Archives for November 2010

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Investing for Near-Term Goals

When we talk about how to invest your portfolio, we’re usually talking about retirement savings. And, therefore, we’re usually discussing the best way to invest over a period of multiple decades.

Of course, we all have some nearer-term goals as well: buying a home (or a second home), college for the kids, etc. So what’s the best way to invest money that you’re saving for those types of goals?

It depends. First, we need to back up a step and answer two other questions:

  1. How long will the money be invested?
  2. How problematic would it be if there was actually less money at the end of the period than at the beginning?

Let’s tackle question #2 first.

Can You Afford to Lose Anything?

If you know with absolute certainty that you’re going to need every dollar of that money and you’re going to need it on a specific date, then the answer is simple: Stocks can’t be a part of the allocation, regardless of whether we’re talking about a 3-year time frame or a 15-year time frame.

In such cases, my suggestion is to use fixed income investments (CDs or bonds) with maturities that match up with when you expect to spend the money. For example, when you’re 5 years away, any money that you save toward the goal in question would go into 5-year CDs. When you’re 3 years away, any money saved would go into 3-year CDs.

If, however, if things go poorly, you wouldn’t mind a) delaying the spending for a few years or b) spending less than you’d hoped, then you can afford to take on more risk. Exactly how much risk depends on what kind of time frame we’re talking about.

How Long Will the Money Be Invested?

If we’re talking about periods of 5 years or less, anything more than a very minor stock allocation is quite risky. From 1928-2009, there were twenty-one 5-year periods over which stocks* lost money on an inflation-adjusted basis. That’s about ¼ of the time. And in the worst of those periods, they lost approximately 45% of their value.

For periods of 5-10 years, I think it becomes reasonable to consider allocating some of the money to stock holdings — though still a small portion of the total amount. And still only if you’re OK with the possibility that your portfolio could be worth less at the end of the period than at the beginning. By way of example: Eleven 10-year periods from 1928-2009 had negative inflation-adjusted stock returns, with the worst being a loss in value of approximately 38%.

Even for periods of 10-20 years, a good-sized helping of bonds is in order. While history shows that stocks are likely to put up decent returns over that kind of time frame, there are no promises.

*As measured by total return on the S&P 500 and (prior to the creation of the S&P 500) the S&P 90.

Simple Investing is Better Investing

I’m a bit zealous in my preference for lazy portfolios and simple investing plans. So it’s no surprise that I sometimes get emails asking whether I really believe that it’s worth “dumbing down” a portfolio just to save a few minutes every month.

My answer: It’s not being lazy or saving time.

Beyond the time saved from not having to monitor your investments everyday, there are multiple tangible benefits to using a simple portfolio and investment plan.

Protecting Against Mistakes

The simpler your portfolio and investment plan are, the easier it is to have a true understanding of them. And the better you understand them, the less likely you are to make mistakes.

A deep understanding of every piece of your investment plan helps prevent technical mistakes like rebalancing improperly. And (perhaps more importantly) it helps prevent emotional mistakes — giving up on your plan to chase performance somewhere else, for instance.

Protecting Your Spouse

If your spouse inherited complete control and responsibility for your portfolio tomorrow, would he or she know what to do with it?

  • Would (s)he know the purpose of each of the investments in the portfolio?
  • Would (s)he know the desired allocation for each of those investments?
  • Would (s)he know how you intended that allocation to change over time?

And, even if your spouse would know what to do with the portfolio, would she have any interest in actually doing it? What you see as “rebalancing” and “regular maintenance,” your partner may see as “hassle” and “endless tinkering.”

The simpler your investment plan is, the better your spouse/partner’s position if he or she ever has to take over maintenance of the portfolio.

Protecting Against Cognitive Decline

It doesn’t happen to everyone. And hopefully it won’t happen to you. But cognitive decline does happen to a lot of people. And, by its very nature, it’s darned hard to self-diagnose. So you have to prepare for it ahead of time.

If you have a simple portfolio — especially one in which each of the parts performs an obvious function — it will be much easier for your loved ones to handle things for you, should that need arise. (Important note: You’ll also have to provide them with the legal authority to do so.)

Ways to Simplify Your Investing

Stick with one brokerage firm: Choose one low-cost brokerage firm, and stick with them. Having everything in one place makes it easier to see how your portfolio is allocated. It makes it easier to track performance. And it makes it easier to rebalance when necessary.

Hold fewer investments: If you can put together a diversified portfolio using just 3-5 index funds or ETFs, I say go for it.

Consider annuitizing: If you’re retired, consider devoting a portion of your portfolio to a single premium immediate annuity. With such annuities, there’s no ongoing maintenance to be done. All you have to do is make sure you’re spending less than the income you’re taking in — something you’ve been doing for years.

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401(k) or IRA? What to Do If Your 401(k) Stinks

Some investors are fortunate enough to have 401(k) plans run by low-cost administrators, offering low-cost investment options. For most investors though, the situation is quite different:

  • The typical 401(k) plan charges administrative fees ranging from 0.5% to 1% per year, and
  • The investment options are often limited to actively managed mutual funds with expense ratios of 1% or more per year.

At a grand total cost of 2% or so per year, investing via a 401(k) plan is not cheap. In contrast, with an IRA, there are no admin fees at all (at most brokerage firms), and you have access to super-low-cost index funds and ETFs with expense ratios of 0.20% per year or less.

So does it make sense to forgo 401(k) contributions in favor of maxing out an IRA?

Not necessarily.

Get that 401(k) Match!

Before contributing to an IRA, be sure to contribute enough to your 401(k) to get any match that your employer offers. In nearly all circumstances, a dollar-for-dollar match (or even a 50-cents-on-the-dollar match) outweighs any other drawbacks such as high admin costs, fund expenses, or a tax-preference for a Roth.

Important note: If you’ve read that your employer offers, for example, a 4% match, that probably does not mean that they contribute 4 cents for every $1 you contribute. It usually means that they contribute $1 for every $1 you contribute, up to 4% of your compensation. This is a big difference! If you contribute 4% of your compensation, they immediately double it.

An immediate, risk-free, 100% return is impossible to beat.

I Got My Match. Now What?

After getting the maximum 401(k) match, the best approach is typically to:

  1. Max out your Roth IRA,
  2. Then, if you still have more to invest, go back and max out your 401(k).

By following this approach, you get your employer match, you take advantage of the lower costs available via an IRA, and you tax-diversify your investments by spreading them out among both pre-tax accounts (your 401(k)) and after-tax accounts (your Roth).


Naturally, in certain situations, it makes sense to do things differently.

For example, if you earn enough to make you ineligible for Roth contributions, it likely makes sense to replace that step by making (non-deductible) contributions to a traditional IRA, with the intention of converting them to a Roth at some point.

Alternatively, there are some situations in which it makes sense to max out your 401(k) completely before making any Roth contributions. For example, if you’re:

  • Getting close to retirement and you’re currently in a much higher tax bracket than you expect to be in during retirement, or
  • Not very close to retirement, but you still think you’re in a higher tax bracket than you expect to be in during retirement and your 401(k) has low admin costs and fund expenses,

…then the benefit of decreasing your taxable income now — via larger 401(k) contributions — would likely outweigh the associated costs.

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