New Year’s resolutions: 5 ways to simplify your financial life
- December 24, 2010
- 16 comments
- Posted in Investing, Latest Posts, Savings & Debt
Make 2011 your year to simplify. The day I started to practice investment KISS (Keep It Simple, Sister*) was when I finally got control of my financial life. I dropped my broker, quit hunting for hot stocks and mutual funds (losers, all), and put my retirement money on automatic pilot. I chose an easy investment program based on the best academic research and let it chug along all by itself. The strategy paid off.
Here are my five rules for simplifying your way to financial success. They work for everyone, all the time. In my experience, they’re the only things that work.
Bump up your savings. The fastest way to riches is saving more money now. It’s far more effective than chasing higher investment returns. For example, say that you’re putting away $500 a month and raise it to $600. That’s a 20 percent gain in your retirement account. Where else can you get a guaranteed increase like that today?
If you’re living paycheck-to-paycheck, you probably think that you can’t save another dime, but you can. Arrange to have the extra money taken out of your paycheck automatically — either through payroll deduction or by using your online bank account to have money switched into savings every time a paycheck comes in. You’ll discover, to your surprise, that your lifestyle won’t change. You’ll adjust your spending – a little here, a little there – to make up for the money that’s no longer in your checking account. It’s the only known magic in the world of personal finance.
Some people living paycheck-to-paycheck are earning $250,000-plus a year (remember the I’m-not-rich outcry when they thought that their taxes might go up?). The higher you live on the hog, the sorrier you’ll be if you hit retirement without enough money to keep your gold-plated lifestyle going.
Use the tax code to ramp up the size of your retirement account. Pack your automatic savings into a tax-deferred retirement plan. I’m constantly running into employees who save enough to get the company match of 3 or 5 percent of pay and then quit. Why would you do that? Tell your company to take more out of your pay or sign up for automatic annual increases if they’re available. Some companies offer Roth retirement plans – you don’t get a tax deduction for your contribution but the earnings accumulate tax free. That’s a deal I’d take.
If your company doesn’t offer a plan, create your own. Pick a low-cost mutual fund group and ask about its Individual Retirement Accounts. The self-employed should consider solo 401(k)s or SEP-IRAs.
Switch to index investing. Give up the illusion that you’re smart enough to beat the professionals whose trading sets the market’s price. They love you to think that way because they charge you high fees to try – wrap fees, insurance fees, annuity fees, marketing fees, brokerage fees, account fees. You can’t help but underperform, after all those costs.
Tons of research shows that mutual fund managers don’t beat the market either, over time. They might ride some hot stocks for three or five years, which is when they’ll roll out the advertising and get you to invest. Then those hot stocks cool and they fall behind. You’ll be paying your manager to miss.
How does Wall Street get away with it? Because most do-it-yourself investors have no idea how well their stock-picking or fund-picking performs. You remember your winners, forget your losers, don’t average the two of them together, and have no idea how well your results compare with general market returns. Odds are, you’ve done worse — much worse. You’d be richer if you had dumped the lot into index funds.
So give it up. Switch to index funds that follow the markets as a whole. The Vanguard Group has the largest variety of super low-cost funds. You’ll also find funds at Charles Schwab, Fidelity Investments, and T.Rowe Price.
Divide your money between stocks and bonds in a way that’s appropriate for your age. That means stock funds as well as bonds. The cautious investors who stampeded into bonds after the 2008 market meltdown missed this year’s 9 percent gain in Standard & Poor’s 500-stock average and the 76 percent gain since March, 2009.
One useful diversification rule is to subtract your age from 110. The number that results suggests how much of your total, long-term investments you could reasonably allocate to stock funds. For example, say you’re 60. Subtracting that number from 110 gives you 50. You might put as much as 50 percent of your money into U.S. and foreign stocks and 50 percent into bonds. At age 40, you’d put 70 percent in stocks and 30 percent in bonds.
Alternatively, invest in a target-date retirement fund, where the asset allocation will be done for you. At Vanguard, you can get target-date and index funds in a single package.
Rebalance your investments. It’s important to maintain your chosen division of stock and bonds. For example, say that your target is 60 percent stocks, 40 percent bonds. If the market rises by so much that you’re now 65 percent in stocks, sell some of those shares to bring the percentage back to 60 percent and invest the proceeds in bonds. If the market drops so that stocks now make up only 55 percent of your portfolio, sell some of your bond shares and reinvest the proceeds in stocks.
Emotionally, rebalancing is hard because you’re going against the herd. But financially, it’s a winner. You’re always selling high, buying low and managing your risk. Don’t bother rebalancing on small dips. Do it only if your target percentages fall 5 percentage points out of line.
It’s impossible to rebalance intelligently if you own individual stocks and difficult, with managed mutual funds. It’s never clear which ones you should sell or buy. So here’s another advantage of working with index funds – they make rebalancing simple. Target-date funds are rebalanced for you, automatically.
Using this five-point program, you can forget about fickle individual stocks, complicated annuities that carry high (and sometimes hidden) fees, wrap accounts, and all the other offerings that will make only your broker rich. KISSes to all, in 2011.
*Some would substitute “Stupid,” but my mother taught me to be polite.
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Tags: automatic saving, index funds, KISS, rebalance, simple investing, target-date funds
I am age 66 so I would have by this guide, a large majority in bonds. As a normal rule, that has been the view. Buy given all the cautions out on bonds now, that at least 2011 will not be good for bonds, are you still a supporter for this formula of mix of stock and bonds , as it is a bigger deal for us older investors who have already taken a lot of hits and loss in the stock market, and in our retirement investments?
Not a large majority in bonds, at 66 — just 56 percent, a little more than half. See my answer to RonReports. If you would feel safer and don’t want to take risks, I’d suggest putting some of your fixed-income money into bank CDs. The rate is low but there’s no risk of loss, under the $250K insured amount.
New Year’s resolutions: 5 ways to simplify your financial life – Your great 12/24/10 article just needs the 5th rule to be bolded to stand out – or number all 1 to 5. “Rebalance your investments”. I think these are all excellent rules to emphasize – Thank you!
Yes, I fixed the missing No. 5. Thanks.
“Five Ways to Simplify”? Didn’t you only list four ways? Advice to save more would have been better years ago, because now interest rates are ridiculously low. Putting a lot of money in bonds also would have been better advice years ago, because if interest rates increase sharply, the value of these investments would fall sharply. I would be interested in reading your reaction to these observations.
Sorry, I forgot to “bold” the Rebalance Your Investments — the 5th on the list. In point of fact, I did indeed advise saving more several years ago — and owning bonds, too. From the start of the bull market in bonds in the late 1970s, bond outperformed stocks for as many as 40 years (depending on when you measure).
I will ALWAYS say “save more,” regardless of interest rates. They is not time to save less, and people need liquid cash. If interest rates rise, the market price of bond funds will fall — but I can’t predict the future and in the next cycle, bond funds will rise again. What’s more, your bond fund manager is buying those bonds that carry higher interest rates, so your income from the fund will rise (or, you’ll get more shares if you reinvest income). You need bonds as diversification because the future is unknown. in the late 1990s, people didn’t touch bonds — and look what happened.
Thank you. This is the best advise I’ve read or been given and that includes advise from some of the fund groups mendioned in your article.
Thanks for the Christmas present. In return, allow me to summarize your five rules into one rule: The secret is that there is no secret.
Believe it or not, it’s worked for me over the past thirty years, although it never seemed to while the practices were being applied, probably because there was always some part of the economy that was temporarily far ahead of indexes.
Dear Jane,
Thank you for your advice. I have listened to your CDs a few years ago and try to use it as a guide. I have now paid off my debt, own a home (with only small amount of mortgage left at 4.5% fixed rate), maxed out my retirement investment every year, contributed to a 529 fund for my son, and contributed to charity. Now I am not sure what to do with the rest of the money as I am only 38 y/o. My income is higher than 250K per year. Should I put them in index funds? Thank you.
As you know, I’m a big believer in index funds — a mix of US and international, with emerging markets stressed. A bond fund for ballast. At your age, you need to invest for growth. A rule-of-thumb allocation would be 70% stock funds, 30% bond funds.
Even if bonds are reported by some to see low returns for a while, if one does follow the mix of stock and bonds per age, minus 110, for bonds, do you favor certain bond funds within Vanguard group, or other bond funds one can select from? Reasons for preference? tx.
I like Vanguard bond funds because of their low cost and high quality. Watch for another bond fund column, coming on the 7th.
With so many finance writers and politicians generating doom and gloom anout our Federal government, I tried to use what I thought was knowing former President Bill Clinton has our federal debt paid up or off when he left office. I thought I saw or read about that someplace. But a friend who is from a country in Europe thinks two things. One , the debt in Europe is exagerated and artificial, to make the dollar look better than the euro. Even more , he feels the Bill Clinton administration never did pay off the federal debt, he only got his budget balanced for first time in long time, and he was not adding to the nation debt part of his years in office. There is a big difference in only balancing his administration budget, and in getting the Federal total debt actually paid off. Which was it he did?
Clinton balanced the budget and began a paydown of the national debt. He did not eliminate the debt, but reduced it during the years he had.
Eurodebt is not being exaggerated. You can see it in the risk markets for Irish, Green, Spanish and Portuguese debt (to a lesser extent, Italian debt). Markets look at facts, not talk.
If one is fortunate to have a defined benefit pension, how does one value it in the asset distribution computation?
Dollar value is a technical question. If you’ll take the pension as a lump sum, you need an accountant to help you figure its discounted present value. Its present value is roughly the lump sum you’d need today that — if invested at a safe rate of interest — would equal the lump sum you’re due at retirement. You’d treat that sum as if it were a bond.
If you’ll take it as a lifetime income, simply add it to your expected income when you estimate your retirement budget.
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