Jonathan Clements's Blog, page 418

Measure for Measure

THIS BULL MARKET is more than eight years old, U.S. stocks are undoubtedly expensive and there’s even talk of war. Tempted to sell? Problem is, there was also ample reason to be worried three years ago and yet here we are, with shares both higher and more richly valued.

What to do? I fall back on my standard advice: Forget trying to forecast the market’s short-term direction and instead focus on taking the right amount of risk. That brings me to two quick-and-easy ways to analyze your portfolio.

First, think about your current split between stocks and more conservative investments. But when you add up your conservative investments, include all future savings. This allows you to factor your human capital—your income-earning ability—into your asset allocation.

Let’s say you’re age 45 and plan to retire at 65. You have $300,000 saved, with $240,000 in stocks and $60,000 in bonds and cash investments—a mix of 80% stocks and 20% conservative investments.

But let’s also assume your annual salary is $100,000 and you save 10%, or $10,000, each year toward retirement. At $10,000 a year for 20 years, that’s $200,000 that is effectively in cash and still to be invested. Factor in that $200,000 of future cash, and your portfolio is 48% stocks and 52% conservative investments.

To be sure, there is a risk you’ll never collect that future cash because you lose your job or earn less you than you had hoped. Those with weaker job security or widely fluctuating incomes might adjust for that risk by trimming their estimate of future savings by, say, 20% or 25%.

Even with a haircut like that, it can be comforting to factor future savings into your asset allocation—assuming you have many years of savings ahead of you. Indeed, if you’re in that camp, a stock market decline is a potential bonanza, because you’ll be able to scoop up shares at bargain prices.

But this formulation isn’t so comforting for those of us who are retired or close to it, because we have little or no future savings. Yes, we could take advantage of a market decline by rebalancing into stocks or even overweighting them if valuations seemed especially compelling. But let’s be realistic: Only the bravest retirees will be that aggressive.

Here’s a possible rule of thumb to ponder: You never want more than 60% of your portfolio in stocks—with your portfolio defined as its current value plus future savings.

No future savings? You should have a maximum 60% in stocks. Just entered the work world? Even if your hold 100% stocks, your current investments plus future savings might be at less than 10% stocks. This highlights how irrational it is for young adults to worry about a market decline. In fact, you could likely hold a 100% stock portfolio into your early 40s and still be below 60% stocks, once you figure in future savings.

Is 60% the right benchmark for you? Here’s a gut check: my second quick-and-easy way to analyze your portfolio’s risk level. Pick a value for your portfolio, below which you wouldn’t want it to fall. Let’s say you currently have $600,000 saved and you’d be distraught if your nest egg dropped more than $100,000, to below $500,000. Experts in behavioral finance say that we get far more pain from losses than pleasure from gains. This is your chance to put a number on just how much financial pain you’re willing to endure.

Now, imagine stocks fell 35%. True, we’ve already seen two market declines of roughly 50% in the current century. But historically, 50% declines have been relatively rare. If you look at times when U.S. stocks have tumbled 20% or more—the standard definition of a bear market—the average decline has been around 35%.

To avoid a loss greater than $100,000 during a 35% stock market decline, you would want to limit your stock holdings to $286,000, or 48% of your $600,000 portfolio.

Want to try this with your own portfolio? This math is easy enough: Just figure out the maximum dollar loss you’re willing to suffer and then divide that number by 0.35. Not only will that tell you the amount you should have in stocks, but also it’ll get you mentally prepared, should it turn out that bad times do indeed lie ahead.

Follow Jonathan on Twitter @ClementsMoney and on Facebook.

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Safety Net: 10 Questions to Ask

WANT TO MAKE SURE YOUR FAMILY is adequately protected against financial disaster? Try grappling with these 10 questions:

What’s the minimum dollar amount you need each month to keep your household running? That’s a useful number to know if you’re forced to slash living costs because, say, you lost your job or you need to cover a large, unexpected medical bill.
How would you cope financially if you were out of work for six months? Think about where you would get the money to cover household expenses—and whether you ought to cut living costs, build up your emergency fund and open a home-equity line of credit.
If you’re retired, should you bother with a separate emergency fund? The big financial emergency is getting laid off—and that isn’t a risk once you’re retired.
Who would suffer financially if you died tomorrow? If you’re single with no children at home, or you’re married to somebody with a healthy income, the answer may be no one. But if you’re the main breadwinner, with a spouse at home and young children, your death could wreak financial havoc—and you may need substantial amounts of life insurance.
Do you own the right sort of life insurance? A majority of policies sold are cash-value policies, which involve hefty premiums—and which can crimp your ability to fund superior investment vehicles, such as your employer’s 401(k) plan. A better strategy: Max out your 401(k)—and protect your family with low-cost term insurance.
Would your homeowner’s policy pay enough to allow you to rebuild? Rebuilding may prove surprisingly expensive, because your new home would need to meet current building codes.
If you required nursing home care, how would you cover the cost? Can you afford to pay out of pocket, should you buy long-term-care insurance, or are you planning to deplete your assets and then fall back on Medicaid?
To reduce premiums, should you raise the deductibles on your health, homeowner’s and auto policies, and also extend the elimination period on your long-term-care and disability insurance?
Thanks to your growing wealth, could you afford to drop various insurance policies and instead self-insure? If you have more than $1 million in investable assets, you might have enough socked away to handle life’s financial disasters without help from life, disability and long-term-care insurance.
Which of your assets would be protected if you got slapped with a lawsuit or had to file bankruptcy? Federal law would likely protect much or all of your retirement account money. But what additional protections are offered by state law?

This is the fourth blog in a series. The earlier articles were devoted to retirement, homes and college. Follow Jonathan on Twitter @ClementsMoney and on Facebook.

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By the Book

WHEN I LOOK AT TODAY’S WORLD, I often think of Charles Dickens’s famous line, “It was the best of times, it was the worst of times.” Technology, including the web and smartphones, has made life so much more convenient.

Still, one thing I really miss from the “old days” is the experience of the traditional bookstore. Shopping online is great, but sometimes it’s easier to choose from a curated set of 10 books on a shelf than to sift through an unwieldy list of a thousand choices online. In that spirit, below is my summer personal finance reading list.

If I had to design a personal finance curriculum around just one book, it would be The Richest Man in Babylon. This classic, written in the form of a parable, is an easy read for people of all ages. While it may seem simplistic on the surface, in reality it covers a lot of ground. For example, this is how it explains the concept of intrinsic value: “Gold in a purse is gratifying to own and satisfieth a miserly soul but earns nothing.”

Index funds have been around for more than 40 years, but the “index vs. active” debate has really heated up in recent years. If this topic interests you, I recommend two books. Both authors are active managers, but they take opposite sides of the debate.

David Swensen, the longtime manager of the Yale endowment, has built the best track record in the industry by embracing active management. In Unconventional Success, however, he delivers a striking condemnation of the retail mutual fund industry, explaining why active management works for endowments like his, but not for individual investors.

Taking the other side of this argument is legendary fund manager Peter Lynch. In One Up on Wall Street, he acknowledges that his success as a stock-picker was unusual. He argues, however, that individuals can do better than professionals if they pick their own stocks and if they stick to what they know: “If you’re a surfer, a trucker, a high school dropout or an eccentric retiree, then you’ve got an edge already.”

With the market regularly hitting new all-time highs, I spend a lot of time thinking about risk. On this topic, I have three recommendations.

In The Black Swan, Nassim Nicholas Taleb makes a simple but powerful argument: Just because something hasn’t happened before doesn’t mean that it can’t happen in the future. For that reason, we should be skeptical of financial theory that assumes stock market returns follow the standard bell curve. Instead, Taleb cautions investors to protect themselves against “black swans”—highly unusual but highly consequential events with the power to wipe you out.

Writing in The Most Important Thing, Howard Marks expands on this idea: “Quantification often lends excessive authority to statements that should be taken with a grain of salt.” In other words, when it comes to investments, don’t put too much faith in numbers. Risk may seem quantifiable, but it’s not—because markets are driven by people and people are rarely logical.

If you want proof that black swan events can and do happen, I recommend When Genius Failed. This chronicles the spectacular failure of Long-Term Capital Management, a hedge fund that was built around mathematical models. Despite having more than one Nobel Prize winner on staff, “the professors had ignored the truism…that in markets, the tails are always fat.” In other words, the standard bell curve does not apply.

Excessive quantification isn’t the only reason to distrust Wall Street. In Pound Foolish, Helaine Olen examines the seedy underside of the business—from TV personal finance gurus, to complicated financial products, to the even more complicated (and opaque) relationships in what she calls the “personal financial industrial complex.” Don’t read every word—it will only depress you—but read enough to understand that you, as a consumer, are in a zero-sum game with Wall Street.

For a more lighthearted, but no less critical, look at Wall Street, read Where Are the Customers’ Yachts? Written in the 1940s by a former stockbroker, this book lampoons Wall Street as a “kindergarten.” This insider’s account seems no less true today than when it was first published.

Finally, I would pick up a copy of The Little Book of Main Street Money by Jonathan Clements, editor of this site (and, no, he didn’t insist I include one of his books). Structured as 21 financial lessons, this book’s title belies its depth. It covers everything from savings strategies, to the nuts and bolts of constructing a portfolio, to debt, insurance and taxes. This book is a highly readable field guide to navigate the financial decisions we all face.

In his Little Book, Clements writes, “we should strive to ensure that money is enhancing our lives rather than getting in the way.” I concur and hope that this summer reading list is helpful as you pursue your life’s goals.

Adam M. Grossman’s previous blogs include Go Fish and  Site Seeing (Part III) . Adam is the founder of  Mayport Wealth Management , a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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Growing Up (Part IV)

THE SOUND AND SMELL of the Pickle will be forever burned into my memory. As a wannabe cool teenager, getting rides to school and soccer practice from my parents in their inherited 1976 green Dodge Aspen coupe with whitewall tires—a.k.a. the Pickle—was beyond embarrassing.

Sometimes, my parents would honk pulling away, just to add insult to injury. Needless to say, it took a bit of humble pie to finally understand the lessons my parents were teaching me, and my sisters, daily.

I didn’t quite grasp what joy my father got from driving old, out-of-style automobiles until one day after soccer practice. On the way home, we took a detour to an affluent part of the small college town I grew up in. He asked me what I thought of these fancy, large houses with beautiful, new cars outside. Like a naive teenager, I remarked that these people must have it all—ultimate happiness and wealth.

That ride home, and several embarrassing Pickle pickups later, I began to understand that perception isn’t always reality. My father pointed out that not every large, beautiful house and expensive car on the block was purchased by someone with sufficient means to pay those bills. My parents didn’t value keeping up with the Joneses. Rather, they had chosen to be conscious spenders. Large expenses were aligned with the values they prioritized for our family—values like adventure, education and a hard work ethic.

On top of Pickle rides, there was Sunday breakfast, which consisted of burned buckwheat pancakes, soccer strategy and a financial lesson. After eating our well-done complex carbohydrates and visualizing our soccer prowess, Dad turned to a financial article or book to explain a new concept. It began with charts of the Nasdaq to explain what the stock market was and what a stock is, followed promptly by why we should care.

He always ensured we had some skin in the game to keep us interested. That skin just happened to come from our farm, manual labor and 4-H earnings. I absolutely despised farm work, but I loved making money. Once I began to understand that money could eventually work far harder on my behalf than I could with my own sweat equity, I was hooked.

In many ways, my parents were way ahead of the curve. They taught us the virtues of frugality, hard work, an unassuming lifestyle and the concept of values-based spending. Perhaps most important, they demonstrated grace in enjoying the ride—no matter how ugly the car might be.

This is the fourth blog in a series. The earlier articles appeared July 25, July 27 and August 1.

Anika Hedstrom’s previous blogs were Getting Schooled and  Site Seeing (Part IV) . Anika is a financial planner with  Vista Capital Partners  in Portland, Ore. She loves to nerd-out and, when given a dollar, will save 96 cents.

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This Week/Aug. 6-12

TAKE STOCK OF YOUR BONDS. Our financial lives are chockful of bond lookalikes, including savings accounts, our regular paycheck, Social Security and any defined benefit pension—all paying us regular income, either now or in the future. Set against these income streams is a big income drain: our debts. Result: Our finances may be riskier or more conservative than our bond position alone suggests.

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August’s Newsletter

WHY DO GREAT FAMILY FORTUNES often get frittered away with alarming speed? It’s tempting to blame profligate heirs. But in truth, the investment math is stacked against us, whether we’re leaving our children $100 million or $100,000. I explain why in August’s newsletter.

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Delusions of Immortality

We are all constrained by the income we have and the wealth we’ve either amassed or had handed to us. Result: Those on low incomes struggle to cover daily expenses. The middle class pay for today, while also socking away money for their own future. What about the rich? They often use their wealth not only for themselves, but also to help future generations.

These are, of course, gross generalizations. Some folks on low incomes manage to save surprising sums for their own retirement. The middle class may not bequeath great gobs of money to their children, but they often help with college costs. And, over the years, many spectacularly rich families have shown an alarming ability to devour wealth, leaving precious little for their children and grandchildren.

Still, I am fascinated by the possibility of helping future generations and the small sliver of immortality it offers. “I never knew my great grandparents, but I couldn’t have gone to college without their foresight,” has a nice ring to it. We may be gone, but it’s comforting to think we aren’t totally forgotten.

I have helped my children financially—a topic I have written about frequently. But what about subsequent generations? When I first pondered the issue, I had high hopes: I might not be able to commit significant sums to help later generations, but decades of investment compounding could potentially compensate.

But the more I’ve thought about it, the less promising the prospects seem—and the less surprised I am by the disappearance of great family fortunes. That doesn’t mean we shouldn’t try to help future generations. But our impact is likely to be limited and short-lived, for two reasons.

Problem No. 1: The math is against us. Efforts to pass wealth down through the generations face two obstacles: rising living standards and growing families.

As investors, we often focus on outpacing the twin threats of inflation and taxes. If we aren’t overcoming those two threats, our money isn’t growing. Seem reasonable? In truth, it’s a tad more complicated.

Our national standard of living is pegged not to inflation, but to per-capita economic growth. Over the past 50 years, U.S. per-capita economic growth has climbed at 1.8 percentage points a year faster than inflation. In other words, if our income rises with inflation, our standard of living might stay the same, but we’ll feel increasingly poor compared to our ever more affluent neighbors.

This need to keep pace with rising living standards creates big problems for family fortunes. Imagine we bequeathed $1 million, with the goal of generating income for our family in perpetuity. Our heirs invest the entire sum in stocks, an obviously risky strategy, and we’ll assume they incur no investment costs. Stocks go on to earn 6% a year, or four percentage points more than the 2% annual inflation rate. That’s a reasonable long-run forecast for stocks, I believe.

“Money doesn’t necessarily kill all ambition. But it seems to put a big dent in financial ambition.”

In the first year, the $1 million we bequeath earns $60,000. Federal and state income taxes would be owed. Let’s say that amounts to a combined rate of 18%—15% for federal taxes and 3% for state taxes—leaving our heirs with $49,200.

Our heirs would need to reinvest a chunk of that money to keep the portfolio growing. How much should they reinvest? Suppose the goal is to ensure the portfolio kicks off an income stream that rises not with the 2% inflation rate, but with per-capita economic growth. If per-capita growth continues to expand 1.8 percentage points a year faster than inflation, our heirs would need to reinvest $38,000. That would leave just $11,200 to be spent—a 1.1% withdrawal rate.

The good news: If our heirs stick to that 1.1% annual withdrawal rate, both the $1 million and the income it generates will rise every year along with per-capita economic growth, and it’ll do so in perpetuity. The bad news: Our heirs will receive pitifully little income.

To make matters worse, there’s a good chance we’ll leave behind a growing clan. Let’s assume we have two children, they each have two children, and those children each have two kids. That means we will have eight great grandchildren, all vying for their piece of the 1.1%.

You don’t need to be a genius to figure out what happens: A whole lot more than 1.1% gets spent, at which point the money we left behind won’t last in perpetuity. Instead, it will be depleted, slowly at first and then ever faster, as the demands for income outstrip the portfolio’s investment gains.

Problem No. 2: Money saps financial ambition. Potentially, our goal of helping our family in perpetuity could still come to fruition—if our heirs viewed their inheritance not as a financial mainstay, but as a nice annual supplement to the income they earn from their jobs.

On that score, however, we’re running up against human nature. Money doesn’t necessarily kill all ambition. But it seems to put a big dent in financial ambition.

I see this with my own children and stepchildren. They won’t inherit huge sums and don’t expect to. But they have grown up in comfortable upper middle-class households, and that’s had an impact.

How so? They all seem to be ambitious—but they don’t appear to be especially ambitious when it comes to making money. You can find that raw moneymaking desire among kids from affluent homes, but you’re far more likely to see it among those who grew up with too little.

I’m heartened that my children and stepchildren are, for the most part, careful spenders. That should help them avoid major financial headaches. But what about their lack of financial drive? Initially, I viewed it with some concern. But over time, I have come to see it as a luxury that comes with affluence: They worry less about money than I did, when I was their age, and that strikes me as a good thing.

Indeed, I have come to believe that, as long as they devote their days to work that benefits those around them, they are leading good lives, even if they aren’t collecting big paychecks. But there’s an obvious financial impact: To the extent that I leave them money, it’ll likely be spent and not passed along to the next generation.

Follow Us

Every week, I post at least three new blogs to HumbleDollar.com—usually on Tuesday, Thursday and Saturday—plus the weekly action item that appears on Sunday. Typically, two of the three blogs are written by others. Over HumbleDollar’s first seven months, the site has attracted a stable of seven regular writers, as well as some folks who have been onetime contributors. Interested in joining them? Check out the site’s blogging guidelines.

In addition to regularly visiting HumbleDollar, I encourage you to follow me on Facebook and Twitter, where I post something every day. And don’t be shy about supporting HumbleDollar’s efforts by buying my books and purchasing from the site’s referral partners.

Finally, I’ve been surprised to learn that some readers still don’t realize that my annual money guide—which appeared in 2015 and 2016 as a paperback and e-book—is now available on HumbleDollar at no charge. Did I mention that there was no charge?

July’s Greatest Hits

Here are the five most popular blogs from last month:

Fooled You
Retirement: 10 Questions to Ask
Looking Bad
Stocking Up
Chasing Points

When a blog appears late in the month, it often gets much of its traffic in the month that follows. In July, that was true of two blogs from late June: To Buy or Not to Buy and Precautionary Measures.

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College: 10 Questions to Ask

GOT COLLEGE-BOUND KIDS? Make sure you and your children are on the right track financially—with these 10 questions:

Can you afford to help your kids with college costs? It’s important to talk to your teenagers early on about how much financial assistance you can offer—and that’s doubly true if they’ll need to shoulder much or all of the cost.
Will your family receive needs-based financial aid? Use the EFC calculator at CollegeBoard.org to figure out how much aid you might get. EFC is an abbreviation for expected family contribution.
Are you funding a 529 college savings plan? This is the best savings option for college savers, thanks to the plans’ tax-free growth and limited impact on aid eligibility.
Should you shutter custodial accounts? These used to be a popular choice for parents looking to help their kids. But you may want to close your children’s custodial accounts, even if it means paying capital gains taxes, and move the proceeds into a 529. Thereafter, you’ll enjoy tax-free growth—and you should improve your family’s chances of receiving financial aid.
Are you investing college savings too aggressively? You’ll likely empty your children’s college accounts before you start to dip into your own retirement savings, plus the college money will be spent over a brief four-year period. The implication: You should probably be taking less risk with your kids’ education funds than with your own nest egg.
How much can your children reasonably borrow? Much depends on their eventual career and likely earnings. A rule of thumb: After graduation, your children shouldn’t be devoting more than 10% of their income to servicing college loans. That cap should guide their college choices and hence how much they borrow.
Do you have a home equity line of credit? Thanks to their low rates and tax-deductible interest, a home equity line of credit can be a great backup source of college money.
Have you checked whether you qualify for any of the education tax breaks? The various credits and deductions all have income thresholds.
If your children will soon enter college, is it time to empty your checking account—and pay off consumer debt? Money sitting in regular taxable accounts will hurt you in the aid formulas, while credit card debt and auto loans don’t improve eligibility. Result: Using spare cash to pay off these debts will improve your chances of financial aid, plus it’s typically a smart financial move.
If you’ve graduated, should you consolidate your student loans—and perhaps apply for an income-based repayment program?

This is the third in a series of blogs devoted to key questions to ask. The first two blogs were devoted to retirement and housing.

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Growing Up (Part III)

I WAS LESS THAN 10 YEARS OLD when I decided that I wanted to earn some extra cash over and above my weekly allowance. I took day-old sections from the Washington Post and went door-to-door in my neighborhood, selling each section for a dime. Not many fell for it, but there was a couple who were willing to hand over a dime to a young boy looking to supplement his allowance.

I doubt that I earned much from this endeavor. Still, it marked the early beginnings of my entrepreneurial spirit. There wasn’t any financial risk taken, but certainly the initiative and the appetite for earning money was there.

It wasn’t until my family’s return to Washington, DC, from my father’s posting overseas, that I—along with my twin brother—took on the next moneymaking venture. We were 16 years old. We advertised our lawn mowing services in the community newsletter, which was sent to hundreds of households. Once again, there was very little financial risk, because we required customers to provide their own mowers. We had enough customers through the summer to keep us busy, not just with mowing, but with add-on services, too. We would do just about any household chore a customer wanted.

Additionally, we did babysitting. Word was getting around that we were reliable. If you asked us to do something, it would get done. If you wanted us to be at your home at a certain time, we would be there punctually. If you called us, we would call you back. This same attitude toward customer service would become a significant factor in the growth of our landscape company two decades later. Customers knew that they could rely on us, a reason so many customers remained with us for all the years that we owned the company. Even customers that we had as teenagers and into our 20s would become customers of the landscape company that we started in our 30s.

As if we were not busy enough, we both took on newspaper delivery routes. We would be up at 5 a.m. to each deliver the 50 newspapers that were dropped off near our home. We retrofitted our bicycles to carry newspapers in a basket, with even more copies stuffed in the canvas shoulder bag that the Washington Post provided to its carriers. The Sunday edition of the paper was substantial, so much bigger than it is today. Either we would have to do two deliveries or we would load the newspapers onto the backseat of our gas-guzzling car and drive to each of the homes.

Deliveries were made in all kinds of weather. We were committed to ensuring that each of our customers received their newspaper. I recall on one winter morning waking up to a heavy snowfall. The newspapers had already been dropped off. We dug them out and walked the newspaper route, something that we also had to do on the days that followed, until the snow had melted. This commitment to customer service was not forgotten by our customers. Many would also come to us for our mowing services.

The cash that I earned was deposited into my bank account, usually on a Friday evening, when I was at the shopping mall with my mother and siblings. For all our hard work, our treat was dinner at Roy Rogers, a fast food chain located just down the hallway from the bank. This discipline of saving diligently and spending slowly continues to this day, though now I hold the purse strings a little less tight.

This is the third in a series. The first two parts appeared July 25 and July 27.

Nicholas Clements is one of Jonathan’s older brothers. He is retired and lives just outside Washington, DC. His previous blogs include Less Green and  Not a Good Time .

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This Week/July 30-Aug. 5

COULD YOU DROP INSURANCE POLICIES? If the kids have left home or you have $1 million-plus in savings, you might no longer need life insurance. With a seven-figure portfolio, you could probably also drop disability coverage and skip long-term care. Even if you can’t cancel policies, consider raising deductibles and extending elimination periods as your wealth grows.

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