"About Us" Part 3:  What We Learned the Hard Way About Investing

Investing well was one of the keys to our financial ability to retire early. In the summer of 2008 (before the crash) in response to a friend's request, we sat back and really examined our experience and hence our advice to others and here it is:

Be Clear About Your Investment Needs

-Do you need an income stream beginning now or at a given point in the future?

-What's your best guess as to your life expectancy?

-Does investing have any 'hobby' value to you or do you want to minimize your time spent managing your assets?

-Do you want to 'pay as you go' with taxes or defer them?

-How much risk can you tolerate?

-Do you have excellent resources for investment and tax advice?

Know How Your Situation is Different From the Average

For instance, conventional advice is often inappropriate for us because of our situation and biases:

-We retired at age 49.

-Though retired, we invest with the aggressiveness of the non-retired (ie didn't shift heavily into bonds).

-We each have 1 parent who lived into their 90's, well-beyond average life expectancy.

-We have no earned income and receive no monthly pension payments.

-We have a larger portfolio than average.

-We did our experimenting with products in our 20's and 30's and now only invest in the old standbys.

-There is no longer any 'hobby value' for us in investing; we want to minimize our time tending to our portfolio.

-We are both comfortable with more risk than the average person but don't invest in high risk/high return products.

Minding the Percentages is Everything

-On average, the US stock market delivers about 10% in annual returns.

-Annual inflation in the US averages around 3% but it varies wildly.

-The cost of help implementing and managing your investments can run from fractions of a percent to 5% or more.

-The losses to taxes vary considerably with the particulars of an investment.

-Assuming a 30 year retirement period, the conventional wisdom is that in your first year of retirement you can

  withdraw 4% of your assets and increase that amount for inflation each year and have a 90% chance you will

  not run out of money.
      -Bill concluded that earnings should be 3% per year over inflation and expenses to have reasonable asset growth.

The Simplest, Safest Investment Strategy

An online Vanguard Fund advisor recommends a very simple strategy, which is to invest 100% of your funds as follows:

1 fund indexed to the total US stock market

1 indexed fund of US bonds

1 indexed fund of international stocks

Using this strategy, the Vanguard advisor recommends:

-80% of the assets should be in stocks, the remainder in bonds

-20% of the stocks should be in international funds

He further noted the aggressiveness of the basic strategy could be increased by having:

-85%  of your assets in stocks;

-up to 40% of stocks in international funds

Were we starting over with our investment portfolio with what we now know, we'd basically follow the more aggressive version of the above simple strategy with the following changes:

-we'd feel more comfortable with greater diversification and would select 3 indexed funds of US stocks

-we wouldn't use an indexed fund for the international stocks but select a un-indexed fund of international stocks

-we'd invest more heavily in stocks and less in bonds

-we'd invest around 30% in international stocks (which is our current position)

The pro's of this simple approach are that it should:

-on average deliver that 10% market return on stocks (less for bonds)

-minimize your risk by prudently balancing risk and return

-minimize your management fees that erode your net profit

The shortcomings of this approach are that it:

-it does not take in to account your needs for an income stream

-it doesn't optimize for your tax situation.

Another Simple Approach

There are mutual funds that we haven't explored which pivot on your targeted retirement date. The funds start out more heavily invested in stocks and transition over the years to being weighted towards bonds. They begin paying out when you arrive at your targeted retirement date. They shift their holdings from stocks to bonds as bonds are the textbook holding for retired people as they have less risk and volatility than stocks and deliver a steady income stream. The downside of bonds is that they average a lower rate of return than stocks and usually incur higher taxes. In our opinion, the shift into bonds shouldn't be based on your retirement age but your life expectancy.

Customizing Your Portfolio For Higher Returns But Greater Risk Than The Simple Strategy

Market Capitalization

An indexed fund of total US stocks will have a mix of  large cap, medium cap, and small cap holdings in the same ratios as exists in the total US stock market.  "Large cap" means large firms, which generally pay higher dividends but  overall have lower rates of return because they are less risky; "small cap" are the opposite: they are smaller firms that are riskier, payout little as dividends but have a greater potential to deliver higher increases in stock value in the long run. Those percentages are: 66% of the US stock market are large cap companies; 27% are medium cap; 7% are small cap. So, if you are willing to incur more risk for the greater potential of higher returns, you could select mutual funds with a higher percentage of medium and small cap funds than the market's average. 

Style Exposure

In selecting non-indexed mutual funds, you can also tinker with the "investment style" of your mix. "Value" firms (firms thought to be undervalued and will increase in value faster than most), "growth" firms (firms thought to be poised to grow faster than most) and "blended", which are a mix of growth and value firms, are your choices. Like with the capitalization type, the style influences whether your returns will be in the form of dividends or capital gains, with value firms and large cap firms paying out their increases in value as dividends and maintaining a relatively more stable share price. The firms traded on the US stock market are identified as 33% value firms, 32% blended, and 27% as growth, with another 7% being uncategorized.

Combining all the possible choices in market capitalization with investment style yields a matrix with 9 possible combinations of firms or funds to consider as you refine the risk you accept, the growth you anticipate, how your gains are received, and the tax consequences of your gains. Non-indexed mutual funds will generally identify their biases in these categories.

Our Experience

In late May of 2008 Bill discovered that one of our funds entitled us to use their online portfolio assessment tool at no charge. Bill imported the names and current values for all of our funds, turned the crank on their model, and surprisingly, our mix of about 20 holdings closely matched that of the market as a whole, both for market capitalization and style exposure as our percentages were close to those noted above.

Read the Fine Print for the Fees, Regardless of How You Invest

Mutual funds are the easiest way to keep you fees low. But even with them you need to read the fine print for:

-Loading:  front or back where one-time 'privilege to own' fees are charged when you buy or sell the product

-Sales commissions to your broker or portfolio manager

-Annual management fees

-Transaction fees

Diversification vs Minimizing Fees

We began investing in our mid-20's by purchasing individual stocks and we felt well diversified in the stock market. In the early 1990's a financial planner/broker nudged us towards giving up that diversification from owning individual stocks and consolidating our holdings into various funds. Consolidating our assets into funds felt less diversified as the list of holdings was shorter but it actually increased our diversification and the safety of our investments because each fund holds many individual stocks.

The consolidation of our assets into funds simplified our bookkeeping and bought us a number of privileges. One such privilege was achieving 'break points' which allowed us to lower the purchase fees in load mutual funds within a particular family of funds. Consolidating allowed us to buy more exclusive, presumably better, products that had higher minimum purchases. And an even smaller advantage that we've only recently began to utilize is  access to additional services, such as access to free portfolio management services we would otherwise have to pay for or would be harder to locate.

Tax Considerations

Why It's Hard

Egads! Tax implications are the hardest aspects of investing to know and to manage. The tax laws change; one's income bracket can change from year to year; tax sheltered products can become disallowed; and what and how firms pay out to their investors changes. And yet, taxes take such a big chunk out of your earnings, their effect cannot be ignored.

Getting good advice for investing and for evaluating the tax consequences of investment decisions isn't easy. To invest well for your needs requires taking tax issues into consideration but financial planners aren't allowed to give tax advice and accountants aren't allowed to give financial advice and brokers tend to recommend investments that pay good commissions to them.... It's up to the individual investor to integrate the information and figure out what is best for their situation, often in hindsight.

And we've received absolutely terrible investment advice over the years: stupid advice, advice that lined the pockets of the professionals, and advice that was totally ignorant from a tax perspective.  We did find 1 financial planner/broker who was a straight shooter and she directed us in making big shifts in how we positioned ourselves in the market. But even with her, Bill quickly learned that he was better at developing an integrated investment strategy than anyone we'd hired so now he 'goes it alone.' He does contact our accountant now and then to determine the tax consequences of a particular change he is planning as keeping up on the tax law changes and their implications is daunting.

Tax Sheltered or Deferred Instruments

Tax deferred plans only defer your taxes, you always have to pay taxes on your income at some point. The assumption is however that when you begin withdrawing from the plan in the future that you'll be taxed at a lower rate because you'll be in a lower tax bracket than when you invested the money.  This assumption may or may not be correct depending upon what you invest in now and the tax consequences of your other investments.

We no longer go looking for tax deferred investment instruments though fully utilized our IRA and 401K options when we had earned income. The mandatory payouts from our investments in those instruments will substantially increase our taxable regular income at age 70.5 and so we'll actually be in a higher tax bracket than we are now. So rather than amplifying that problem by investing more money in other tax deferred plans, we are electing to 'pay as we go' with our other investments. Tax deferred investments are a good option for many people, just remember that they will create a tax burden in the future that may also increase your tax bracket.

Purchasing bonds, on which you pay taxes at your normal income rate, within a tax sheltered devise like an IRA or 401K plan is a way to get the security of bonds without the tax penalty.

Another reason we shy away from tax sheltered plans is that we had bad experiences with chasing the newest attempt to take advantage of tax loopholes. We bought several such products in the early 1980's with a large brokerage firm and got burned. We lost money on them as the tax laws changed and some of them died very slow deaths, complicating our tax situation for many years and therefore increasing the cost of our tax preparation. They were such a mess we could no longer do our own taxes. Some of them were bad enough that they lead to class action suits against the fund developers and brokers.

At this point, we take a 'wait and see' approach to new types of investment products with new tax advantages. Rather than get in early on the great deal, we'd rather wait and see if it holds up under the pressure of changing laws and delivers the stated advantages.

Capital gains vs Normal Income

One's wage, many dividends, and most bonds payouts are taxed as normal income--they are taxed according to your tax bracket. Capital gains, or increases in an investment's value from the time you bought it until you (or the fund) sold it, are taxed at set rate, which is usually lower than one's normal income rate. How capital gains are defined, taxed, and handled changes with the political winds.

Since we've decided to spread out our taxes paid on our investments over our life times instead of maximizing deferring them all until age 70.5, Bill selects funds that largely payout as capital gains when a stock within the fund is sold. This strategy is the best way for us to reduce our total tax bill.

Creating an Income Stream

Our investment life was simpler before retirement as we continued pouring earnings into carefully selected funds and had any payouts they generated automatically invested. Whatever taxes were due in April on profits made by fund transactions were paid out of surpluses from our normal, earned income.

Having all of one's capital gains and dividends reinvested can create cash flow challenges. In years when one's funds have stellar performance you may incur taxes on those gains at yearend though not have the cash to pay the taxes from your regular income. Selling a portion of your funds to cover your taxes owed will then create more capital gains on which taxes will have to be paid in the following year.

After retirement there was no earned income stream for our living expenses or our income taxes and we began withdrawing funds from the earnings of our investments. Bill agonized over the selection process of which funds should payout what portions of capital gains or dividend payments. Almost 100% of the payouts from our funds come in the last 10 days of the year and only when the last payout is made do we exactly know how much cash we have to live on for the next year. His agonizing paid off however as only once in the last 8 years have we've  needed to sell funds to raise more cash for the coming year. On years that are too abundant, the excess payouts are reinvested in existing funds.

So, once you begin drawing on your retirement savings, you need to consider how you'll handle the details.   But as a back-up, you should do as Bill has done and know from which fund you will withdraw for tax and income reasons if you are short of cash and where you will invest if you have excess cash. 

If you shop around, you will find some funds that are designed to make more regular payouts for a smoother income flow. The caution with these funds is the same as with any product with extra features: you are likely accepting a slightly lower return for the extras. In general, the simpler the product, the greater the return.

Other Investment Devices

Metals

We've never invested in metals like gold and silver and agree with others that those are too risky and too ill-liquid for the average investor.

Real Estate

In the past, we considered owning real estate as one of the ways in which to diversify our portfolio. We owned some shares in limited partnerships that held property and we've owned 3 houses: 1 was purchased as a rental and the other 2 started as our home and then were converted to rentals. We agree with our recent DVD economics' professor that real estate is too ill-liquid and too risky to be a good investment. Plus, the amount of money that one has to pour into a house for general upkeep and renovations for selling muddy the waters in really understanding the rate of return. We prefer investing in the stock market which takes less energy and is easier to track one's rate of return.

The required record keeping, the tax accounting, and changing tax laws also disqualify real estate investments from being a simple way to manage one's investments.

2009 Addendum

This piece was written in the summer of 2008 and by October of that year the international world of finance had collapsed and few individuals in the world were untouched by it. Our fate rises and falls with the market and like the market, we lost about 40% of our net worth--depending upon the day. We consider ourselves among the lucky ones however in that none of our holdings went belly-up. The fact that they went down but didn't disappear means that they, and we, still have the opportunity to recover.

Luckily, Bill's excellent financial planning allowed us to continue our cyclotouring lifestyle. A stash of maturing US Savings Bonds were good candidates for selling to raise cash for our revenue stream that all but disappeared at the end of 2008. Those bonds, unlike other holdings, wouldn't be sold at a loss.

We are confident that the market will recover and that it will recover in a timely enough fashion so that we don't have to change our lifestyle. Like riding a bike, investing in the market takes confidence and one must position oneself so that they still can be confident when the going gets tough.