Time and Money and Your Retirement

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By Steven Podnos MD, MBA, CFP                   

Learn more about Steven on NerdWallet’s Ask an Advisor

There are many factors to consider as you save for an eventual retirement.  The factors of long term returns, asset allocations, expenses and discipline are often glossed over, but are crucial to success. Let’s review what’s important for a secure retirement financially.

In today’s investment world, I think it is reasonable to consider the following as distinct asset classes:

  • American Stocks
  • American Bonds
  • Foreign Stocks in Developed Countries,
  • Stocks in Emerging Market Countries
  • Foreign Bonds
  • Cash
  • Real Estate Securities, domestic and global
  • Commodities, including Gold

Although the past does not predict the future, historical returns are a valuable input for making decisions about the future.  Inflation is a strong concern, as our investment capital must keep up with both inflation and taxes just to be able to buy the same things in the future (purchasing power).  Therefore, if we look at “real” returns (after inflation) for the last 85 years, we find:

  • American Stocks returned 6.6% annually
  • American Bonds returned 2.3% annually
  • Money Market/Cash returned 0.6% annually

We do not have well-referenced data on the other asset classes, and will have to make some assumptions about them that may or may not pan out.  What we can see is that the historical data supports the thesis that only equities actually grow significantly in value after taxes and inflation over long periods of time.  We can see that cash makes almost no return after taxes, and Bonds make little as well.

Understanding Some Basics of Asset Allocation

Modern Portfolio Theory guides investment theory and practice and has two main factors.

The first tenet is that owning a group of asset classes that do not move in same direction at the same time (i.e., they are poorly correlated) usually adds to long term returns while reducing risk.  Therefore, it remains reasonable to have some different asset classes in your portfolio that are not expected to move together in lock step.  Note that this is not always so easy to do, as the correlation between movements of various asset classes changes over time.  Still, most investment experts agree that portfolio diversification is wise.

The second tenet is that one must make predictions of future returns in order to best assemble a poorly correlated group of assets.  It is this second tenet that is often misinterpreted by various pundits.  It has become common practice to use historical returns of various asset classes in order to predict their future behavior, a practice fraught with danger and error.  For example, using the last thirty years of Bond returns (during perhaps the greatest Bond bull market of all time, as long term interest rates dropped from the high teens to below 4%) as a prediction of the next thirty years would be a mistake.  Similarly, assuming that real estate would have the same return as the past( say right during the rapid run up in prices through 2006) would have been an expensive error.  We can use various methods of valuation to decide if any particular asset class is expensive, probably fairly valued, or historically cheap.  A prudent method of picking asset classes appears to be avoiding the expensive classes, favoring cheap asset classes, and diversifying widely into the rest.

Understand Your Time Horizon for the Retirement Portfolio

A common error people make in determining how long their investments will exist is to assume that the portfolio “ends” in retirement.  For example, I recently met with a physician who was 58 years old (wife age 56), and he told me that he plans to retire at age 65.  When we discussed that equity investments have the best overall return over long periods of time (10-15 years at least), he told me that he only has seven more years, and should probably hold more fixed income.

My response was that he had perhaps at least 40 more years as a time horizon for his money.  His retirement investments will need to at least maintain purchasing power after inflation and taxes for that long, given the increasing longevity likelihood that either he or his wife (or both) will live well into their tenth decade.

Understanding this much longer than assumed time horizon for one’s investments is a crucial factor in making an asset allocation.  It favors a higher equity allocation for most portfolios.

Understanding Volatility Vs. Loss

We know that recovering from a loss is difficult.  The cliché (but true) is that after a 50% loss, you  need a 100% gain to break even.  But knowing that market investments are volatile (up and down) is very different than having a realized loss.  It is human nature to use daily or weekly (or yearly) prices to judge gains vs. losses, but with most investments you do not actually  have the gain or the loss unless you sell the position.

Selling for emotional reasons often leads to true losses, and buying in an up market from euphoria may be equally damaging to your long term wealth.  However, in a sense we are “paid” to own equities by tolerating their increase volatility compared to fixed income and cash.  The successful equity investor understands that 20% down bear markets can occur every few years, and that usually they are an opportunity to buy and not to sell.

This all is very important to remember when dealing with a retirement portfolio, as these funds are virtually all to last for decades.  Worrying about short term swings in prices and acting in an undisciplined manner is deadly to your chances of success.

Understanding that Expenses Matter

Very few individuals actually understand how much their investments cost.  If we take a broker sold mutual fund, we’ll find many layers of cost.  First, there may be a front end load (money subtracted from the initial purchase), which is usually 4-5% immediately.  If the commission is not at the front, it is paid out by the year to the broker and subtracted either annually (usually C class funds) or at the sale of the fund if sold before a certain number of years (Back end load).  In any event, a typical charge might average out to 1% a year over the first five years.  In addition, the broker is often paid an annual fee from the mutual fund averaging 0.25-0.5% annually (12b-1 fees).  Next comes the stated internal expense ratio of the fund-that pays the salaries and profit of the mutual fund company itself (0.8-1.5% annually for most funds).  Finally, there are hidden internal transaction costs due to the typically higher turnover (buying and selling of assets) in actively managed funds.  Adding up all these costs makes one understand how hard it is to make money.

These costs also make it easy to understand why most actively managed funds do not perform as well as “index funds” that hold a particular asset class without much trading.  I do believe there are certain asset classes in which it is worth paying the costs of active management, as when a particular asset class is not easy to study, and is felt to be inefficient in its behavior.  But for most asset classes, buying the index fund is the best bet.

This is not to say that paying an advisor is wrong.  But paying significant expenses for a simple asset allocation may not be a smart long term move.  If you are paying an advisor, the fees should be transparent and reasonable, or you should be getting additional financial advice.


Sources to help find advisors:

The Financial Planning Association

Garrett Planning Network

National Association of Personal Financial Advisors

NerdWallet’s Ask An Advisor