OUR LIVES are an ongoing struggle between the shortsighted desires of our current self and the financial needs of our future self. This is a battle that our current self wins with alarming regularity. Think of the diets that fail, the commitments to exercise that fall by the wayside and all the dollars that somehow never get saved.
We can blame all this on the instincts we inherited from our hunter-gatherer ancestors. They didn’t need to worry about dieting,
ALBERT EINSTEIN didn’t say, “Compounding is the eighth wonder of the world.” But if he had, the praise would have been richly deserved.
As many investors are aware, investment compounding—coupled with heaps of time—is the leverage that can turn modest savings into huge sums. A simple example: If you invested $1,000 and earned 6% a year, you’d have $10,286 after 40 years. What if you invested $1,000 every year? After 40 years, your $40,000 total investment would grow to $164,048.
WE ALL LIKE to think we make smart, level-headed financial decisions. A slew of research suggests otherwise. Our missteps have been detailed by academics focused on behavioral finance, happiness, behavior change, evolutionary psychology and neuroeconomics.
What’s the common theme running through all this literature? It seems our instinctive reactions—bequeathed to us by our hunter-gatherer ancestors—frequently let us down. We’re hardwired to act in certain ways, and it often takes great effort to behave otherwise.
AS WE TRY TO WRAP our arms around this sprawling thing we call a financial life, we might begin with what’s often our most valuable asset—ourselves. Economists refer to our income-earning ability as our human capital. Our regular paycheck—or lack thereof—should figure into a slew of financial decisions, including how much debt we take on, how much emergency money we need, how much we should save for retirement, what insurance we purchase, and what mix of stocks and bonds we buy.
WHAT ARE the most important financial ideas? In this chapter, we don’t focus on specific financial terms, like diversification, correlation and momentum. Instead, the goal is to offer up larger ideas that can help us think more clearly about our financial life and our own behavior.
Be an Owner
Risk and Reward
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WE ALL HAVE limited money, so we need to weigh carefully how best to use our dollars. That means pondering not only what we’re getting, but also what we’re giving up. This is one of life’s great financial tradeoffs, rivaling the tradeoff between risk and reward.
Indeed, at times, the two notions overlap. Suppose we stash our money in bonds and notch 3% a year. Yes, our wealth will grow. But if we had bought stocks instead,
ALTERNATIVE investments—including hedge funds, real estate partnerships, natural resources and venture capital funds—have long fascinated investors. Folks love the idea of owning sophisticated and often exclusive investments that not only have the potential to post gains when stocks are suffering, but also could deliver outsized long-run returns.
Indeed, in recent decades, there’s been much chatter about the so-called endowment model, which is closely associated with David Swensen, who oversees Yale University’s endowment. Swensen has pioneered a strategy of investing relatively little in U.S.
AS INDEX FUNDS garner ever more assets, proponents of active management have all but given up claiming that there are reliable strategies for beating the stock market averages. Instead, they’ve sought to persuade folks that they should avoid index funds, because indexing is bad for the smooth functioning of the stock market.
In essence, investors are being told, “We know that, on average, indexing beats active management. But you should still trade stocks and buy actively managed funds,
IN THE FINANCIAL world, making money is the most popular pastime—but having a good argument is a close second. What do folks argue about? In this chapter, you’ll get the skinny on 15 of Wall Street’s greatest debates.
Money Buy Happiness?
Are Investors Idiots?
Hire an Advisor?
Beat the Market?
How Much Abroad?
Bonds or Bond Funds?
Buy a House?
Invest or Reduce Debt?
Term or Cash Value?
STOCK MARKET valuations have been higher than the historical averages for much of the past three decades. For instance, since year-end 1989, the companies in the S&P 500 have traded at an average 24.3 times trailing 12-month reported earnings, versus 13.5 for the 40 years prior to that. Similarly, the S&P 500’s dividend yield has averaged 2.1% since 1989, versus 4.1% for the prior four decades.
Faced with those sharply higher valuations, pundits have regularly warned that a great reckoning is at hand and that share prices will soon revert to more normal valuations.
AS BOND YIELDS have fallen in recent decades and stock market valuations have climbed, some experts have suggested that the standard 4% portfolio withdrawal rate may be too high—and that retirees who spend that much risk running out of money.
A refresher: The 4% rule assumes retirees withdraw that portion of their nest egg’s value in the first year of retirement. Any dividends and interest payments that are spent count toward the 4%. After the first year,
WALL STREET loves to depict everyday investors as fools. But there’s scant evidence this is true—and plenty of reason to question Wall Street’s motives in perpetuating this myth.
No doubt about it, many individuals make investment mistakes. But so, too, do many professionals. Indeed, if everyday investors were so incompetent, it would presumably be easy for professional money managers to take the other side of their misguided trades and thereby beat the market. Yet reams of data prove that most money managers trail the market averages.
CAN YOU AFFORD to retire—or should you tough it out in the workforce for a few more years? It’s time to run the numbers.
First, take all your retirement savings and divide that amount by 25. That’ll tell you how much you could potentially withdraw from your nest egg each year, assuming a 4% withdrawal rate. Be warned: You might need to make those withdrawals during a major market downturn. As a precaution, consider keeping five years of portfolio withdrawals in a money-market fund,
IF WE AREN’T on track to retire debt-free, we should make a big push to pay off all loans before we quit the workforce. Why? There are the obvious reasons: Once we retire, we’ll no longer have a paycheck to service those debts, plus—by paying off all loans—we lower our cost of living and make retirement more affordable.
But there’s a less publicized problem: If we carry debt into retirement, we’ll need to generate additional income to service those loans.
WHEN WE’RE AROUND age 50, we should give our insurance coverage a serious rethink. There’s the usual question: Should we raise the deductibles on our homeowner’s and auto policies, because we’re now wealthier and can afford to take more financial risk?
But the thornier issue involves three other policies: Can we afford to drop our disability and life insurance—and should we purchase long-term-care coverage? In each case, we need to consider how much we’ve already saved for retirement or how much we’re likely to have once retirement rolls around.