accept what you can change;
change the things you can;
know the difference.
This is good advice, but when I talk to my friends about their finances I often find them struggling with this issue. I often hear things like:
- “I’m nervous about the market; I’m thinking of getting out”
- “I’ve got a guy, he’s picking the best stocks”
- “I’m really excited about XYZ Stock; I’ve gone into it big time”
- My advisor is really expensive, but he’s worth it!
These are all efforts to control the uncontrollable at the expense of things you can control. It’s not surprising people are confused, there’s an entire industry whose job is to confuse you on this topic. They claim to control the uncontrollable (for a fee!) There is a lot of evidence they’re fooling themselves and you.
With that in mind, let’s talk about what you can and can’t control.
As an example case, let’s say you put away $10,000 every year for 40 years at 8% return. I’ll use this below to show how much the factors impact your outcome.
Here are some things you can control:
- Fees. This is a big factor. Will you hire a fee planner vs. commissioned salesperson? Will you buy index funds or managed funds? Making expensive decisions here can cost you half of your retirement savings. In our example, a 2% fee fund yields $1.6M and a 0.2% fee Index fund ends with $2.6M.
- Asset allocation. What stock/bond mix will you own? Which stock classes (small vs. large, value vs. Growth)? Individual stocks vs. mutual funds? What percent of your assets will be in bonds vs. stocks? Again, this can have a huge impact on your performance and risk. As an example from detailed historical analysis, a 70/30 mix will yield a 10% return but a possible 44% drop in a bear market. a 50/50 mix will yield a 9% return with a possible 32% drop. These are big tradeoffs.
- Expenses/Savings. Do you save 5% of your income or 25%? This is perhaps the biggest factor you control. In our scenario, saving $10K/yr yields $2.8M, $5k per year $1.3M.
- Taxes. How do you use tax-advantaged accounts? Roth vs. traditional IRA? Buy and hold vs. churn in and out of things? Trade fast and pay 35% taxes vs. buy and hold and pay 20% has a big impact.
Again, the above are things you can choose and control. Do you want to save too little, invest in high-cost assets that have low performance and pay high taxes? Duh. But lots of people do just those things in pursuit of controlling the uncontrollable.
What are these things you cannot control?
- Market performance. Some generations are luckier than others because market performance isn’t always the same. Over a 40 year career, you can expect market performance between 3% and 9% after inflation, which makes a vast difference. 3% return ends with $775k after 40 years, 9% ends with $3.7M. And there’s literally nothing you can do about it. To correct for this if you’re unlucky? Save more. Of course, there will be lots of advisors who will claim to be able to fix this by timing the market or picking only the winners. Vast academic research shows they’re mistaken and will just add fees.
- Inflation. Inflation acts like fees, above, subtracting from return. Again, you can’t control this but can save more and invest in assets that keep up with inflation. In our example case, 2% inflation gives you $1.6M in purchasing power, 4% inflation gives you $900k.
- Lifespan and Health. If you live longer, you’ll need more money. Many people just plan to work longer to make up the difference, but your health is another item you can’t control; many people are forced to retire early due to health problems.
- Health costs. A huge drag on your ability to save, getting huger. Want to retire early? Get ready for $20k+ per year of health care expenses. Better save for that!
- Politics. “Trump got elected, the end is near – SELL!”. “Obama got elected, we’re going to be a socialist nation, SELL!”. You can’t control these, but history shows that the market doesn’t listen to MSNBC or Fox News. I’ve had a surprising number of friends try to time political events, and the results are stunningly bad. Just ride them out.
As I’ve said, there’s an industry looking to charge you 1% or more per anum to magically control the uncontrollable through things that don’t have a history of working: Stock picking, market timing, nontraditional investment strategies and alternative asset classes. I think you need to resist these dreams and stick to basics. My advice based on the above?
- Save a lot. Then saves some more. This will mean spending less, but it’s worth it.
- Invest it in low fee index funds. I know, you’ll never beat the market. But you will beat 90% of advisors and mutual funds over time.
- Diversify broadly across stock, bond, and geographies to maximize return and lower risk.
- Hold them for a long time to minimize trading fees and taxes.
- If you’re going to hire an advisor, get a fee-only fiduciary advisor who charges very low fees. Never hire someone who works on commission!
- Even it you’re going to hire an advisor, know what you’re doing. There’s no more important topic to your financial well being so take some time. Read Jack Bogle’s book. Heck, download Merriman’s free ebooks here – they’re excellent.
- Have a plan and battle test it with good financial planning tools. I’ll blog about my favorites sometime soon.