs to LED bulbs.


The intangibles

So as an investment I think the solar panels are a bit mixed.  We’re getting 4% with the chance that it increases a bit.  It’ll never be anything magical that rivals the stock market.

However, there is another piece that is important—the “green” perspective.  In these two years, our solar panels have generated a total of about 12,000 kWh of pretty much pollution-free electricity.  Given that Duke Energy still generates most of it’s electricity from coal plants, that has a positive carbon footprint.

Using back of the envelope math, that’s about 7 TONS of carbon dioxide that isn’t in the atmosphere.  Basically, we’ve offset both of our cars, plus two of our neighbors’ cars.  I don’t know how you personally value that, but that’s what you’d have to do to make the solar panels make sense in your head as a good investment.


The other day Foxy Lady and I were chatting about home improvements (she desperately wants a pool), and the solar panels came up.  She asked me what I thought about the decision.  I thought for a few seconds and said I regret doing it.  The electricity generated was a bit short of what I had hoped, and the return was therefore below expectations.

I do think solar panels are the wave of the future.  Right now, unless you are totally green, the federal tax incentives are a must for them to even be a consideration.  You never know when they will end, and back in 2016 I think I had a bit of “get on the bus before it leaves” mentality that made me pull the trigger maybe sooner than I should have.

I know panel prices have gotten better (more kWh per panel) and prices have fallen, so I think if I was able to do it at current prices the return might be a bit better, but it’s still going to be in the 5-6% range.