Saturday, August 3, 2013

Recapping the Sound Reasons for DIY Stock Investing and the Impact of the Rule of 72 Over Time

As I've said many times, don't try to time the market. It hit new record highs again yesterday, and all the gurus are and will be debating about whether it's peaked for now, getting ready for a fall, aka 'correction,' going to remain 'stuck in a trading range' at current levels, or a combination of all of the above.

Here's all we know for sure about the short term market moves. Prices will fluctuate. They always do.

But if you're a long term investor, try to ignore the short term noise and simply stay the course. If you're not a long term investor, however, now's as good a time as any to 'take some money off the table,' especially in non-taxable accounts like 401(k)s and IRAs.

And here's some more advice from an admitted amateur.

Don't give your investment money away to 'expert' advisers and brokers. It's your money, your financial future and your risk that is at stake, so it should be your reward, too.

And follow the rule of 72 over a long period of time.

The above are my common sense, experienced based and very simple rules for individuals. Of course, they aren't generally followed. But they should be.

3 fixes for retirement investors on the edge provides a great summary for common sense individual investors:

"What's a "good" return on your money for retirement investors these days? Ten percent? Less? More?

There's a good deal of confusion over what return a retail investor should expect. Not many years ago, a 10% annualized return was a standard guesstimate from a financial adviser. Unsurprisingly, many near-retirees still use that rule of thumb.

However, low current interest rates being what they are, many of the top financiers today talk of accepting 5%, perhaps 6% at best. That's not settling for less. That's their target, what they consider a reasonable average over 10 years or more.

It's a monstrous gap. Using the rule of 72, we know that money doubles in just over seven years at a 10% return. Drop that expectation to 6% and you'll be waiting nearly 12 years.

We don't know when interest rates will rise. Plenty of financial speculators, some of them quite famous, have lost their shirts over the past few years trying to outguess the Federal Reserve. We'll leave that exercise to them.

Rather, retirement investors should adopt the posture that trying to "figure it out" is just about the worst way to make money.

The research firm Dalbar made this point in one of their recent analyses of investor behavior. Looking back over 20 years, they calculated how average mutual fund investors did by trying to time their holdings.

Pretty badly, it turns out. While the Standard & Poor’s 500 Index gained 7.81% a year on average, the typical retail investor clocked an annualized 3.49%. Active bond investors put up even worse numbers: Their index returned 6.5%, while investors earned just 0.94%.

"But I'm different! I beat the market with my strategy!" Yes, you probably did, last year and the year before. Maybe even three years out of four. You are above-average, congratulations.

And, as happens with even the most highly paid and widely admired money managers on Wall Street, your eventual comeuppance will be a shock to you. Your strategy will work until it doesn’t. When it fails, expect it to fail miserably.

One day, the "market" will turn irrational, from your perspective, and stay that way for far longer than you will be able to stay solvent. And that's how your track record, once combined over years, will fall back to an earthly frame of reference — or worse. Make no mistake, you will be tested.

Perhaps you are in the business of managing other people's money. In that case, stop reading now. You are safe. You can keep fiddling with your pet investment theories and charging your usual fees to put them into action. Your retirement, built on the fees of your customers, is in fine shape.

If you're the customer, well, you have a problem. But it's a problem that can be fixed. Here's the plan:

1. Stop paying needless fees

Do you have any idea what money management really costs? If you said, "Just a percent or so," you are right. But the true number is much, much higher. A mutual fund that costs 1.27% a year removes money from your retirement fund at a rate that will cost you nearly a third of your potential gain over three decades.

Put simply, if you made a dollar on an investment, the fund keeps 32 cents of that dollar. Minimizing investment fees is paramount.

2. Own the market, not a stock

Wall Street is built around our human weakness for a great story. It's the same logic that drives the advertising world. Every broker knows that he must call his best clients every day and pitch them "the story" on a given stock. It's that, or no commissions. Financial cable TV shows do the same shtick, endlessly speculating on near-term data in the economy and the latest utterances of star CEOs.

Economists and business managers know this is drivel, but they play along. The solution is to turn the volume down on all that and simply own the market via index funds or ETFs, and to practice diversification by using a careful asset allocation plan.

3. Understand the math

Compounding using the rule of 72 is infallible. If you have just 10 years to retirement age, you know perfectly well what your final portfolio is likely to be worth. If that plus Social Security and any pensions you have isn't enough to retire, you won't. You'll keep working.

Reaching for a few extra percentage points on your return isn't a reasonable answer. You greatly increase your risk of blowing a hole in your retirement plan. It might work out, or you might end up broke in retirement. Instead, find ways to either increase your savings now or seriously reconsider your goals.

That last point is 100% sugar-coating-free for a reason: The sooner you can take action to build your retirement safely and securely, the more likely you are to succeed. Wild bets are for Vegas. When it comes to retiring on time, the better counsel is to lessen risk and put yourself on a path toward achievable success."
Summing Up
With 5% inflation, a 10% nominal return equals a 5% real rate of return. That 10% nominal return is the same as a 5% return in an environment of no inflation. 2% inflation with a 7% growth is also equal to that same 5% real rate of return. The real return over time is what matters.

A 5% real return over time is attainable with stocks. Not so with other investments.
Accordingly, individuals must always take into account the impact of inflation when evaluating different investments and estimating the future real value of today's $1.
We oldsters can remember the days when a McDonald's burger cost 15 cents, fries were a dime and so was a Coke. 35 cents for the meal. The same meal today costs a whole lot more in current dollars, but the hamburger, fries and Coke are the same. That's inflation.
Forming good habits is a good idea.
Repetition is a good way to develop good habits.
Hence, for individual investors I keep repeating the same story in different ways.

It's a story that needs telling and a habit that needs to be developed.
Thanks. Bob.

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