Should you invest in gold?

Long before there were ever stocks or bonds, the original investment was gold.  Heck, even before there was paper currency or even coins, gold was the original “money”. 

That begs the question, What role should gold have in your portfolio?  If you don’t want to read to the end, my quick answer is “None”.  However, if you want to have a bit of a better answer, let’s dig in.

Gold as an investment

Just like stocks and bonds, gold is an investment.  The idea is to buy it and have it increase in value.  Makes sense.  And historically, it seems to have been a good one—back in 1950 an ounce of gold was worth about $375 and today it’s worth about $1300.  Not bad (or is it???).

However, there is a major difference between gold (and broadly commodities) as an investment compared to stocks and bonds.  Gold is a store of value.  If you buy gold it doesn’t “do” anything.  It just sits in a vault collecting dust until you sell it to someone else.

That’s very different from stocks and bonds.  When you buy a stock that money “does” something.  It builds a factory that produces stuff or it buys a car that delivers goods or on and on.  What ever it is, it’s creating something of value, making the pie bigger.  That is a huge difference compared to gold, and it’s a huge advantage that stocks and bonds have over gold.  You actually see that play out by looking at the long-term investment performance of gold versus stocks.

Golden diversification

Statistically speaking, gold gives an investor more diversification than probably any other asset.  We all know that diversification is a good thing, so this means that gold is a great investment, right?

Well, not really.  Stick with me on this one.  Gold is negatively correlated with stocks (for you fellow statistics nerds, the correlation is about -0.12).  Basically, that means when stocks go up gold tends to go down, and when stocks go down gold tends to go up. 

Over the short term, that’s probably a pretty good thing, especially if you want to make sure that your investments don’t tank.  In fact, that’s one of the reasons gold is sometimes called “portfolio insurance”.  It helps protect the value of your portfolio if stocks start falling, since gold tends to go up when stocks go down.

However, over the long-term, that’s super counter-productive.  We all know that over longer periods of time, stocks have a very strong upward trend.  If gold is negatively correlated with stocks, and if over the long-term stocks nearly always go up, then that means that over the long-term gold nearly always goes (wait for it) . . . down.

That doesn’t seem right, but the data is solid.  Look back to 1950: an ounce of gold cost $375.  About 70 years later, in 2019, it’s about $1300.  That’s an increase of about 250% which might seem pretty good, but over 70 years that’s actually pretty bad, about 1.8% per year.

Contrast that with stocks.  Back in 1950 the S&P 500 started at 17, and today it’s at about 2900.  That’s an increase of about 17,000%, or about 7.7% per year.  WOW!!!

Just to add salt in the wound, inflation (it pains me to say since I think the data is suspect) was about 3.5% since 1950.  Put all that together, and gold has actually lost purchasing power since 1950.  Yikes!!!

A matter of faith

Fundamentally, if you have faith that the world will continue to operate with some sense of order, then gold isn’t a very good investment.  So long as people accept those green pieces of paper you call dollars in exchange for goods and services and our laws continue to work, gold is just a shiny yellow metal.

However, if society unravels, then gold becomes the universal currency.  The 1930s (Great Depression), the 1970s (OPEC shock), and 2008 (Great Recession) were all periods where gold experienced huge price increases.  Those are also when the viability of the financial world order were in question.  Each time, people were actively questioning if capitalism and banks and the general financial ecosystem worked. 

People got all worked up and thought we were on the brink of oblivion.  Gold became a “safe haven”. People knew no matter what happened, that shiny yellow metal would be worth something.  They didn’t necessarily believe that about pieces of paper called dollars, euros, and yuans.

Yet, the world order hasn’t crumbled.  Fiat currencies are still worth something.  Laws still work, so that stock you own means that 1/1,000,000 of that factory and all it’s input belongs to you.  Hence, gold remains just a shiny, yellow metal.  

The bottom line is that stocks have been a great long-term investment, and gold hasn’t.  And that’s directly tied to the world maintaining a sense of order.  So long as you think that world order is durable and we’re not going to descend into anarchy Walking-Dead style, then gold isn’t going to be a good investment.

So the survey says: “Stay away from gold as an investment in your portfolio.”

The Fox family’s 2018 investment performance

2018 was an “interesting” year for stocks.  Everyone wants to think “this one was different” but 2018 did seem to be pretty crazy. 

We had some wild swings pretty much the whole year: from January to December.  Going into December, I was marveling at what a genius I was with my prediction from the beginning of 2018 that the market would be up about 5% for the year.  Going into December it looked like I was going to be spot on . . . and then the bottom fell out of the market and you have where we are now.

Our stock performance

Just like most everyone else, we had a down year.  Of course, since we only invest in index mutual funds, by definition whatever the market did is the return we got.

Investment Ticker % of total portfolio 2018 return
US stocks VTSAX 50% -8%
Int stocks VTIAX 45% -18%
REITs VGSLX 5% -12%
TOTAL -12%

We were down 12%, and obviously that sucks, but . . .   There’s really no “but” so let’s not try to sugarcoat it, but maybe there is a silver lining.  Since the Great Recession in 2008, stock were up about 150% (about 11% annually) and had a 10 year winning streak. 

Dark blue was US stocks (down 8%) and light blue was International stocks (down 18%)

This year we had a down year, so it’s a bit hard to complain.  Historically, stocks are down for the year about 30% of the time.  We were probably due, so we shouldn’t get too greedy.  Still, it isn’t fun to go through a down market, but that’s life.

Notice any changes?

We also made a few simplifying changes to our portfolio starting in late 2017 and continuing into 2018.  At the end of 2017 we sold all our commodities as I discussed here.  In 2018, we also exited our Lending Club investment which was also a disappointment (although not nearly as bad as the commodities). 

That took us from five investments (US stock index fund, Int stock index fund, REIT fund, commodities ETF, and Lending Club) down to three.  If you remember the post on Three Investing Ingredients, I was getting closer to following my own advice.  The only thing still there was REITs.  In late 2018 we finally sold those off, so as of now, we are totally following the Three Investing Ingredients.  It’s nice to get back to basics.

At the beginning of 2020 when you read about how we did in 2019, there should only be two investments.

Inflation

The other thing I always look at at the end of the year is inflation.  US inflation came in at 2.4%.  It’s been inching up steadily over the past few years, and now it’s the highest it’s been since before the Great Recession.  Even so, 2.4% is still incredibly low.

We spend a ton of time talking about the impact inflation will have on your portfolio.  A few years back I even wrote almost a love note to the investing gods for 2015 being a no-inflation year.  The fact that inflation remains very tame compared to historical standards—I use 3% as a target for inflation—means we’re ahead of the game.

Wrapping it all up

Let’s chalk up 2019 to a crazy year and a “bad” year.  But we know sometimes we have bad years.  In the grand scheme of things it definitely could have been worse.

MY 2019 PREDICTION—I think our new normal for the next several years will be a lot of volatility, like we saw in 2018 and so far in 2019.  I never like trying to predict the stock market, but it just “feels” like we’re in for another down year.  I predict down 7%.  Of course I’ll use this as an opportunity to keep socking money away and buy stocks at prices that in 10 years will look bargains.

Will you lose money with stocks?

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This is probably the most common question you get from people who are considering starting to invest in stocks.  It’s pretty understandable; you work hard for your money and the idea of it disappearing into the black hole of an unpredictable and often times not-well-understood stock market is pretty hard to stomach.  Add on that scars from the 2008 Great Recession, 2001 Internet Bubble, Black Monday in 1987, Black Tuesday in 1929, and on and on and on.  Even recently, 2018 has had a bunch of wild freefalls, including the one we’re in right now.

So, what’s the answer to the question:  Who knows?  The stock market is unpredictable and no one knows what will happen in the future.  That’s not an especially satisfying answer, but it’s the truth.  If I could predict the stock market I would own my own island in the Caribbean next to Johnny Depp’s.

But I can hear you saying, “Come on, you’re Stocky Fox.  You can do better than that.”  You’re right.  I’m taking on the challenge and answering the question: Will you lose money with the stock market?

I won’t try to predict what will happen in the future, but I think you can look to how things have behaved in the past, and get a pretty good perspective.  Of course, there’s no certainty that the future will be like the past, but that’s the best we have to look at.

You can get somewhat decent data on the stock market going all the way back to 1871.  Back then, your great-great-great grandmother was getting The Stocky Fox as a newsletter delivered by the Pony Express.  Going that far back, you can calculate the percentage of the time that you would have lost money investing, historically.

So imagine starting in January 1871 and investing $10 every month in the US stock market.  By January 1872, you would have invested a total of $120 and your stocks would be worth $128; congratulations, you just made a profit.  You can do that for every 12-month period since 1871 (there are about 1700 such periods), and you come out ahead 71% of the time, which seems pretty good.  But the flip side is that you’d have lost money 29% of the time, and at least to me that is too high to be really comfortable.

Chart for losing money

However, remember that when investing stocks, time is on your side.  Do the same exercise but for five years; if you started in January 1871 after 5 years you would have invested a total of $600 which would be worth $679 in January 1876 (yeah, profit again!!!).  Do that for every five-year time period and you end up losing money only 13% of the time.  By adding another four years to your investing time horizon that decreased the chances that you would have lost money by 20%!!! That seems pretty amazing.

You can keep doing that for longer time periods, and as you could guess, the percentage of times you would have lost money keeps going down.  Astoundingly at the 20-year mark, you would have lost money only one time out of the nearly 1500 periods possible (the one month was June 1912 which, you guessed it, was 20 years before the Great Depression bottomed out).  At 30 years, there isn’t a single time period where consistent investing would have lost money!!!  That’s not a misprint.  Read that paragraph again.

There are no guarantees, but if you use history as a guide, it’s pretty much a sure thing that you’ll make money in the stock market.  Certainly it involves a lot of discipline, investing month after month no matter how bad things look (dollar cost averaging).  Also, it doesn’t necessarily mean you always make a lot of money, but the data seem pretty powerful.  Additionally, I didn’t take inflation into account so that would definitely skew the numbers downward (but you know how I feel about the integrity of the data on inflation, so there you go), but the message remains largely unchanged.

I must confess that I was a bit surprised by the data.  Actually, I spent about 30 minutes going through the spreadsheet to see if I made any mistakes; I’m pretty confident the analysis is sound.  As Dr Brown asked Marty in Back to the Future, “Do you know what this means?” (just don’t take what he says after that and apply it to my analysis).  If your time horizon is 20 years or more, at least based on history, there’s virtually no chance that you’ll lose money.  I figured it would be a pretty low chance, but zero chance?  I didn’t see that coming.  Even people who invested for 20 years then pulled out after the Great Recession in 2008 did fairly well (invested $240 which became worth $339).

So there you go.  My answer to the question posed at the top is still: No one knows what the future holds.  But the historic data confirms my personal belief that the stock market is a really great place to invest your money.  I lose no sleep worrying about the Fox family’s investments increasing in value.  I know over the long term they will.

Light at the end of the tunnel for Bitcoin?

Last year about this time, the nation was gripped in Bitcoin-mania.  It was dizzying.

As with most bubbles, it transcended financial markets and wormed its way into the mainstream. Everyone was talking about it, from late-night talk show hosts to grandmothers and everyone in between.

I wrote my thoughts on the matter here.  Just after that post, Bitcoin rose another 10% and then cratered precipitously.  I predicted its decline would result from it being connected to a terrorist attack and world governments using that as a pretext to extinguish it.  As it happened, it just seems that the bloom fell off Bitcoin’s rose.  Sometimes financial markets are fickle.

In 2017 Bitcoin rose from about $1000 to a peak of almost $20,000.  As fast as the rise was, the fall has been nearly as fast; from $20,000 to about $4000 today.  But this post isn’t a victory lap—Bitcoin bears were clearly proven right, so what’s the point of adding on there?

The point of this post is to give a little bit of love to Bitcoin.  I wouldn’t say I’m making a bullish bet on Bitcoin (I certainly haven’t bought any, and have no plans to).  However, here is an argument why it may not be doomed.

You can actually buy stuff

The biggest problem for Bitcoin was that it had no intrinsic value.  That’s not a deal-breaker: fiat currencies (dollars, euros, yuan, etc.) are only valuable because their home countries say they are and pass laws that you can use those pieces of paper to pay for stuff (more on this in a second). 

Without that government backing, Bitcoin becomes a bit like gold or diamonds, inherently worthless pieces of stuff but are valuable because enough people in the world think they are valuable.  Of course, a big difference is that you can hold gold or a diamond, but not so much with Bitcoin.

In December 2017 enough people thought Bitcoin had value that it pushed the price to $19,000. Today, many fewer think it is valuable so it’s worth much less, hence the $3400 price.

Through it all, Bitcoin was missing a major component of a currency (like a dollar) or even a store-of-value commodity (like gold)—you couldn’t buy anything with it.  I don’t think you would have had near the crash (and probably not the run-up either).

Until recently, you could only buy stuff with Bitcoin on the fringes of the economy.  Certainly, the black market accepted it, but that’s not exactly what we’re going for.  A very small handful of regular stores(virtual or brick-and-mortar) did, but that was minuscule.

That may be about to change in a profound way.  The state of Ohio recently announced that you can pay your taxes using Bitcoin. It’s hard to understate the importance of this.  Paying taxes, by definition, is about as legitimate a transaction as there is. All the sudden Bitcoin is a legitimate currency, at least to the state of Ohio.  To compound the point, I don’t believe you can pay your taxes in Ohio in euros or yuan (undeniably currencies)or gold or diamonds (undeniably stores of value).

How will this impact Bitcoin’s price

Now that Ohio will accept it, that will create a real market for Bitcoin.  That begs the question,what will that do to the price?  You should expect my normal answer: I have no idea. But I do have some thoughts.

Bitcoin’s price has been in freefall for months now.  This was caused in large part by the tiny, tiny issue of Bitcoin not being used anywhere. Now that has changed.  I still think Bitcoin could go down, but I definitely think it will not go down as much as it would have if Ohio hadn’t made it’s decision.  It’s impossible to know if I’m right or wrong on that, since we can’t test things in alternate dimensions.

It’s not to say Ohio is getting in the Bitcoin game.  It just takes the Bitcoin payments, sends them to a market to get exchanged into dollars, and they have their money.

Ohio has taken the first step and it’ll be interesting to see if any other states follow suit.  If a large state like New York, Texas, or California also starts accepting Bitcoin, I think that will definitely buoy it’s value as it becomes even more of an accepted currency.  And of course the coup d’etat would be the Federal government accepting it.

Overall, I still think Bitcoin will be volatile, probably to the downside.  However, I do think maybe we’ll back in five years when Bitcoin has settled to something of value,probably less than $4000, and look at this Ohio decision as the first step towards that stabilization.

Top 5 investing highlights from 2018

We’re all getting used to me going for extended periods without writing a blog post.  I’m sorry about that, but I’ve had a consulting job for the past couple months that has been keeping me busy.  It’s starting to wind down, so I should have more time to consistently write posts.  As always, thank you for sticking with me.

 

Wow!!!  It’s been a crazy few months in the stock market since I’ve been gone.  I figured for my first blog back I would give you my list of the craziest/most interesting things to happen in the investing world the past few months.  Some of these deserve their own post, so we can dive deeper into those in future posts.

Without further adieu, here are my Top 5 investing highlights since April:

 

5. Interest rates on the rise: 2018 has been the year of the interest rate increase by the Fed. In response to the 2008 financial crisis, the Fed cut interest rates to nearly 0%.  There they stayed for nearly the entire 8 years of the Obama administration.  It was only in December of 2015 that the interest rate was raised to 0.5%.

Since 2015, there have been 7 rate increases (including 3 so far in 2018), bringing the Fed rate to 2.25%.  This stuff makes finance nerds giddy, but it does have real-life impacts on the rest of us.

I think the biggest direct impact is that mortgage rates have started to go up.  Now a 30-year fixed mortgage is at about 5%.  A couple years back it was at 3.5%.  That’s a major change that could mean hundreds of dollars per month on a families mortgage.  This impact stretches to housing affordability (gets worse) and number of families refinancing (goes down).

 

4. Massive tax law passes: I know the big tax law passed in December 2017, but I feel a lot of the ramifications hit in 2018. By mid-year it seemed the impact was starting to hit the market—GDP growth was higher than it had been in a really long time, unemployment was lower, and because of the low unemployment inflation had kicked higher.

The immediate impact of the tax break had a major boost to the markets in late December and early January.  Then there was a huge market drop in late January and early February.  However, it seemed that the benefits of the tax breaks (higher GDP, lower unemployment) started boosting stock, with the US markets hitting all-time highs in September.

Obviously, since September stocks have been on a major slide, but we’ll leave that for reason #1.

 

3. US elections in November: Politics are different from investing, but obviously they are connected. The soap opera that is Washington DC hit a fever pitch on November 6, with an unusually high amount of drama for a off-election.

Republicans increased their majority in the Senate, while Democrats gained enough seats in the House of Representatives to take over that chamber of Congress.  The headline was obviously that the US would have a split government for the next two years.

Pundits spent innumerable hours debating the impact split government would have on the nation broadly and the investing markets in particular.  The common thinking is that split government is a good thing in that government can’t make major changes, giving some level of predictability for business.  I tend to agree with that.  In fact, when you look at the data, the stock market does best with a split government.

In case you were curious, the market was up 2.1% the day after the elections, so clearly the markets liked the outcome of the election.

 

2. America is #1: I had a blog on this a while back, but I’m still fascinated by this phenomenon. As of now, US stocks are down 2.2% for the year while international stocks are down 14.2%.  That’s a 12% difference!!!  That’s huge!!!

Curiously, they stayed fairly coorelated all the way through April.  Then, starting in May, they really began to diverge.

The reasons aren’t entirely known.  Many people have many opinions, and I imagine this will be examined for years.  However, my belief is it’s a combination of the US winning the trade wars, China’s economy slowing down, and Europe figuring out Brexit and the future of the EU.

Who knows if I’m right or wrong.  But certainly this is interesting.

 

1. The rollercoaster that is the stock market: It has been a wild ride all of 2018.

January started out on fire, then the stock market took a huge dump in February, rallied towards the end of the month, fell again in March, then plodded out a 8-month upward march that peaked in September, and has since fallen to its current levels.

Those a 6 distinct moves, all of which are major.  I’ve talked about how I think volatility is becoming more inherent in the market, so I think that’s a piece of it.  But the change of directions this dramatic is definitely an unusual twist.

And we still have a month to go.  Stay tuned.

First half of 2018—much ado about nothing

I wanted to write a recap of the stock market in the first half of 2018.  It’s taken me a little while to get to it because I actually have a job that I’m working on.  Sorry about the delay, but here it is.

 

At first blush, you might think that the stock market has gone crazy.  I don’t know if you can objectively measure things, but it seems the media which has always been in a frenzy the past decade or so, has gone into overdrive lately.

Obviously there are the big rocks like: school shootings and gun control, the #metoo movement, the eternal Russia meddling probe, the North Korea talks, the retirement and impeding replacement of Justice Kennedy, and the separation of families of illegal immigrants.  There are probably more but those are top of mind.

Most of those are social issues, but they have major economic components.  The gun control debate will have a profound impact on gun manufacturers, many of whom are publicly traded.  #metoo has forced the resignation of several business leaders.  North Korea and Russia talks impact trade and possible war with mass destruction, which of course has a hugely negative impact on the economy.

And this misses the most exciting/depressing/entertaining news item (depending on your persuasion): President Trump.  He alone creates enough material to fill the 24-hour news cycle.

 

US Stock Market . . . happy yawn

So with all this, what has happened with the stock market.  Despite a few gyrations, it’s been fairly stable over a long-term point of view.  It had a  great January (continuing the really strong momentum from 2017), and then things peaked.

There are a few important takeaways.  First, there were a couple huge drops at the end of January and the end of March, but we recovered from those fairly steadily.  Second, we are now at where we were when the stock market peaked in January.  Third, remember that all this 2018 performance is coming on the heels of a spectacular 2017.

All things considered, that seems pretty good.  The market is up 4% so far for the year.  Maybe that seems a bit dissatisfying because it’s been flat since the peak in late January, but up is still up.  Let’s not look a gift horse in the mouth on this one.

 

International Stock Market . . . interesting

What I think is most interesting is that since May the US stock market has marched higher while international stocks markets have gone the other way.  Look at the chart for 2018 so far.

Most of the time, US (blue) and International (orange) stocks tend to move in sync.  Sure, there are always small differences, but by and large when one goes up the other does too and vice versa.  That was the story for sure for the first part of 2018.  Then something happened in May; since then US stocks have marched upwards about 6% while International stocks have fallen about 3%.  That’s a 9% difference!!!

I’ve racked my brain, and I don’t have a clear reason.  Sure, the North Korea situation continues to be goofy.  Italy elected an anti-immigration government that turned a boatload of refugees away.  Brexit unfolds like a car wreck in slow motion.  Syria, Russia, Venezuela—all the usual suspects.  But what has changed in the past couple months that has been so good for the US and so bad for the rest of the world?

The only thing I can really think of is the trade war Trump has initiated.  Typically in these there are winners and losers, so maybe the market is predicting that the US will “win” this and the rest of the world (especially the developing markets since those stocks are down the most) will “lose”.  There are a ton of complications and nuances and a million different things could happen, but that’s the best I could come up with.  I guess we all need to stay tuned.

Either way, what is going on right now with such a disparity in the performance of major stock indices is not common.

 

If you put that all into the pot and mix it, things have gone pretty well for the investor.  That seems a bit different from the constant news stories about how the world is on the brink of disaster, but that goes to show you that long-term investing washes away a lot of those shorter-term swings.

As always we are and have been fully invested in this stock market.

Problem solved: Race Relations

We are living in a country where race relations are at a multi-generational low.  Despite decades of approaches and policies meant to improve things, up to this point it doesn’t seem to have gotten better (it actually seems to have gotten worse).  Maybe personal finance can move the needle?  Admittedly, personal finance isn’t going to solve every issue, but I think it is uniquely positioned to make a major impact, all the while without redistributing wealth in a way that makes it a dead-on-arrival policy.  Let’s dig in:

 

Income (and net worth) inequality

Data show that there is a huge difference between the haves (whites, Asians) and the have-nots (hispanics, native Americans, and blacks).  Just for simplicity, for the rest of this post we’ll contrast the black/white differences, although this entire post could easily be about black/Asian or hispanic/white or hispanic/Asian and the concepts would be nearly identical.

Race Income (2015) Net worth (2013)
Asian $80,720 $112,250
White $61,349 $132,483
Hispanic $46,882 $12,458
Native American $39,719 N/A
Black $38,555 $9,211
TOTAL $57,617 $80,039

 

The median income for whites is $61k and the median income for blacks is $39k.  That’s a big difference, but the difference becomes even more pronounced when you look at net worth–$130k for whites and $9k for blacks.

The income disparity gets A TON more press than the net worth disparity, and that’s a big miss.  You don’t eat income or use income to buy a house or pay for college: you use net worth for that.  Obviously they are closely related, yet they are different, and the data shows just how uncorrelated they are.

Racial challenges are multi-dimensional, very complex, and nuanced.  There’s no single path to address all of them, but I think you get the biggest bang for your buck by closing the income/net worth gap.  Obviously, by definition, closing the income gap addresses the income gap (incredible insight there, Stocky) and also goes a long way in addressing the net worth gap.

It also addresses a lot of other racial issues: interactions with law enforcement—police have infinitely fewer negative interactions with rich people than poor people. Education—rich people have much better access to high-quality education at every level than poor people.  Healthcare—exact same statement as education.  Political voice—exact same statement as education.  And on and on.

So the challenge is how to increase the income, and more importantly the net worth, of blacks to get it closer to the levels of whites?

 

Net positive, not sum-zero

This becomes a delicate subject.  An obvious solution is wealth distribution based on race.  To address the net worth issues, we as a society could tax white people and give those proceeds to black people.  This actually has a name: Reparations.

Michigan congressman John Conyers had introduced a reparations bill in every Congress since 1989.  Every single time, the bill never came to a vote and “Died in a previous Congress”.  Given it didn’t even have the support to come to a vote it’s hard to imagine having the support to pass both houses of Congress and get the President’s signature, plus withstand the legal challenges.   I would certainly be opposed to such legislation.

While people can have a lively debate about reparations in particular, they are extremely unlikely.  Broadening that out a bit, I think the idea of punishing/taxing/taking away from one race of people to give to another just isn’t realistic or moral.

That speaks to net worth disparity (give net worth from one race to another), but there is a similar train of thought on income disparity.  We could take certain high paying jobs and force companies to employ blacks but not whites.  This again causes similar challenges.

Actually, this played out in real life recently at Youtube.  Allegedly, they excluded white and Asian men from consideration for some roles.  I’m not certain to the legality or illegality of this, but from a PR perspective this is a practice that Youtube (they are owned by Google) vigorously denied.  They said they hire “candidates based on their merit, not their identity.”  If a private-sector company in an at-will state won’t publicly say they do this, there’s zero chance such a practice would be codified with legislation.

Getting back to the task at hand, that means we can’t address the income and net worth gap by taking from whites and giving to blacks.  We have to find a way to increase the income and net worth of blacks that has no impact (or dare I say a positive impact) on whites.

 

It’s what you do

If you read this blog, you know I am an enormous advocate of personal finance, and “doing the right thing” with your money, whatever that means.  We live in a country with very low financial literacy, which means that people don’t really understand concepts of compound interest, appropriate asset allocation, tax avoidance strategies, and much more.  That applies to all races.

That ignorance comes at a huge cost.  Take two twins, Bill and Jill.  Bill represents your average American who isn’t too financially savvy, while Jill knows the best ways to invest her money.  If they are identical in every way—same job, same salary, same income growth, etc.—Jill will end the game much, much wealthier than Bill.

Just to put numbers to it, let’s assume they each start at 22 with a $50,000 job that grows to $150,000 over time, and they save 10% of their income.  At age 60 Bill would have $630,000 and Jill would have $2,640,000.  Read that again!!!  Jill ends up with a full $2 million more than her twin.

How does such a thing happen?  They both made the same incomes, and they both saved the same amount.  The short answer is Bill wasn’t smart and Jill was.  Bill saved all his money in a brokerage account with a mix of stocks and bonds.  Jill saved her money in a 401k (tax avoidance), got the match (free money), and invested in all stocks (asset allocation).

Those are all fairly simple strategies for personal finance, certainly they are ones we have talked about on this blog quite a bit.  Those couple gems translate to millions of dollars, literally.

But what does this have to do with race?  Unfortunately in our country, personal finance participation is much lower among blacks than whites.  That’s short hand for: blacks tend to act more like Bill than Jill.  “Personal finance participation” is a tricky term that loosely means having investment accounts, having retirement accounts, investing in stocks, and generally doing what personal finance theory says you should.  Make no mistake, it’s an impossible term to define and calculate (which is probably why it’s such a hard problem to tackle).

Certainly you can look at the difference in “personal finance participation” as a function of wealth.  Whites are richer than blacks so of course they are going to have more brokerage accounts and 401k’s and all that other stuff.  That’s true, but even when you control for jobs and income and the other factors like that, black “personal finance participation” is significantly lower, 35% lower by some estimates.

That impact is ENORMOUS and devastating if your broad societal goal is reducing net worth disparity.  If you believe the studies, and use our example of Bill and Jill, the average black person is getting 35% less of the investment gains that Jill got.  That’s could easily be a difference of $600k (in reality is probably even more) and that’s HUGE.

GOAL 1—Increase black “personal finance participation”

 

It’s what you know

Education is a pretty powerful tool, and one that certainly plays a role in the black “personal finance participation” issue as well as the broader income inequality issue.

In college there is a striking disparity between the majors that black students and white students pick.  Statistically, black students tend to pick majors which lead to much lower salaries than their white peers.  That alone can address the income gap in a major way.

However, we’re going to go deeper into the world of finance.  Finance is a pretty good college major, as majors go.  I proudly earned my bachelor’s degree in finance from Pitt.  The average salary for finance majors is $120k.  In a country where the average income for the whole population is $58k, being a finance major seems to be a pretty sweet deal.

Breaking down that by race tells a profound story.  About 14% of all college students are black, in line with the total population—that’s a good thing.  A similar 14% of all business majors are black—so far so good.  However, only 2% of finance majors are black—Houston, we have a problem.  Similar to the issue a couple paragraphs above, finance is a high-paying major and black students are picking it way too infrequently.

That leads to two major problems:  First, those classes for finance majors are a great way to learn the skills critical to “personal finance participation”.  Remember, that accounted to $2 million that Jill had which Bill missed out on.  If you take finance courses, you’re much more likely to be a Jill than a Bill.

Second, finance majors get high paying jobs—remember the average salary is about $120k.  More to the point of this post, finance majors can become investment advisors (much, much more on this in a second).  Data is hard on this, but most estimate that only about 1% of investment advisors are black.  As it is, the decisions black college students are making when choosing a major are cutting them off from all of this.

GOAL 2—Black college students major in finance

 

It’s who you know

Let’s start bringing all this together, shall we?

About 45% of blacks are in the middle class.  Add rich blacks to that as well and you’re talking at least 20 million people.  That’s a lot.

Based on the “personal finance participation” statistics we know a lot of those people aren’t investing the way they should, and they are missing out on a lot of money because of that.  This is true among all races.

I am a financial advisor (I passed my series 65), and my experience tells me that the vast majority of highly-successful professionals, independent of their race, aren’t doing near what they should be doing with their finances.  On a scale from 1 to 10, I see a lot of 3s and 4s among people who are incredibly smart and successful.

Fortunately, those people who would be a 3 or 4 on their own can hire someone, and for a small fee bring them up to a 9 or a 10.  Jill showed us that being a 9 or a 10 can be worth $2 million (and really it’s a much, much larger number), so if you aren’t there on your own hiring someone to help you seems like a good idea.

Understandably, if you hire a financial advisor, that needs to be an incredibly trusting relationship.  Personally, all my clients I knew for at least 5 years before I ever started advising them; also, they’re all white and my age, plus or minus a couple years, and live in my time zone.  Once you start working with a client it becomes a very intimate relationship.  You learn all sorts of super personal things about your clients—what they spend money on, what are their goals, what do they try to do but fail at, etc.  I think it’s even more intimate and personal and trusting than a doctor or a lawyer or a minister/rabbi.

The point of all this is: who are those rich and middle-class blacks going to go to for financial advice?  It’s reasonable, and not racist in any way whatsoever, that they would have a preference (possibly unconsciously) for a black financial advisor.  Not because of skin color per se, but because of shared experiences and understandings.  Someone who grew up how you did, had a similar family dynamic, have similar likes and tastes, prioritizes things in a similar way—those are all really good reasons to pick one advisor over another.  Those all correlate strongly with race.

A black person is probably going to have a lot more in common with a black financial advisor.  It’s not that you can’t pick someone from a different race for your financial advisor, but there’s an undeniable level of comfort for many.  Here’s the rub, at least based on my experience, if you don’t find a financial advisor you’re really comfortable with you don’t often pick the “next best thing,” but rather you don’t use anyone.  “Not picking anyone” tends to lead to “not doing anything” and you start to look much more like Bills than Jills.

Let’s be clear, a good financial advisor of any race can help a client of any race.  No question.  But we live in the real world, and here those personal relationship and trust dynamics are powerful.  This isn’t racism, it’s just being comfortable and having a trusting relationship with someone who is dealing with an incredibly personal part of your life.

Clearly the data show this is happening.  Blacks participate in personal finance at much lower rates—they’re closer to Bills.  And that costs them millions.

GOAL 3—Black financial advisors to work with black clients

 

Everyone wins, no one loses

Black college students become finance majors and then financial advisors.  Because they can relate to middle-class and wealthy blacks better, they get those clients and increase their wealth (becoming Jills instead of Bills).

We wanted to close the income gap.  We just found thousands of really high paying investment advisor jobs for blacks.

We wanted to close the net worth gap.  We just converted millions of black families from Bills to Jills by connecting them with highly skilled financial advisors.

Clearly, those are two winning cohorts, but there are no losers.  As blacks become better investors, that really doesn’t impact the investment returns of whites.  The stock market is more like a club with room for everyone, than it is like a high school basketball team where there are only so many spots and if you get a spot that means I don’t.  Also, those black financial advisors aren’t taking clients away from white financial advisors; those black clients weren’t using anyone before so it’s all upside.

 

My local plan

I’ve been trying this with very limited progress so far.  I haven’t gotten past step 1, but I’m not giving up.

  1. Find a couple black college seniors from UNC-Greensboro or North Carolina A&T who are finance majors. Unfortunately, as I mentioned, there aren’t a lot of these and I haven’t had luck so far. But I’m still trying.
  2. Teach the protégés the ins and outs of investing, not necessarily investment advising but just investing. Actually, it would really just be telling them “read all the posts I’ve done in my blog, understand the concepts inside and out, and then come to me with questions.” We’d work together and get them extremely financially literate.
  3. Go to a large gathering of rich and middle-class black people (a church, an NAACP meeting, fraternity alumni meeting, whatever) with my protégés . Tell the audience the story of Bill and Jill, and say I’m here to help.
  4. Work with a couple clients, taking my protégés to every meeting. Legally, the protégés wouldn’t be able to talk or do anything since they aren’t certified, but they could observe and build a non-investment advisor relationship with the client.
  5. Protégés would graduate, then pass their Series 65 or Series 7, and get a job with some investment company. Completely out of left field 😉, the clients I had been working with in the presence of the protégés would leave me for them.
  6. Protégés would take my clients to their new firms. Given most financial advising jobs are meat grinders where getting new clients is the toughest part, my protégés would have a HUGE head start. That would translate to a higher income, faster promotions, and altogether a better career.
  7. Rinse and repeat.

BREXIT—when experts were idiots

On June 23, 2016, the UK voted to leave the EU—Brexit.  The outcome of the vote was unexpected and EVERYONE freaked out.

As it turns out, nearly all those dire predictions were totally overstated.  A more objective view shows that the UK and the broader world are doing JUST FINE, probably even better than fine.  This is a good lesson that just because experts say something, especially in this world of 24-hour news cycles where crazy proclamations get the headlines, doesn’t mean they’re going to happen.

Brexit is a really good example were most experts, at least the loudest experts, got it totally wrong.

 

Let’s everyone totally freak out

The general consensus among mainstream media was this was an unmitigated disaster.  The imagery of UK self-inflicting a fatal wound was pervasive.

CNN described the impending “Brexit hangover” as though the British were a bunch of youngsters who did something immature and thoughtless like vote to leave the EU (or go out on a drinking binge).  In the light of day they would realize their error and suffer economically for their folly (hangover).

CNN also had the headline “Brexit + Deep Uncertainty = Market Chaos”.  The first line claims, “One of the foundations of the political world was thrown in disarray.”  The world in disarray????  Maybe a bit melodramatic on that one.

Magazines and newspapers had provocative headlines and covers.  The Economist called the vote “tragic”; the New York Daily News called it “foolish”; the New Yorker equated it to a suicidal leap off a cliff.  Let’s be serious for a second.

Even President Obama lent his voice to the echo-chamber chorus, warning Britians before the vote that Brexit would put them at “the back of the queue” when doing trade deals.  Clearly this was meant to scare British as a threat to their economy and livelihoods.

Making it more local, my Facebook feed was filled to the brim with dire Brexit predictions.  Nearly all these posts are from graduates of the University of Chicago’s business school.  These are people who have studied economics MUCH MORE than your average Joe.  Look at some of those comments.  Equating Brexit to World War II???   Really???

The point is Brexit was fairly universally acknowledged as a total disaster in the making by the loudest (but not necessarily the smartest) voices.  It’s easy, just based on the volume and frequency, to imagine there was something to that.  It’s been almost two years, so let’s look at what has actually happened to the UK since its citizens voted for Brexit.

 

Just the facts

For all the talk that Brexit was going to tilt the ENTIRE WORLD into financial disaster, let’s be real.  First, the UK isn’t that important.  It’s 21st in terms of population (a country with 0.9% of the world’s population), and it’s 6th in terms of GDP (3.4% of world’s GDP).  Let’s not overestimate the impact, ambiguous at best, that such a political move might have on the world.

In case your curious, the world’s GDP grew about 2.5% last year.  Equity markets are up about 25-30% since the vote happened.  That seems pretty darn good to me.

Looking at the UK in particular, it seems like things are going okay too.  There’s no totally objective way to assess the “strength of an economy”, especially among people whose political views predispose them to think one way or another.  That said there are some widely accepted metrics to look at.

 

UNEMPLOYMENT—UK unemployment since the vote has fallen pretty much in lockstep with the rest of the EU.  In June 2016 it was at 4.9%, and now it’s at about 4.3%.  That’s very slightly above Germany (widely regarded as the strongest economy in the EU), and much lower than the other major EU countries who have embraced EU-ism: France (9.2%), Italy (10.8%), and Spain (16.4).  VERDICT: not total disaster.

 

GDP GROWTH—UK GDP growth has been at about 0.4% quarterly since the vote.  That’s fairly middle of the road.  As usual, Germany’s metric is a bit better (0.6% growth), while France’s and Italy’s are in line (0.4-0.5%), Spain’s is higher (0.7%).

GDP growth is a very fickle metric in that it looks at changes, not absolute values.  Were Spain’s higher numbers because it is doing well now or that it was doing so poorly a few years back, and today’s number just look favorable compared to crappy numbers.  You can see the challenge.  Either way, it’s pretty clear that the UK isn’t performing at substantially worse level than the other major EU players.  VERDICT: not total disaster.

 

STOCK MARKET—The UK stock index (FTSE) is up about 20% since the vote.  That’s a bit less than the US (33%) and Europe (26%).  Maybe that’s evidence that the stock market thinks the UK made a mistake.  First, being up 20% definitely defies the idea that the UK is a disaster.

Second, just like GDP growth, there are a lot of factors that make it a bit challenging on how exactly to interpret it.  Right after the vote, the UK’s stock market well outperformed the others, and then it decelerated.  I chalk it up to general market gyrations.  VERDICT: not total disaster.

 

EXCHANGE RATEAfter the Brexit vote, the exchange rate for the British Pound to the Euro fell from about 1.25 down to its current rate of 1.12.  Definitely you can see a clear move down.  Often times a depreciation in your exchange rate reflects negative circumstances for the country’s economy (see Venezuela).  Yet, that’s way too simplistic a view.  In the past year, the US dollar is down about 15% compared to the Euro, and I don’t think anyone seriously thinks the US economy is in a state of disaster compared to the European economy.

Also, if you look at the Pound/Euro exchange rate over a longer time period, the 1.15 range is actually where it has spent most of its time.  It was there in the early 2010s (when the UK was part of the EU), then it rose dramatically in 2015 when Greece’s drama unfolded as it nearly toppled the EU’s common currency (hmmmm . . . maybe that’s a reason why the British voted for Brexit).  Now it has fallen back to those previous levels.  VERDICT: not total disaster.

 

The point of all this is that it’s definitely not CLEAR that the UK’s Brexit vote was a total disaster.  Despite the incredibly smart people with a firm grasp of macroeconomics at CNN and the New Yorker among many, many others (I’m totally being sarcastic here—I think they’re idiots), just because they say something doesn’t mean it’s true.  They have the loudest voices in media today, but that doesn’t mean they have the smartest.  Remember, I am smarter than a Nobel Prize winner, and I do think Robert Schiller is really smart.

If you were Rip Van Winkle and slept through the last two years, and then upon waking were asked which Top 20 economy voted on an economic policy that was tantamount to “Tragically foolish suicide that pulled the world into chaos”, I’m not sure you’d zero in on the UK.  Actually, you’d think things look pretty good there, not nearly as horrible as that description would lead you to believe.

There’s a bit of a lesson here.  Keep this in mind when everyone in the media and on your Facebook feed starts talking about how obviously good or obviously bad something is.  Quick things that come to mind are: economic impact of Trump’s tariffs, inevitability of China overtaking the US in GDP, the impact/harm of the Trump tax cut.  These things are highly complex and very nuanced; rarely are they unambiguously good or bad in the manner that grabs headlines in our oversaturated media landscape today.  Don’t be a sucker.

Final Four—Savings rate v. Tax optimization

Basketball hoop

Welcome to the second game of the Final Four of my investing strategies tournament.  Here we have Savings rate taking on Tax optimization.  In the first round, Savings rate beat Mortgage just on the sheer power that saving more money can have on the ultimate size of your nestegg.  Tax optimization squeaked by Starting early due to the enormous value created with minimal sacrifice by setting up the accounts to minimize your taxes.  As always, give the disclaimer a peek.  With that out of the way, let’s see who wins.

bracket-game 5

 

Reasons for picking Savings rate:

Savings rate is a simple but overwhelming force, maybe like Patrick Ewing when he dominated the Final Fours during his years at Georgetown (I don’t mean to call Ewing’s game simple, but you’ll see what I mean).  Ewing just owned the basket—any shot you put up he blocked, if you did get the shot up he got the rebound, when he got the ball you weren’t stopping him.  It all revolved around Ewing, and his dominance on the inside covered up for his shortcomings (outside shot, passing) as well as those of his teammates.

patrick_ewing

In the investing world, the sun really rises and sets with Savings rate.  Without any savings, you can’t invest so it really doesn’t matter what you do with things like Index mutual fundsAsset allocation, or Free money.

Also, unlike any other investing strategy, Savings rate can make up for any other mistakes you make along the way.  It’s a lot like Ewing protecting the rim on defense; if your guy beat you, you could be pretty confident that Ewing would bail you out by blocking his shot.  You could completely screw up Asset allocation and stuff all your money in a mattress—just crank up your Savings rateand there’s no problem.  Don’t participate in your 401k and walk away from the Free Money—save a little more and you’re okay.  You get my point.

Let’s use the same example of Mr Grizzly starting out at age 22, making $50,000 which will eventually rise to $100,000, and who wants to be a millionaire by the time he’s 60.  Let’s say he does everything right, plus he has a horseshoe growing out of his rear end, and over his investing career he averages a 10% return; he would only need to save about  3% of his income.  That’s probably a breeze.  Now, instead he has an average investing track record with returns of about 6%, he would need to save about 9% of his income.  So Savings rate was able to make up for his lack for tremendous luck.  Keep going down that path and let’s say he put all is portfolio in a local bank earning 1% interest, which I think we would all agree is a pretty terrible investing strategy, and he still becomes a millionaire so long as he saves about 24%.

 

Return Savings rate
10% 3%
6% 9%
2% 20%
1% 24%
0% 29%

 

So you can see that Savings rate can make up for all manner of investing sin.  Pretty much any other investing strategy has its limits to how far it can take you before you exhaust its benefits.  But of course there are no free lunches.  Increasing your Savings rate comes at a much higher cost than other investing strategies, namely all that money you’re saving means you can’t spend it on other things.  So when Mr Grizzly needs to crank up his Savings rate, that money has to come from somewhere—he passes up on that salmon fishing trip, or buying Mrs Grizzly some artisan honey from the farmer’s market, or getting some detangling shampoo for his coat.  We can debate whether those purchases are worth the money, but to Mr Grizzly they are (cut to Lady Fox nodding and pulling out a Pottery Barn catalog).  Sure, you can start by cutting away the layer of winter fat, but the higher you make your Savings rate the more you start cutting into muscle and eventually into bone.  That, my friends, is the rub with Savings rate.

 

Reasons for picking Tax optimization:

Taxes are to investing what water damage is to a house—unwelcome, can really ruin stuff if not attended to, and it gets into everything.  The tentacles of taxes traverse tremendous territory to touch your total transactions (I challenged myself to see how many “t-words” I could use in a sentence).  Seriously, taxes pretty much affect everything in investing.

There are the obvious big rocks, some of which we’ve already discussed, like a 401k and an IRA; using those accounts to defer taxes can save you hundreds of thousands of dollars.  Medium-sized rocks like 529s and tax-deductible interest on your mortgage can save you tens of thousands in taxes over a shorter time span.  Then there are tons of small rocks which can certainly add up—flex spending accounts and dependent care spending can save you thousands.  Add all that up and that’s a lot of clams (if you didn’t read yesterday’s post, I am trying to use as many slang phrases for money as I can).

And then you can get into the really obscure Tax optimization strategies.  “Loss harvesting” is when you sell investments at a loss so you don’t have to pay taxes on your winners.  “Dividend location” looks to put your high-dividend investments in tax deferred accounts like a 401k, so you don’t have to pay taxes on the dividends during your high-income/high-tax rate years.  There are millions of these little loopholes and strategies that allow you to pay less taxes.  A major part of the accounting industry is based on this fact.

Just to illustrate the point, I’ll share a story from Medtronic.  If you’re a high-compensation employee (I do not qualify, so I can’t take part in this) you can participate in the Capital Accumulation Program (CAP) which allows you to defer a portion or all of your bonus into a tax-advantaged account—think of it like an extra 401k without the match.  This is a veritable tax goldmine, and sadly very few of the people I talk to take advantage of this.  Let’s assume Mr Executive makes $300,000 per year, with $100,000 of that being his bonus; and assume that he’s working hard to build his nestegg, so after maxing out his 401k he saves $50,000 in his brokerage account.  That’s probably pretty close to the people I’m describing.

What Mr Executive could do but probably doesn’t is defer his entire bonus.  He’s already saving $50,000 per year and since he’s in a pretty high tax bracket, that’s probably pretty close to what his take-home would be on that $100,000 bonus.  However, by deferring his bonus he avoids paying the 40% on taxes now and only pays 5% in taxes when he pulls the money out in retirement.  If you do the math, that’s a potential savings of $35,000 ($100,000 x (40% – 5%)) on top of what he’s already saving.  When I ask executives why they don’t do CAP they tend to say they never thought of it or they didn’t understand it.  When I show them the math says they’re leaving at least $35,000 on the table, their eyes bug out and they need to sit down.

That’s just one example of the power of Tax optimization that is out there that goes largely unutilized, even by really successful people, even by those who have tax advisers helping them out.  And there are thousands of other examples like that out there.  That’s $35,000!!!  That’s a lot of money, even if you are pulling in $300k.

My point with this and the others is that in the US (and probably every other country) the tax code is super convoluted.  Add to that that when you’re making more and more money, you pay more and more in taxes, so the stakes start to get pretty high.  That’s a perfect recipe for hidden 1% coupons; some of them are easy to find, some a little hard, and some require serious digging—but they’re there.

 

Who goes on to the championship game?

Just like in the Elite Eight, I think Tax optimization pulls out a squeaker over Savings rate, 71-68.  While Saving rate has unlimited potential, it comes at a real cost of foregoing purchases today.  Tax optimization isn’t necessarily unlimited.  There are only so many wrinkles and loopholes you can take advantage of, but there are an awful lot of them and I bet you’d run out of time and energy before you’d run out of tax strategies.

bracket-game 6

But what tips the scale is that most of the Tax optimization gambits are free.   You’re already going to save for your retirement so why not do it with a 401k and not pay taxes on it right now?  You’re already going to save for your kids’ educations so why not use a 529 and not pay taxes on the appreciation?  You’re definitely going to need to pay for childcare so why not use a Flex spending account and do it tax free?  You and the family are going to get sick so why not use a Flex spending account for that, too?  None of those cost any more than you would have paid already, but you’re cutting Uncle Sam out of his 40% (legally, of course).

Thursday we will see who wins it all, Asset allocation or Tax optimization.

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.