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Archives for September 28, 2022

Rules for Financial Success

For most of us, some phase of growth is the stage we’re in. Growth is the phase of accumulation, positioning, cash flow, savings, making short & long-term decisions. This is where your financial model is used the most. Each decision you make has a ripple effect in this phase, so it helps to have some rules to use as guidelines.

Ideally, achieving financial balance should be your first goal. This can be done by adhering to simple rules that ready you for growth:

  1. Annual Savings (15-20% of gross income)
  2. Short-term Liquidity (3-6 months of cash, 6-12 months of near-liquid assets)
  3. Short-term Debt (ZERO)

The Rules

RULE: Become a first class saver by saving 15%-20% of your income annually. This is one of the most important ingredients to reaching your full financial potential. If you can’t do this, then everything else has to work that much harder. It puts additional pressure on all other aspects of your financial life, including a greater likelihood of failure! What is standing in the way of your saving this amount? Write it down. Figure out how to overcome these obstacles so you can reach your full financial potential. Hint: Remember, your financial model can help you find lost opportunity. You can recapture those dollars, and add that to your savings.

RULE: You should always have at 3-6 months of cold hard cash on hand. It would even be wise to have 6-12 months of near-cash (i.e. short-term bonds) that are easily accessible as well. A cash cushion provides multiple benefits, such as giving you the ability to increase your insurance deductibles and lower your premium payments. It gives you peace of mind knowing that whatever short-term obstacle (accident, fire, job loss, illness) may pop up that you can easily handle it without having to go into debt. Plus, you have the ability to capitalize on an opportunity that may present itself, take a trip, make a substantial purchase (whether it be something you need or simply want) and more.

Cash can also make you a happier person in general. In Jonathan Clements’ book, How to Think About Money, his research found that those with cash on hand – and in the bank – were much happier than those without any or with small amounts.

HELPFUL TIP: Opt out of your 401(k) until you have built up your short-term liquidity! Take care of today first and you will be better equipped to take care of tomorrow. Statistics show that 28% of all 401ks have loans against them, and it’s because this liquidity bucket is neglected or never filled to being with.

Understanding the 401(k)

401(k) Traps:

  • 10% penalty if you withdraw before 59 ½
  • Taxed as ordinary income
  • Limited investment options
  • Must withdraw a portion at 70 ½ or suffer a penalty
  • Match can go away
  • Can create double taxation
  • Can’t use it to pay for other life events
  • Typically use more expensive mutual funds

Are all 401(k)s bad? NO! If your company has one and they provide a company match, you should at least participate to the point of the match. But not until after you have sufficient liquidity. Discuss this with your personal advisor.

RULE: Short-term debt should be zero. Period. Liabilities are what hold most people back. Short-term debt negates any future profits on your balance sheet. For example, $19,200 debt x 5% interest (lost opportunity) = $253,570 in 10 years. In 20 years, it’s upwards of $666,000.  

Two of the most common short-term expenses among our clients are automobiles and credit cards. Cars depreciate 50% after the first three years on average. Look for used cars with low mileage that you can drive for a long time. You can often find a used car that is 25% cheaper than a new car. So if you must carry auto debt, then do it smarter.

Credit card debt can wreak havoc on your financial life. Interest rates average around 15%. That’s extremely high! This is exactly why Rule 3 is so important. If you have adequate liquidity not only can you pay off your credit cards every month, but you can limit what you charge on them since you have the ability to pay for things in cash. Think of it this way – if you have credit card debt carrying 15% interest, every dollar you don’t completely pay off costs you $0.15 each year. While there are always special circumstances, a good general rule of thumb to live by is if you can’t pay for it in cash, you probably can’t afford it.

You may need to slow down short-term debt payments in order to build liquidity and get protection in place first. You may even need to restructure your debt. But it is critical that you follow this order to provide relief, reduce stress, and build the foundation for growth.

LIFE HACK: if you are saving 15-20% of your gross income then short-term debt may just become part of your lifestyle burn rate.

While we’re on the subject of debt, we need to briefly discuss mortgages. Even though a mortgage isn’t considered short-term debt, it is a guaranteed debt that almost everyone will have to experience. Your mortgage payment should not exceed 15% of your gross income. My father used to tell me to buy as much house as you can afford. Back in the day, and still, people saw their house as an investment. However, what we do know is that real estate can and does decline in value. We also know that you can’t eat your house, it doesn’t produce income, and has multiple expenses (maintenance, taxes, updates, etc.). Any equity in your home is semi-restricted and you may not be able to access it when you need it most. Therefore, your mortgage payment should be part of your lifestyle burn rate, not your savings.

What do you do if your payment exceeds this number? First, ask yourself if the payment is preventing you from saving 15-20% of your gross income. If not, then consider it part of your lifestyle and know you may have to limit yourself in other areas. If so, then you could consider refinancing, selling, or maybe you just have to stay put.

Learn how to apply these simple financial rules to a model you WILL succeed with:

Two Major Risk Factors to Retirement Success

For most people its not until they hit 50 do they have the O.S. moment – do I have enough money for retirement? Am I on track to continue my lifestyle when I stop working?

There are many principles we focus on early and often in financial life management, but a couple very few address are a couple risk factors that are largely out of your control but you must prepare for – Sequence of Return Risk and Longevity Risk. Traditional financial planning just can’t address these two issues so they largely are ignored, however, they are critical to what your “retirement’ lifestyle will be if you don’t address them now.

#1 - Sequence of Return Risk  is the order in which you get returns on your portfolio, i.e. 5% year one, 12% year two, 8% year three, -9% year four, etc. It’s not just the real return which matters, but also the order of these returns. Getting negative returns at the start of retirement can have a devastating impact on your retirement and how long you can live without running out of money. A 20% drop could wipe out 30 years of gains!  You never know when the down market will appear and its effects on your portfolio.

The sequence of returns leading up to and into retirement make a huge impact on the amount of income you will have. Suppose you have a $500,000 retirement fund and need to know how much you can withdraw to live on for the next 20 years. The stock market has averaged 10.24% annual return from 1926-2014. So you would think you should be able to pull at least 10% per year, on average, and have your money last 20 years. On $500,000 that gives you $50,000 annual income. Even if the return fluctuates in the future, as long as it averages at least 10 percent per year, the fund should last 20 years, right?

Wrong! Given typical levels of stock market volatility there are only slim odds that the fund will survive the full time. The following charts simulate this retirement strategy with actual S&P 500 returns starting in various years from 1992 – 1995.

As Ed Easterling puts it in Unexpected Returns, “The cycles that occur during an individual’s period of investment will dramatically influence the returns that investor realizes.” For investors to ignore the strategic implications of this investing reality is folly.

Even with the same behavior and doing everything “right,” you can get very different results even with the same average return.  This is sequence of returns risk!

#2 - Longevity Risk – The risk that you will live a long life and outlast your money. In retirement, longevity risk becomes the greatest risk because the longer retirement lasts (the longer you live) the greater the chance you will succumb to other forms of risk. Increased longevity means more time for another financial crisis, increased chances for health problems, housing costs, more time for inflation to compound, and so on.

Running out of money is usually at the top of the list of concerns when building a retirement income plan. And, it should be!

Once you get into retirement you no longer have an income. Your income is determined by your assets. Retirees often require regular withdrawals from their portfolio to pay for living expenses. Traditional methodology is that you spend the interest off your assets (hope that is enough!) or a combination of interest and the assets themselves.

To ensure your money will last your advisor says to invest more conservatively to lessen your chances of losing money. But at the same time you are diminishing your returns, which means a greater likelihood of dipping into your principal. Neither is a prospect for success!

Maintaining some acceptable level of return means a portion of your portfolio is at higher risk. High portfolio volatility increases the likelihood that you will have to withdraw funds while the portfolio is down, maybe even deep down. The amount of remaining principal determines the amount you can safely withdraw each year. High portfolio volatility and suffering a large loss requires a reduction in retirement income (and lower standard of living). This matters a lot because now you’ve begun a downward spiral from which you may never be able to recover. Sharp  drawdowns  and roller-coaster volatility can drive you to sell equity holdings to cover living expenses. As a result, you get to experience the decline but not the recovery, which will quickly erode the portfolio and leave you without any income.

Diversification is traditional portfolio theory’s answer to managing these risks. While diversification may manage non-systematic risk (specific risk), it fails to manage systematic risk (market risk, day-to-day fluctuations in the market), particularly during bear markets. Asset allocation, as we’ve noted above, only gets you so far. Many markets that were once normally non-correlated now move together under economic stress. Diversification can then fall short when it is needed the most.

So what’s the answer? We’ve studied this A LOT and have come up with some unique answers that are easy to understand and simple to implement.

Download our free guide to learn how we avoid these major risks to your retirement and start living the life YOU want:

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Investor Behavior: Are You Your Own Worst Enemy?

Your poor investment returns may be entirely your fault! I say that tongue in cheek but Dalbar’s Quantitaive Analysis of Investor Behavior study shows how poorly investors perform relative to benchmarks and the reasons for that underperformance.

DALBAR publishes a study every year. Here are some key takeaways from the 2017 study:

  • In 2016, the average equity mutual fund investor underperformed the S&P 500 by a margin of -4.70%. While the broader market made gains of 11.96%, the average equity investor earned only 7.26%.
  • In 2016, the average fixed income mutual fund investor underperformed the Bloomberg Barclays Aggregate Bond Index by a margin of -1.42%. The broader bond market realized a return of 2.65% while the average fixed income fund investor earned 1.23%.
  • Equity fund retention rates decreased materially in 2016 from 4.10 years to 3.80 years. (This is directly related to psychology and behavior.)
  • In 2016, the 20-year annualized S&P return was 7.68% while the 20-year annualized return for the Average Equity Fund Investor was only 4.79%, a gap of -2.89% annualized.
  • 2016 was a great study in investor behavior as fear generally won out as evidenced by several months of steep outflows.

Investor Psychology

Analysis of the underperformance DALBAR data shows concludes that investor behavior is the number one cause of this. Fees are the second leading cause. It’s more than just buying and selling at the wrong time, it’s about breaking down the emotional triggers and traps that plague the investor psyche. This is why it’s important to understand the thoughts and actions that drive poor decision making.

There are nine distinct behaviors that can wreak havoc on investor’s portfolios:

1. Loss Aversion. Loss is felt much deeper than the gratification that comes with gaining. Many bad investor behaviors arise from this, including holding on too long to avoid realizing loss, expecting high returns with low risk and stock picking only those stocks they believe will produce large returns.

2. Narrow Framing. This is when decisions are made without considering all of the implications. Market bubbles are great examples of this. Most of those investments are made based on the hype and initial skyrocketing growth. What often isn’t factored in to those decisions are the economic implications down the road.

3. Mental Accounting. Investments may be mentally segregated, with different criteria and due diligence applied to them. You end up taking undue risk in one area while avoiding rational risk in another. Examples include how people spend tax returns, bonuses, etc.

4. Diversification. While important, investors often tell themselves they are seeking to reduce risk, when they are actually using different sources that may be just as risky. Diversification should again be evaluated as a whole, examining the risks of the different investments. These make up the overall risk of the portfolio. You may not be as “diversified” as you think.

5. Herding. We like to copy the behavior of others even in the face of unfavorable outcomes. This is a representation of confirmation bias to a certain extent. There’s comfort in following the crowd, but it often leads to dire consequences.

6. Regret Aversion. We tend to treat errors of commission more seriously than errors of omission. For example, this causes investors to sell winners prematurely in order to lock in profits before they turn into a loss. It can also cause them to hold losing positions too long, in the hope they may turn profitable.

7. Media Response. It’s easy to react to news from television personalities and financial “gurus” without reasonable examination. Confirmation bias plays a big role here too. If the information investors are listening to and gathering confirms their own beliefs, actions and/or opinions, they fail to gauge how that decision may negatively impact them. They fail to look to other sources of information that challenge their own way of thinking or offer other perspectives.

8. Overconfidence. A natural human thought is that good things happen to me, bad things happen to others. For investors, this causes them to think that they have the skills and knowledge to consistently beat the market. And they’ll succeed, because blow ups don’t happen to them. However, they quickly learn otherwise.

9. Anchoring. We determine how to behave based on previous experiences, and relevant facts. Investors tend to anchor their thoughts to a reference point – like that time they took a risky leap and lucked out with a big reward – even if that reference point has no relevance to the decision at hand.

The long term consequences of poor decision making

Dalbar notes that, since 1994, they have seen that investors are impatient and move into and out of investments too frequently, typically 36 to 56 months depending on the type of fund. These flows tend to happen at the worst possible time. This behavior has been observed every year since 1994. The results are an equity performance gap of 4.7%. In terms of dollars, on a $100,000 account invested for 20 years the difference is shortfall of $185,471*.

*($100,000 invested at market return of 7.69% vs 4.79% over 20 years = $440,874 vs $255,403 respectively.)

These behaviors can be harnessed. They can even be eliminated. Using a rules-based system is one way to do it. Our Factor VI portfolios were created on this very premise and are designed to keep you invested, create a smoother investment experience and remove emotion/bias from the decision-making process.

Ready to learn how to reach your full financial potential by adjusting your behaviors? We’ll teach you how. Get in touch with us today and let’s work together!