Work 401k Seminar Prep

As part of my job, I was recently put in charge of hiring new graduates to join our finance department. Once they start, we pair them with a mentor and I stay in touch and offer career advice and guidance as needed.

As part of my ongoing advice and guidance, I’ll be hosting a 401k seminar later this month. This is the first time I’ve done something like this, and I’m honestly pretty excited. I’ve solicited questions from the group and a couple of themes have emerged. As part of my preparation, I wanted to share some of my thoughts on these topics.

To provide some context, the audience is all 20-something recent college graduates working at their first job. We pay them pretty well (mid 50’s), are in a lower cost-of-living area, and provide some amazing benefits. Our company offers an excellent 401k match and relatively short vesting period.

401k Match – this is ‘FREE MONEY’ and there are almost no good excuses for passing this up. As an incentive to get you to contribute to the account, employers will often provide matching contributions. Make sure you’re at least getting your full match.

Vesting Period: The money your employer puts in your 401k might require you stay working there for a period of time. I’ve seen as short as 2 years and as long as 7. If you leave the company before you are fully vested, you may forfeit some of the employer contributions. The money you put into a 401k from your paycheck is always yours and you’ll never have to give it back. 

Q: What is the difference between After/pre-tax contributions and which should be a priority?

A: We have the choice between traditional and Roth 4o1k’s. My general advice to anyone is to focus on Roth contributions. This is especially true for those who are young. The difference between the two is that you end up with lower take-home pay by doing Roth, but you end up with much more in retirement. Here’s a simple example:

Either way, a 6% contribution puts $3k into your 401k. The difference today is that if your contribution is in a Roth, you end up paying slightly more taxes now, but won’t ever have to pay taxes on that money again.

If you invest $3k per year for 30 years and it grows at 8% per year, you end up with $339,000. Not bad for only investing $90,000, right? But you will pay taxes when you withdraw if your contributions are made pre-tax (traditional). All of a sudden that $339,000 is more like $288,000 (15% taxes). It’s even less if you want to take out so much that you get pushed into a higher tax bracket.

On the other hand, if you had been making Roth contributions, that $339k is ALL YOURS. This is why I sometimes say that Traditional 401k/IRA’s include ‘Phantom Money’. Even though you see the balance, it’s not all yours unless it’s Roth.

My preference is to have all of my contributions go into Roth. Since employer contributions can’t go into Roth, I’d prefer to have as much as possible actually be MINE. For those currently doing pre-tax contributions, I’d consider transitioning your contributions over.

Q: Can you talk about 401k early withdrawal penalties and payback options?

A: Honestly, I’d rather not. Long term you’ll always be better off finding ways to avoid taking money out of your 401k before retirement. While you are actively employed, the only way to get money out of your 401k is to take a loan. Loans are paid back via increased payroll deduction. Although it is true that you pay yourself back with interest, the interest rate you pay yourself is generally much lower than the returns you’d be missing out on if the funds had stayed invested.

The big risk of a 401k loan is that if you leave the company, the balance of the loan is due in full within 60-days. Any amount left unpaid is considered an early withdrawal, taxed, and penalized (if you’re younger than 59 1/2).

Several in my audience may be considering going back to school for an MBA in the next few years. To them, I would recommend avoiding student loans but definitely plan ahead and do not rely on 401k funds to pay for the degree. Although there are provisions where Roth contributions can be withdrawn without penalty, I still believe that it should be avoided before retirement.

Q: What’s the right mix of stocks and bonds?

A: This is perhaps the hardest question to answer because there really is no one-size-fits-all answer. The right mix for each person depends on your goals and risk tolerance. You may have heard that in the early stages of your career you should be as aggressive as you can tolerate, but without having gone through a bear market it’s hard to really know your risk tolerance.

There are rules of thumb out there like “120 minus your age is the percentage you should have in stocks and the rest in bonds”. Rather than give that blanket statement, allow me to share how my asset allocation has shifted over the years.

My Asset Allocation History

When I started my first 401k, I loaded up on stocks and maybe only 5% in bonds. This was back in 2006 and the market was hitting new record highs, sound familiar? A few short years later, I had built up around $25k with more of a 70/30 stock bond split. And then the financial crisis hit. My portfolio was basically cut in half in what seemed like a matter of days. This was a huge gut check for me and caused me to rethink my asset allocation. Thankfully, I didn’t get out of the market like many clients I was advising at the time wanted to.

I kept a 70/30 mix for years and was a believer of the age-based asset allocation model. When friends or family members were just starting out, I would recommend using Fidelity Freedom Funds or Vanguard Target Retirement Funds that automatically rebalance as you get closer to your target retirement date, eventually landing in a 20/80 stock/bond mix. There is nothing wrong with this approach, and for many people, it may still be a great one.

My Current Allocation Strategy

Where I differ now from the mainstream age-based strategy is that I am planning on retiring much earlier than traditional retirement age. Also, I believe that we in the DIY$ household have proven to not act irrationally during bear markets. During down markets, we don’t sell and continue to dollar-cost-average into our investments. This tells me that we can handle having a larger allocation to stocks. Our current asset allocation is over 90% stocks, and we plan to keep it that way until and during retirement.

I am subscribed to the strategy outlined in Simple Wealth, Inevitable Wealth. Simply stated, this strategy is to only invest in stock mutual funds, and during retirement to keep a cash reserve equivalent to 2 years expenses. During retirement, we will replenish cash from investments except during significant down markets. During those times, we’ll draw down cash to allow the market to recover and build the cash account back up after the investments recover.

This strategy may not work for everyone, but this is why personal finance is so personal. You need to find what works for you, develop a plan, and stick to it. That’s the important part though, having a plan vs. not having a plan. I’m sure we’ll have plenty more to talk about, but these are the thoughts I’ve collected thus far.

Some thoughts on Bubbles and Student Loans

“The market can stay irrational longer than you can stay solvent” – John Maynard Keynes

These words from the famous economist John Maynard Keynes come to mind whenever I think I see some type of bubble in the stock market or elsewhere. The saying refers to the risk of taking a short position, or betting that a particular investment will go down in value. When you simply purchase an investment, your risk of loss is your purchase price and your potential gain is unlimited. When taking a short position, you profit as the investment loses value and lose as the investment gains in value. In shorting, your gains are limited to the point that the investment goes to $0 but your risk of loss is unlimited.

Michael Lewis’ book turned movie, The Big Short, popularized short selling by showcasing investors who won big betting against the U.S. housing market in 2008. The Greatest Trade Ever showcases other traders who made even larger gains on similar types of trades. One thing that was common between both stories was the serious risk of insolvency many of the investors faced as they continued to pay premiums waiting, and waiting, and waiting, to be proven correct. They knew that the housing market couldn’t continue rising indefinitely, yet it continued to defy their predictions almost to the point that they (and their investors) could no longer handle the continued losses.

FINDING THE NEXT BUBBLE

It seems like every week I come across an article predicting the rise of another bubble. There’s the ‘Auto Loan Bubble’, the ‘Housing Bubble’ (again), and don’t forget the ‘Student Loan Bubble’.

“An investment in knowledge pays the best interest” – Benjamin Franklin

For hundreds of years, this mantra has been repeated in this country and for the most part, I tend to agree. Education can be the key to a better life and can allow for significantly higher lifetime income. What is missed from this simple quote though, was clarified by John Adams who said:

“I must study politics and war that my sons may have liberty to study mathematics and philosophy. My sons ought to study mathematics and philosophy, geography, natural history, naval architecture, navigation, commerce, and agriculture, in order to give their children a right to study painting, poetry, music, architecture, statuary, tapestry, and porcelain.” – John Adams

Interpreted for our day and age, I take this to mean that education is great, but don’t study something that doesn’t have a financial return unless you don’t need a financial return. If you build a legacy sufficient to sustain the next generation, then by all means, allow them to study something they love that may not pay the bills, because you’ve got that covered for them. If you don’t have this luxury and do actually need your education to provide a return, then you need to study something that has value in the marketplace.

TOO MUCH OF A GOOD THING IS BAD

Where we run into problems is the belief that an education is worthwhile at any cost. I recently was reading about the astounding levels of debt the average dentist owes. The author of this article finds the average dentist just starting out has an average of $450,000 in student loans with an income of just $120,000 without even taking into consideration the cost of buying into a practice or other borrowing such as a mortgage. Add it all up and it’s not difficult to find a dentist with over $1,000,000 in total debt. An income of $120,000 sounds great, but it doesn’t go very far with debt levels approaching 4x annual income.

Is this a new thing? One of my favorite fiction authors, Michael Crichton, started his career going through Harvard Medical School (which later helped him as a writer for the hit TV show E.R.). While he was a student there, he wrote Five Patients where he walks through the hospital visits of 5 hospital patients in the 1960s. The book was first published in 1970 and I read it 40 years later in 2010. Even though the book was 40 years old, I was surprised how relevant some of the stories were and was shocked that some of the same problems that existed in the medical field then, persist to this day. I specifically remember that he highlighted that in order to enter the medical profession one had to either come from a well-off family or have a strong tolerance for high levels of debt.

I’ve been saying for years that it doesn’t make sense that students are able to borrow as much as they do and that reform is imminent, yet for years I’ve been proven wrong. Thankfully I haven’t made any investments based on that theory. If people have been saying this as far back as 1970 though, are we truly close to the bubble bursting?

$233,000 to raise a child? Not mine…

CNNMoney recently posted an article stating that it costs over $233,000 to raise a child citing a report from the Department of Agriculture.

In our house, I can tell you right now that I don’t expect us to spend anywhere near that amount to get our kids raised and through high school. We have three children and the oldest is about to turn 6 and so far, we aren’t on track to spend that much for all three let alone for each one.

Just for kicks, I went back and looked at our household expenses in 2010 (the year before we started having kids) to 2016 (when we had three kids at home). Here is what I found:

  • Our total out of pocket housing costs are roughly the same. We live in a larger, more expensive home but aren’t making as much extra principal payments. Interest and taxes are around $200/mo higher. Even if we didn’t have kids, we would have upgraded houses from where we were living in 2010 so any increases really can’t be blamed on them.
  • Auto expenses are up $65/mo, mostly from having insurance on 2 vehicles instead of 1 and my longer commute increasing gas. We don’t shuttle our kids all around town to participate in every possible activity and we would have purchased a second whether or not we had children so this is also unaffected. Yes, we have an Expedition for carrying a lot of people but even if we had no kids our second vehicle would be a large SUV or pick-up truck with similar ownership costs.
  • Utilities are up ~$150/mo, mainly due to electricity, garbage, and needing pest control in our new home. We moved to a warmer climate, use the air conditioning a lot more throughout the year, and consider pest control a necessity where it wasn’t before. Garbage pickup is just plain more expensive in our new area, we aren’t paying any extra for having more trash. So again you can’t really attribute this to having kids. Are you seeing a trend here?

To be fair, there are a few areas we do spend more:

  • We now spend $375/mo more on groceries and restaurants. $125 of this is related to eating out, something we pretty much didn’t do at all before we had kids, but only because we were paying huge tuition bills for my MBA. Since whenever we do eat out our kids don’t actually eat anything (darn the pickiness), almost none of this increase can be pinned on them. The $250/mo increase in groceries is probably mostly due to having more mouths to feed (and diapers, which we file in this budget category).
  • In 2010 we lived in a house we had built just a few years earlier so our home improvement projects were mainly just cosmetic and very inexpensive. Now we live in a house that is a bit older and came with a long list of things we’re working on changing to make it our own. In 2016, we spent $12,000 more than 2010 on home repairs, maintenance, and furniture. Can we blame this on kids? Not really. Maybe $500 for the whole year was furniture for the kids’ bedrooms, but we would have furnished rooms as a guest bedroom, office, man cave, etc. if we didn’t have kids. I used to have an affinity for high-end entertainment systems that I no longer purchase/own so you could make an argument that kids are saving me money in this area since I would want to be buying much more expensive home entertainment equipment if I weren’t worried about kids destroying things.
  • We spend $575/year on life insurance now that we didn’t have before we had kids. When it was just me and my wife, no one truly depended on my income so we didn’t bother getting life insurance. As soon as we started having kids, we took out a term life insurance policy on each of us and we pay the premium annually right around the time of our oldest child’s birthday.
  • Our clothing expense is up $70/mo from 2010. A lot of this is from kids’ clothes, but we’ve increased spending on clothing for ourselves as well. We were spending very little on clothing for ourselves while we were paying grad school tuition each year.
  • Travel/Entertainment is up $4,000/yr from 2010 to 2016. We would undoubtedly travel even more if we didn’t have kids, it takes so much energy to go anywhere with our little people. So whatever we spend on travel for them, I feel like we would spend that and maybe beyond on ourselves if it were just the two of us. I like to be able to show our kids new places and to have them experience new things, but all of this definitely falls in the discretionary category and wouldn’t be what I consider a core cost required to raise a child.
  • We put $200/mo into a 529 last year. We wouldn’t do that if we didn’t have kids, but it also isn’t a cost that will help ‘raise’ them as outlined in the study since really it is intended for use after they are supposedly off on their own.
  • Our charitable giving is up $7,000 from 2010. Again, not because we have kids.

The way I see it, our expenses are up roughly $600/mo more now on things that I consider directly attributable to the (three) children. Multiply that out 18 years and you get $130,000, or roughly $43,300 a child…a fraction of the amount stated in the article. Even if you assume the costs double (as things will certainly get more expensive as they get older), it’s still nowhere near the costs they assume. Any other increases in our expenses are for things we would have done whether or not we had kids. This also ignores the substantial tax credits we receive each year for each child.

The study assumes that you need to purchase a larger home with an additional bedroom for your child but I question that logic. We owned two separate three-bedroom homes before we ever had our first child, and simply converted one room to be a nursery when we were expecting our first. We didn’t go out and buy a larger house just because we were starting a family. We wanted to own a home whether or not we had children in order to build equity and to stop sharing walls. Our current home is somewhat larger than we would buy if we had no children, but if we had a smaller home it would likely have more expensive finishes and furnishings instead of a more ‘kid-proof’ décor and more square footage.

Lastly, the author cited that one of the big expenses for raising children is child care, which averaged $37,378 per child. The way I read this, they are referring to direct costs paid for child care, something that we do not pay at all. I understand that this is a very large expense for many households and that $37k might even seem a bit low, but we are fortunate to have created the option for ourselves that my wife is able to stay home with our children. This option is not without a cost. Although we don’t pay anything out of pocket, the opportunity cost of my wife not working is substantially more than $233,000 over 18 years. If she were still in the workforce I have no doubt that her income would exceed $100,000/yr but we have made the conscious decision to allow her to stay home and raise our children.

In conclusion, I think the author and the study completely miss the point. Kids can be as expensive as you let them be, but don’t have to be very expensive at all. If you’re trying to raise kids the way you see others are doing on social media, you can easily get caught in the modern day version of keeping up with the Joneses and think that raising kids is extremely expensive. I recently read Rachel Cruze’s new book Love Your Life, Not Theirs where she talks about how to gain contentment and avoid the trap of comparing ourselves to others, and I think the concepts are extremely applicable to this.

I know people who are so intimidated at the cost of having children that they significantly delay having them, and others who go so far overboard saving for future college expenses or spending obscene amounts of money on activities that they can spend significantly more than this article alleges. I’m glad we waited a couple of years after we got married to have kids, but I’m also glad we didn’t wait much longer. It was important to us to be financial stable, but if you wait until you feel 100% ready, you’ll do nothing but wait. On the other hand, if, when you do have kids, you lavish every extravagance on them you’re not doing them any favors either. All things in moderation.

August 2016 Net Worth Update

Happy Labor Day weekend and belated August net worth update. I’ve been super busy the past couple of days out of town and wanted to get this posted before too much more time passes.

August was another great month for our net worth, which increased nearly $13k to an all-time high of $576,261. There are only a few more month in the year, but hitting $600,000 net worth by year-end feels within reach. Most of the increase this month was from our house, which Zillow estimates increased in value by $9k. It still feels reasonable since there have been homes selling in our neighborhood for closer to $500k, and has previously been in this price range.

Aug16

CASH: Our cash stayed about the same as last month. I’d like to keep our cash between $20-25k for the time being and we’re sitting right in the middle of that range.

INVESTMENTS: Nothing too exciting here either – we didn’t see much growth outside of our normal monthly contributions, and didn’t make any changes to investment allocations or locations.

CARS: Nothing too exciting here either. I expect our cars to go down in value a bit each month but they don’t have much more value to lose. The cars are worth more to me than Kelly Blue Book says they’re worth and we have no plans to sell or replace either in the immediate future. That being said, I just hit 190,000 miles on my car and know it will eventually need to be replaced. For now though, it is still driving fine and only requires regular maintenance. I’m hoping I can make it until 2018 or later before I need to get a new one.

MORTGAGE: We continue to make extra payments on the mortgage and have our sights set on getting the balance below $200k. Each year, we get our tax refund about the same time as my year-end bonus pays out and these lump sums are used for retirement contributions, charitable donations, and the rest towards the house. We’ve done some Roth IRA conversions this year that will reduce our tax refund, but my year-end bonuses are looking like they’ll make up for it.

I’ll end again with this historical view. Looking at this always helps me to remember how far we’ve come and to reflect back to the different stages of life and sacrifices that were made to get to this point.

DIY Within a month

within a month

 

I recently came across this gem of a quote and had to share.

“There is nothing in ordinary gardening, carpentering, or work about a house that any intelligent man cannot learn in a month by giving his mind to it.” William J. Dawson, The Quest of the Simple Life

Personal finance isn’t all that different from home improvement projects in this sense. This is not to say that you can master something in one month, but if you truly dedicated every spare moment to it, it’s amazing what you can learn in a relatively short amount of time.

Investing in a 401k

        

I recently met with someone who has decided to begin investing in his work 401k but didn’t know how to get started. He had all of the plan literature from when he got hired, but had ignored it because he didn’t really understand it and it seemed like so much information that he didn’t know where to start. Unfortunately, I’ve found this response to be common. In an effort to remove some of the roadblocks to getting started, Congress now allows employers to automatically enroll new employees into their company 401k into default investments (usually ‘target date funds’). While this is a good start, it certainly isn’t enough. Below I will walk through the decisions you need to make when investing in your 401k.

How much should I put in to my 401k?

  • Your 401k through your employer can be a great place to invest. My rule of thumb is to invest whatever you need to in order to get the full employer match. Every 401k is different so you’ll need to look up your plan specifics. My employer matches up to 5%, so I make sure that I always contribute at least 5%. The person I helped the other day was eligible for a 50% match up to 6% contributions (so if he put in 6%, the employer matched with 3%). If you are able to save more than what your employer will match, you should set up a Roth IRA on your own. Why not just max out your 401k? Generally speaking, your 401k is going to have limited investment options. If you wanted to invest in something that wasn’t in the lineup, you wouldn’t be able to do so. Maybe the fund choices are great, maybe they’re not. I would only recommend adding non-matched money to your 401k after you have already maxed out your Roth IRA for the year (current maximum is $5,500 for IRAs).

Pre-tax or after tax?

  • Whenever possible, and with few exceptions, I recommend making your 401k contributions AFTER-TAX. This means that the money you are adding to your retirement is invested after you have already paid income taxes on it, but also means that when you withdraw it, you can do so TAX FREE. Money that your employer contributes to your 401k, or that you put in PRE-TAX, is considered taxable income when you withdraw it in retirement.
  • To illustrate the true power of TAX FREE growth, consider this example. If you invested $5,000 per year over the course of a 30 year career and earned an average return of 10%, you would have over $800,000 at the end of 30 years. How much is actually yours (as opposed to the tax man) depends on whether you put the money in before or after taxes.

        

  • Make sense now? I’ve talked about the power of compound interest, but here again you can see that of the if you invest for a long period of time the majority of your account ends up being earnings. The first column shows how much you’d have if you simply put $5k/year under a mattress and the second column is if you put it into a savings account (assuming a 3% return, which is currently very high but average over a long period of time).
  • The advantage of a 401k is shown in the last three columns. Under each of the three scenarios, I am assuming that you earn an average return of 10%, the only difference is how and when you pay taxes. If you invest $5k/year outside of a 401k, you’ll have to pay taxes on earnings as they happen and end up with the middle column, or about $500k. Not bad. However, if you invest in a 401k, you don’t have to worry about taxes each year, so you’re able to keep the entire amount invested and growing. You actually end up with the same amount in your account whether you are contributing PRE-TAX or AFTER-TAX, but the difference is if your account is PRE-TAX, then only about 75% of that money is actually yours, the rest you’ll have to pay to the IRS as you withdraw. If you withdrew the entire amount all at once, your tax rate goes up and you get to keep even less than that.
  • The takeaway here is that if you make annual contributions of $5k PRE-TAX, you end up getting an annual tax benefit of ~$1,250, but end up paying about $200,000 in taxes down the road, whereas if your contributions are made AFTER-TAX, you don’t get the tax benefit now, but end up paying a lot less in taxes over time.

How to invest the money once it is in the 401k

  • The most important part of saving for retirement is to actually put money in your account. The second most important thing is to minimize taxes. Once you’ve done this, the next most important part about saving for retirement is how you actually invest. This topic is often the part that is considered the most confusing or intimidating part of investing, but it doesn’t have to be. Unless your 401k plan has hundreds of investments to choose from, I generally recommend one of two different options, and it is dependent upon how much time and effort YOU want to put into managing your account.
    • Age Based Strategy: The aged based strategy is what I would recommend for someone who prefers to be hands off, doesn’t want to pay additional fees for customized professional management, and who has not yet done significant research into the various investment options that exist. Nearly all 401k plans will offer this type of strategy and you can often identify it by the funds including the target year (2020, 2030, 2040, etc). These tend to be very diversified and are invested with the assumption that you plan to retire in or near the ‘target year’ mentioned in the name of the fund. While I do NOT have any of my own money invested in these types of funds, I don’t lose sleep knowing that I have friends and family invested in them when they are bought for the right reasons.
      • A thought about Age Based Funds: I have frequently seen investors buy multiple different age based funds in their 401ks. I met someone recently who was wanting to retire in 20 years and had invested his 401k across several different age based funds (He had 2020, 2030, and 2040 funds). These funds are generally structured so that you only should be buying one, and investing the majority of your assets in that one fund. If you were to look at what the funds are invested in, you’ll see that you don’t get any additional diversification by having a different target year fund (they will generally invest in the same things, just in different percentage allocations). If, for example, you were to invest half in a 2040 fund and half in a 2030 fund, you’ve essentially just created a 2035 fund, which is probably a separate fund you can choose. If you feel that you need something more customized than this and want to do the leg work, you should build your own portfolio using other funds.
    • DIY Asset Allocation: This is the method that I invest in my personal 401k, and the method I recommend for anyone looking to manage their own 401k. Because the majority of 401k’s only have limited investment options, I almost always recommend looking for the index fund options. Index funds are invested to match the performance of an index, like the S&P 500, whereas other funds are invested to try and beat the market. There is a lot of debate out there as to whether mutual funds even can beat the market, but the data clearly shows that many funds do not do as well as the index they are trying to beat. Because you generally only have a few choices for funds in your 401k of the thousands of funds that exist, the odds of your employer selecting the best of the best actively managed funds in all categories in all times, is virtually zero. Once you eliminate the actively managed funds from your selection, you will probably be left with only 3-6 funds to choose from.
    • The next question you need to ask yourself is: How much risk can you handle? For these purposes, risk can be measured by the portion of your account invested in stocks vs bonds.
      It has been said that the younger you are the more aggressive an investor you should be. While I agree with this in theory, it isn’t a perfect one-size fits all approach. I would add two additional considerations. 1) If you are invested so aggressively that you lose sleep worrying about losing money, or if you find yourself frequently wanting to sell everything, you may want to invest with slightly lower exposure to stocks than your age would dictate. If you do this, you should understand that you’ll need to be saving and investing more to compensate for the lower returns you should expect. 2) If you are reasonably confident that you will NOT need to use a portion of your assets in your lifetime, and plan to leave an inheritance to your heirs, you should invest that portion with THEIR timeline in mind and not yours. This means you may have a more aggressive portfolio than your age alone would indicate.
    • The way I have invested my 401k is to put 50% in the S&P 500, 10% in International stocks, 10% in Small/Midcap stocks, and 30% in bonds. Roughly once per quarter, I will look at my account balances and see how this has shifted and rebalance back to the same mix. Over time, one would expect stocks to outperform bonds, so naturally the 30% in bonds may shrink. Gone unchecked for long-enough, the bond allocation could shrink so much that my whole account is more aggressive than I intended. Periodically rebalancing is a process to naturally ‘take earnings off the table’, by reducing exposure to whatever has had the best relative performance.


 

TAKEAWAY: The most important part about investing in a 401k is ACTUALLY PUTTING MONEY IN YOUR ACCOUNT. The next step is to make sure you’re doing so in the most tax efficient manner. Lastly, you’ll want to make sure that whatever you’re investing in is right for you.

Do you have any questions about your 401k?

Don’t invest in anything you don’t understand

When I would meet with prospective new clients, the main reason they said they were looking for a new financial advisor was poor performance. What I often found in these cases was that their former advisor had not done a good job of helping the client understand what they were invested in and why. As a result, I would find portfolios that didn’t make sense, had high fees built in, and the client had no idea what they were invested in.

The most common example I would see would be when someone had bought a variable annuity and had no idea how it worked, why they owned it, or what benefit it provided to their overall financial plan. In these scenarios, the penalty for ending the contract early often outweighed the savings they could realize by doing so, so they were effectively stuck with a poor decision for several years. In many cases, had they understood what they were investing in and why, it is unlikely that they would have actually made the investment.

Only investing in things you understand sounds obvious, but the fact that some of the worst financial products continue to be sold is proof that it isn’t. Individual investors aren’t the only ones guilty of this. In the run up to the financial crisis of 2008, the city of Narvik, Norway, lost $64 million investing in synthetic CDO’s, a complex product that essentially was tied to sub-prime US mortgages. A good book that talks about this in greater detail is David Fabers “And Then the Roof Caved In”.

Investing in things you don’t understand doesn’t always end poorly, but should be avoided nonetheless. Back in early 2008, I bought shares of Visa (V) right when they first began trading. I paid around $59 per share and held them for about 6 ½ years, selling for around $260 per share, earning an average annual return of 24%. Sounds good right? The problem with this investment was that when I bought the shares, I didn’t know how Visa made money! I figured it would be a good investment just because of the ubiquity of the brand name, but didn’t really know what would have made the stock go up or down. Did you know that credit card companies make money every time you use your card, but aren’t actually loaning you any money? This has become more common knowledge now that products like Square are allowing anyone to accept credit cards and pay swipe fees, but back in 2008, it was something I didn’t yet know. This investment worked out well for me that time, but I attribute all of that to luck and not to my own understanding of the investment.

One thing I’d like to make clear though, is that although you should never invest in something you don’t understand, not investing in things you don’t understand is not an excuse to avoid learning about investments. Just like starting to save early will have compounding benefits in the values of your investments, the sooner and more you can learn about ways you can invest your money the better. The benefits will compound as many different investment types are interrelated and you can understand how several work by learning the basics.

To help avoid investing in something you don’t fully understand, here are few questions you can ask yourself before taking the plunge.

  1. What factors will contribute to your investment going up or down in value?
  2. Are there any risks unique to this investment that wouldn’t affect the overall economy?
  3. What are some comparable alternatives and how have they done? Why is this investment better than the alternatives?
  4. Who is recommending the investment and what are their incentives?
  5. What are the costs, upfront and/or recurring?
  6. How do you get money out and how long does it need to be kept in?
  7. Are there any guarantees? If so, who provides the guarantee and what exactly is guaranteed?
  8. If there is a guarantee, how often in the past XX (100?) years would I have needed the guarantee? (hint – the answer is likely close to 0, and if so, you probably don’t need to pay for that guarantee).

If you can comfortably answer these questions, you’re in a good spot and should have a decent grasp on what you are investing in. The idea here is not to be so knowledgeable that you can run your own mutual fund, but rather have enough of an understanding of what you’re putting your money into that you are making a conscious decision of how to invest your money rather than simply doing something because someone told you to do so.

If you’d like to get a good handle of the basics, one of my favorite books for that purpose is Learn to Earn, by Peter Lynch. It’s a book I’ve given to recent high school graduates or college graduates and it explains very simply how mutual funds work.

 

My Work History (part 2)

I quit working at the 100% commission based financial advisor job just a few months after I started and began to look for another job. I was still in school, but the prime period for on-campus job recruiting had passed, so I had to do a lot of work researching companies in the area and apply for jobs without the assistance of any type of on-campus interviews or job postings.

I had enjoyed working with clients in my former job, and would have stayed at the job if there was a way that I could have made a decent living while also offering only investment products that I was comfortable with ethically. This would have also been easier if I had clients with a lot of money to invest, but generally speaking, anyone with a lot of money is going to want a financial advisor who has experience and isn’t just a recent college graduate with little to no real experience. I had seen something that I liked doing, but needed experience to be able to do it well. How then, was I to get the experience?

The solution I found was to get a job at a large financial services company working in one of their call centers. It wasn’t what I initially had thought I would be doing, but it ended up being ideal for what I needed to learn. Starting out servicing accounts and talking to clients without initially having any ownership stake in their financial plans, I was able to see firsthand the consequences of many different decisions, both good and bad. This experience proved invaluable a couple of years later when I was placed in a position where I was again a financial advisor and had a responsibility for the financial success of my various clients. One of the main things I was able to take away from this experience was the understanding that even though a portfolio may look ideal on paper, the plan is useless if an investor isn’t going to stick with it. Keeping this in mind, I was able to build more customized solutions for clients, which resulted in happier clients, more referrals, as well as more income for me.

Over the course of seven years with that employer, I had a total of 6 different job titles (one for only 2 months), and was able to see my pay increase from a $35,000 to over $150,000 just a few years later.

While I truly enjoyed many aspects of my work in financial services, I chose to leave the industry for a career in corporate finance to further develop additional skills. Below, I have detailed my annual income over the years to further illustrate this point.

You’ll notice that my total income has come down a bit in recent years. One of the things I was looking for in a career move was more stable income. Although my income in 2012 was over $160,000, only $45,000 of that was guaranteed base salary with the rest being highly variable, whereas now my salary is over $100,000 with a much smaller portion of my income coming in the form of variable bonuses. I also have higher growth potential with my current job whereas I was nearly at my peak earning potential in my previous role. Also, because the majority of my pay in 2011-2013 was paid in semi-annual bonuses, I had to live on a much smaller income during the year until those paychecks arrived. I knew that I wasn’t going to spend the rest of my career in that job and chose to save and invest the majority of those bonuses while living on little more than the base salary.

One other thing worth pointing out is that my income didn’t decrease from 2008 to 2009, rather my 2008 income included a relocation bonus for when I moved across the country. My income was relatively flat from 2008 to 2009 because overtime and bonuses were slashed amidst the financial crisis.

My Work History (part 1)

While thinking about the importance of growing your income, I wanted to take some time to outline my work and career history. In a later post, I may do a more comprehensive work history like J Money over at BudgetsareSexy.com, but for the next couple of posts I wanted to focus on the income and jobs I consider to part of my career, and not all the different jobs I have done before. The hope is that this will illustrate not only how I have grown my income, but when income is managed properly instead of living beyond your means or succumbing to lifestyle inflation you can truly begin to build wealth (see evidence in my recent post on net worth).

My first foray into the financial services industry was during my senior year of college, and was where I learned an important lesson that has helped me significantly since then. I was hired as a financial advisor by a company that resonated with me in the way they talked about doing the right thing for the customer and helping people reach their dreams, and was told that once I was licensed, I would be given clients to work with that the office didn’t have the bandwidth to properly support. I would be working 100% on commission, but the average rep made $40,000 in the first year, and to not let the 100% commission part worry me. Over the course of a month or two, I got all of my study materials and studied my brains out and passed all the necessary exams. The next day I went to the office, excited to get started helping people reach their goals. I still remember my heart sink when my boss said something like “All right! Now that you’re licensed and ready to sell, let’s make a list of all your friends and family and start calling them and selling them crap you wouldn’t buy if you actually had any money of your own!” At least, that’s what I heard. Wait a second, what about all the clients they had told me about who simply needed a rep assigned to their account that I could call to set up an annual review? Anything besides trying to pitch a variable annuity to my grandma! Sadly, my experience isn’t all that uncommon but could have been avoided had I done better research on the industry or had someone I trusted teach me what to look for.

The next carrot that was dangled in front of me was that I would be given some existing clients to work with once I had generated $3,000 in gross commissions, and I was given 90 days to do so or be let go. On the surface this didn’t sound very difficult since I had been told that ‘average’ new hires made $40,000 in their first year. When I started to dig into what I would have to do to get to that number, I wasn’t quite as optimistic. The products that paid the most commission were the ones that I didn’t want to be selling to ANYONE (whole life insurance, variable annuities, etc). In the end, I did meet with several people that I was able to help get started investing for retirement, and I didn’t sell any investments that I felt betrayed what was right. I ended up working for about a month and had a mutual parting of the ways with the company.

I learned a lot of things while working for this company, but the main takeaway for me was that I will never feel comfortable with anyone I know investing through a company where the reps are paid solely on a commission basis. I have yet to hear an argument for the commission model that makes any sense and isn’t from someone who has some type of vested interest in the model. The vast majority of people who join this type of company don’t make it through their first year, and because of this, these companies will often have low entry requirements to be hired (which perpetuates the turnover problem).

This may not be the best example of ‘growing your income’, but was a very helpful step in getting me to my next job that I’ll be talking about in my next post. It also was useful down the road when I actively helped people to avoid investing in companies like the one I was with for a short time.

Step 5 – Grow Your Income – Financial Offense vs Defense

It’s been said that “Offense wins games, Defense wins championships”. Similar to sports, you need good offense and defense to be successful financially.

I like to refer to things like budgeting and frugal living as financial defense. Spending money can be very easy, and have good financial defense ensures that you aren’t spending everything you earn and are saving and investing for the future.

Financial offense is your income. Growing your income and career are some of the best investments you can make to enable financial success.

Financial success is NOT guaranteed with a higher income, but it certainly helps.

To illustrate this point, let me share an interaction with a prospective client several years ago that I will never forget. He called my office and asked to set up an appointment with a financial advisor. Our office had 8-10 different financial advisors, and like many financial service companies, we generally determined what advisor a client was paired with based on the amount of money they had to invest. This segmentation of clients is common since different strategies and complexities exist for larger portfolios than smaller portfolios that may not have as many alternatives. The prospect wasn’t very forthcoming about his investments, but assured the scheduler that he probably should meet with the most experienced advisor in the office. When he came in, it wasn’t long before we realized that he was the poster child for the phrase “all hat, no cattle“.

This prospect bragged that for the preceding 8 years, his income had been between $500,000 and $800,000 per year as an attorney, and felt he had reasonable expectations for that income level to continue. Clearly he had done well growing his income and playing financial offense. The problem though was that he was not very good at financial defense. His total investable assets (checking/savings accounts, investment accounts, retirement accounts) were only about $100,000. Where did it all go? Well, he had a beautiful house and an equally beautiful vacation home, both of which were worth considerably less than he owed on them. He also had multiple very expensive luxury vehicles with very large car payments. If that wasn’t enough, he also felt that his income justified picking up aviation as a hobby, so he had bought a small airplane for $300,000 or so. In total, his debts were approaching $2 million and he had a negative net worth. It was hard to believe that someone with that high of income could be living paycheck to paycheck.

Sadly (or maybe not so sadly), this person never ended up becoming a client of ours. He didn’t have enough investable assets to meet my minimums, and our philosophies differed so much that it wasn’t worth making an exception.

On the flip side, I have met several people who have become millionaires while earning average $40-50,000 incomes, but mastering financial defense.

The point of this is that YES, growing your income is useful in building wealth, but doing so can be meaningless if financial defense isn’t also practiced.

In the next post I’ll continue discussing financial offense, including my income history and what I’ve done to grow my income.