All posts by Tom Canfield

How does the second largest actively-managed fund – Fidelity Contrafund (FCNTX) – rank against its peers?

This post puts the second largest actively managed mutual fund – Fidelity® Contrafund® (FCNTX) – in the same barrel that I put American Funds Growth Fund of America (AGTHX) in two weeks ago. How well has FCNTX performed over the recent past compared to its peer index or a peer index fund? Basic answer: a lot better than AGTHX, but not as well as its peer index or peer index fund. Over the last decade, the annual return of FCNTX has lagged its peer index by about 1.5 percentage points per year.

 

== The glory days for Contrafund ==

 

In the two decades of the 1990s and 2000s Contrafund burnished Fidelity’s reputation for actively managed funds that outperformed almost all others. I pointed out in this post that that overall reputation for Fidelity has faded away: now very few of Fidelity’s actively-managed funds outperform their peer index, and none outperform close to the level that Contrafund did for 20 years.

 

The most famous Fidelity fund is the actively-managed Magellan Fund (FMAGX). Its heyday was in the years prior to 1990 when its legendary manager, Peter Lynch, retired. For the decade before he retired Magellan was a rocket ship outperforming the market by more than 10 percentage points per year. Since then it has lagged. After 1990 Contrafund far outdistanced Magellan and the market for two decades: Contrafund beat the market by about 4 percentage points per year over 20 years. $10,000 invested in FCNTX in 1990 accumulated to more than twice that of the market as a whole by 2010.

 

 

[Full disclosure: I was an investor in Contrafund for many of its glory years. I sold my last shares to switch to only index funds in 2014 when I started our financial retirement plan following my advice in Nest Egg Care, Chapter 6.)

 

Fidelity tells me I’ve been a customer since 1984. I thought I was a customer earlier. I’m sure the $2,000 that I put in my IRA account at Fidelity each year for many years – starting no later than 1984 – was solely in Contrafund. That’s why I’m sure my IRA investments at least matched the strategy of holding a low cost index fund over the decades that I describe here.

 

I had a logic as to why I picked Contrafund: I concluded the only way to beat the market is to invest in a company judging that earnings and profitability will grow much greater than other investors – the market as a whole – expects. That’s a Contrarian Strategy: invest in companies that are out of favor with under-appreciated potential. If they deliver, performance is at a much higher level than expected. Stock price jumps to reflect the new expectations of future performance. I’d like to think I was very smart in picking FCNTX, but that’s just hindsight: one’s memory always places oneself in a good light. Likely reality is that I was just very lucky.]

 

Contrafund is a completely different fund from the 1990s. It’s a behemoth in terms of assets under management. It’s essentially limited to investing in companies with very large market capitalization values: it has to concentrate on the top companies in the S&P 500®. Companies at the top of market capitalization value today are clearly in the growth category. As I mentioned two weeks ago, that category – Large Cap Growth – has outperformed others in at least the last five years, and all funds in that category are going to look good relative to many other funds.

 

 

As an aside, Contrafund is an immensely profitable fund for Fidelity. It’s Expense Ratio – the money Fidelity gets – is now .82%. .82% * $85 billion = about $700 million per year! Wow!

 

== Recent Performance vs. the peer Benchmark ==

 

I use the same Morningstar (M*) data that I used two weeks ago to see how Contrafund has performed. I also include AGTHX for reference.

 

1) FCNTX against its peer Large Cap Growth index. This 10-year data shows FCNTX lags the index for Large Cap Growth by about 1.5 percentage points per year. The accumulated value from FCNTX would be about 15% less than the index.

 

 

2) FCNTX against an index fund – actually an ETF – that attempts to mirror the Large Cap Growth index. I only have five-year data for that ETF: VONG. This is a better way to look at relative performance, since you could actually own that ETF rather than FCNTX. You see FCNTX lags VONG by 1.5 percentage points per year.

 

 

== Can FCNTX outperform in the future? ==

 

We don’t know but the evidence suggests that FCNTX will not outperform, and clearly that record of 4 percentage points better per year for many years looks impossible. Below I show FCNTX’s stock picking ability over the last decade. I add back the current .82% Expense Ratio for each of the past 10 years; that should be a pretty accurate apples-to-apples comparison to the index, which has no costs deducted. The table here shows no trend of FCNTX to outperform. An investor who paid .82% Expense Ratio per year – about 11% of the real, expected 7.1% growth for stocks – lost on that choice over the past decade and is losing this year so far.

 

 

 

Conclusion: Two actively managed funds dominate all others in terms of assets under management, AGTHX and FCNTX. This post looked at FCNTX’s performance over the last decade. FCNTX’s performance does not match its peer index or a peer index fund. Over the last five years it has lagged a peer index fund by about 1.5 percentage points per year. The stories of AGTHX and FCNTX confirms many other studies: funds that perform well over a time period just don’t sustain that performance over the long run. These two funds were top performers at one time. Money rushed in from new investors, changing the nature of these funds. Now they lag.

Is it time to get a mortgage or refinance your current mortgage?

Is this a crazy question to ask someone who is retired or nearly retired? No! Mortgage rates now are low, low, low. The average 30-year mortgage now is about 3.7%. I summarize data from this graph that shows rates are within .4% of their lowest over the past 58 years. Patti and I want money to give to our heirs now, not after we are dead, and I view taking money out of our largest non-financial asset – our home – as a low cost source of cash. The purpose of this post is to explain my thinking of why you should consider a mortgage or consider refinancing your current mortgage.

 

 

I bet my thoughts about having a mortgage when retired or refinancing to a bigger mortgage is not what most retirees would consider. Most retirees I talk to want to get rid of any monthly payments. They want to own their home with no mortgage. That’s the comfortable decision. I get that no mortgage is comforting, but I make a different choice.

 

== Mortgage: always had one. Always will. ==

 

When I was in the Save and Invest phase of life, I did not want to invest too much in a non-financial asset – our home – that I thought would grow in real value only about one percent per year. (That turned out to be true.) I knew that over the long run I was going to do much better by investing in stocks that likely would grow somewhere between 6% to 8% real return per year. (That turned out to be true.)

 

When I borrowed – got a mortgage – that simply meant we put less of our savings into the 1% growth asset and had more money to invest in the ~7% growth asset. Yes, I had to consider the cost of borrowing, our real interest cost for a mortgage. But I always thought of that as no more than 3% per year, the nominal interest rate adjusted for inflation. 7% real growth (stocks) is more than 3% real cost (borrowing).

 

== I refinanced every 10 or 15 years. ==

 

When mortgage interest rates declined I’d refinance at a lower rate and always for 30-year term. In this example I use the mortgage rate we obtained in late 1977 and assume I refinanced in 1992. Here is the logic I followed:

 

1. Patti and I bought our home in Pittsburgh in late 1977. We had an $80,000 mortgage at 9% interest. That would equate to a mortgage payment of $640 per month. (I use a mortgage rate calculator or Excel® for these calculations.)

 

2. I decided we should be happy to keep the same real monthly payment over time. Our income increased by more than inflation over time, so paying the same real amount as in 1977 was easier. An inflation calculator tells me that $640 in late 1977 was the same – in real spending power – as $1,460 per month in late 1992. (Those 15 years were a horrible period of inflation.)

 

By 1992 – 15 years – I’d paid a total of about $115,000: $640*12*15. Let’s assume $25,000 of this was principal. That made our loan balance $55,000 in late 1992.

 

3. 30-year mortgage rates at the end of 1992 were 8%. Using the $1,460 that I was comfortable in paying, this is a mortgage of almost $200,000. Let’s assume our house appraised such that we could get a $200,000 mortgage.

 

4. I refinance. I borrow $200,000. I pay off the loan balance of $55,000. I take out $145,000 in cash to invest – essentially in stocks. If returns matched the long-run average of 7% real return rate per year, that $145,000 doubles every decade following the Rule of 72. That would be about $925,000 today. Yes, taxes on annual gains distributions would take a bite out of that, but if I never refinanced this mortgage, my net after taxes on that would exceed P+I payments for 27 years and the remaining debt balance on that $200,000 mortgage.

 

 

==Our new mortgage in 2007. My age 63. ==

 

Patti and I sold our first home and in 2007 moved into our current home less than one mile away. Our current home is smaller but much nicer; we have much more open interior space and nicer yard. After needed renovations it cost more than we sold our home for. I did not hesitate to get a bigger mortgage.

 

I’m not remembering the amount of our mortgage, but as I look back in my Quicken checkbook register I can see that our monthly mortgage payments were $1,650 per month. I can use the graph cited above and see the rate at that time was about 6%. Those two equate to a mortgage of $275,000.

 

== Refinance in late 2012. My age 68. ==

 

By late 2012 mortgage rates declined to their lowest level in 50 years. I was lucky and froze our rate at 3⅛% interest in December 2012 and finalized our current mortgage a few months later. My 3⅛% rate is lower than on the graph for that month.

 

When I refinanced this time I wanted to lower our monthly payment. I picked $1,250 per month, $400 per month less. That payment and the 3⅛% equated to a 30-year mortgage of $290,000. My mortgage balance on my original $275,000 loan was approximately $245,000. I therefore was then able to take out $45,000 in cash and lower my monthly payments by $400 per month.

 

 

== Would I consider refinancing now? Age 75. ==

 

Yep. Interest rates will never – I think – drop to my 3⅛% rate, but that would not be a key consideration. Patti and I have a goal to give more to our heirs now while we are alive. It doesn’t make sense to think that most of what they may get is when they split of the proceeds from the sale of our house after we are dead. The idea is to give them a piece of that non-financial asset now. Let them enjoy the money or invest it for their retirement.

 

I also view refinancing as a tax-free source of tax-free cash to give to them. I like the more than two alternatives that shrink our financial assets, and I’m not as comfortable in doing that now: 1) sell taxable securities and pay capital gains to get the net cash to gift; 2) withdraw more from our Traditional IRAs to and pay income tax to get net cash to give them.

 

Here’s the approximate math on refinancing now:

 

 

1. I’ll assume we’d be happy with the same real monthly payment now as in 2012. We have a bigger nest egg now even after five years of withdrawals for spending since we’ve had very good returns for stocks since then. That means we would be happy to pay $1,540 now. That’s the same real spending power as $1,250 seven years ago.

 

 

2. At 3.7% borrowing rate, the $1,540 monthly payment translates to a mortgage of about $335,000. Let’s assume an appraisal would support that.

 

3. I get $335,000 from the new mortgage. I pay off the loan balance of about $250,000. Patti and I net $85,000.

 

== What’s the disadvantage? ==

 

We’ve tapped our non-financial assets such that we have diminished a deep, deep reserve to our financial retirement plan. I don’t consider this as a problem: 1) we already have a greater Reserve with our financial assets – more than two years of spending on average. (See Chapter 7 Nest Egg Care and “The Patti and Tom File” at the end of Part 2.). 2) Our Safe Spending Amount (SSA) has increased in real spending power by 20% since the start of our plan. It would be very easy us to lower spending back to our original SSA. Going back to this spending level would buy us a big, added margin of safety – more years of zero chance of ever depleting our Investment Portfolio.

 

 

Conclusion: I’ve had a mortgage and always will. I most recently refinanced in late 2012 and have a rock bottom 30-year mortgage rate of 3⅛%. Patti and I want to give money now to our heirs rather than after we are dead. A good option is to take money from our non-financial asset – our home. We’d do that my refinancing our current mortgage, and now is a good time to consider that option since mortgage rates are very low. If we did that – paying the same real monthly payment that we were happy with seven years ago – we’d net about $85,000 of cash, tax-free, that we could use for gifts.

Have we reached the tipping point for the demise of actively managed funds?

This article states that in July the amount invested in passive index funds passed the amount invested in actively managed funds: roughly $4.2 trillion each. The first Index Fund started in 1976. That means it took 43 years for Index Funds to win 50% share of all investors’ money. Is this a tipping point? Will Index Funds continue to gain share? What’s that mean for those of use who invest in Index Funds?

 

== Index funds will increase share ==

 

The arguments favoring Index Funds are too powerful, and more investors understand the arguments.

 

• Actively managed funds in aggregate must underperform index funds by their higher costs. That’s just simple math. The article above says the average cost of Index Funds is 10% of 1% of assets invested (.10%) and is 70% of 1% (.70%) for Actively Managed funds. Index cost = 1/7th of Active. That’s a cost difference of .6 percentage points in return per year. For a portfolio mix with perhaps 5.9% expected real growth per year, that’s about 10% less in annual return.

 

 

A .6 percentage points or 10% lower return rate over, say, ten years accumulates to a larger percentage difference in dollar growth. The difference expands with more years.

 

 

[My total Investing Cost is less than 5% of 1% (.05%). That’s 1/14th of the average for Actively Managed funds. That’s a bit more money in my pocket over a decade.]

 

• A rare few actively managed funds can claim to outperform and their outperformance is not consistently better. SPIVA reports show us that: see here and here for my most recent summaries. Fewer than 6% of Actively Managed funds beat their peer index in a decade. Those that do outperform don’t consistently outperform over time. There is no predictive power in thinking that outperformance over one period extrapolates to future outperformance.

 

The article above has a link to another article discussing the Capital Group, the fund manager of AGTHX, the fund I discussed last week. It’s a vocal defense of Actively Managed funds. AGTHX did have a very good run in the early and mid 2000s; it did not decline nearly as much as it’s peer index during 2001-2002 and in 2008.  It looks good when you include those years.

 

But how relevant is a fund’s performance more than a decade ago? Last week’s post shows its performance against its peer index – Large Cap Growth – has been DISMAL over the last decade. It’s under-performed its peer Index Fund (VONG) by 2.6 percentage points over the last five years. That translates to 20% lower return rate. And AGTHX has a front end 5.75% sales charge that goes to a financial advisor. Add the on-going annual charge to an advisor, and the effect is REALLY DISMAL.

 

I like the quote highlighted in the article: “People are too fixated on fees. They should be fixated on their total return after all fees.” Well, yeah. That’s exactly what last week’s post and those SPIVA reports show: it’s almost certain that you keep more money – you have higher return – when you pay less to the financial gurus.

 

• The anchor has dropped to 0% cost for index funds. We tend to gage everything against an anchor – our quick simple understanding of the Investing Cost of funds, for example. Investors know the cost of Index Funds is low, but the anchor – what does low cost really mean – was not really clear. Fidelity planted that new, obvious anchor in August 2018 when it started two stock funds at ZERO PERCENT Expense Ratio. FREE. And now there are two more of these ZERO COST funds at Fidelity. An anchor of NO COST is much clearer, much more obvious than LOW COST. An investor has to ask, “What exactly am I getting by paying the financial folks more than ZERO?”

 

 

== Do Index Funds distort prices of stocks? ==

 

The article states this argument: investments in Index Funds result in too high of prices for stocks. They don’t react to changes in the market. Index Funds will add volatility to returns. This makes no sense to me. Index Funds just buy at prevailing prices to deploy investors’ money and then they hold; they don’t transact after they’ve deployed investors’ money. Actively Manage funds and individual investors do all the buying and selling after that, and that’s what determines the price of securities. And they’re only buying and selling among themselves. Actively Managed funds create volatility or diminish it. Not Index funds.

 

If it were true that the growth of Index Funds results in over-valuation, one would have to conclude that Actively Managed funds must be improving in their performance relative to Index Funds. But this is not the case.

 

 

Conclusion: After their start 43 years ago Index Funds now have more invested in them than Actively Managed Funds. This trend will continue. The arguments for investing in Actively Managed funds are just too poor. They mathematically have to underperform in aggregate by their higher costs. The average amount they underperform – roughly .6 percentage points per year – is a big deal. That is likely 10% of future growth of an investor’s portfolio, and that difference compounds to a bigger dollar difference over time. Only a few Actively Managed funds – perhaps 6% – manage to outperform, and there is no predictive power as to which one today will outperform in the future.

How does the largest actively managed fund – AGTHX – rank against its peers?

Year ago I remember two actively managed funds battling it out in terms of top rank of size of mutual funds – the amount of money investors have in them: American Funds Growth Fund of America (AGTHX) and Fidelity Contrafund® (FCNTX). Both these funds had their heyday: that’s why they have so much invested in them now. The time period when both funds rocked – performed much better than the market as a whole – was in the 1980s, 1990s and early 2000s. Today a number of index funds outrank these two in terms of assets under management, but they are still the two largest actively managed funds. Morningstar data says that AGTHX is roughly 50% larger in terms of assets under management than FCNTX. $185 billion invested in AGTHX still must be the smart money, right? This post displays how AGTHX ranks against its peer index fund over the past decade. Basic story: not well at all. That great performance from more than ten years ago hasn’t meant anything for the last decade.

 

 

== Performance vs. the correct Benchmark ==

 

Morningstar (M*) does an excellent job of displaying performance of funds, ETFs, and individual stocks over time. M* always has had – well, for as long as I can remember – a graph and data that displays a fund’s performance relative to a performance benchmark. You can see the plot of the fund vs. the benchmark index. Small print at the top of the graph showed what $10,000 invested would have grown to for the fund and the benchmark index. Within the past month or so, M* has changed its display to be more useful to investors.

 

1) M* now displays a funds performance against its peer index fund. A Large Cap Growth Fund like AGTHX is now compared to a Large Cap Growth index. Previously, M* compared AGTHX (and other funds) solely to the benchmark of the S&P 500® index. Over the past five years Large Cap Growth has been the place to be. It’s the only style box that has outperformed S&P 500 index. I think this holds true over the last decade, but I don’t have 10-year data for all the style boxes.

 

 

This new comparison – fund to its peer index – is same logic as used in SPIVA reports that compare the performance of Actively Managed Funds to their peer index. Those reports consistently show that roughly 94% of Actively Managed Funds fail to beat their peer index over a decade. Is AGTHX the rare winner of this competition?

 

2) M* now shows the cumulative dollar growth of a fund relative to the growth of its peer index in BIG, OBVIOUS NUMBERS. Previously you had to look hard a small numbers above the graph to find the comparison.

 

 == How does AGTHX stack up? ==

 

Hmmm. Not well. I show the comparison two ways:

 

1) Against the peer index. This 10-year data shows AGTHX lags the index by a whopping 2.5 percentage points per year. That cumulates to 20% less than the index; you’d be behind by $10,000 for every $10,000 you had invested in AGTHX a decade ago.

 

 

2) Against a fund – actually an ETF – that attempts to mirror the index. This is a better way to look at this, since you could actually own that ETF rather than AGTHX. I only have five years of data for that ETF: VONGYou see AGTHX lagging by more than 2.6 percentage points per year.

 

 

Actually it would be worse than this. AGTHX charges a front-end commission of 5.75%. That means your $10,000 was really $9,425 invested into AGTHX and a $575 commission paid to your advisor. On that basis, you were behind VONG by about 3.1 percentage points per year. Ugh: if you decided to invest $10,000 in AGTHX five years ago, you’d be roughly $1,900 behind the alternative of investing in VONG – about 25% behind in growth.

 

 

== Few are leaving AGTHX. Why? ==

 

M* has a display of funds flow for each fund: this shows if investors are pouring money into a fund or withdrawing it. Investors are sticking with AGTHX despite the fact that its performance averages about 2.5 percentage points lower return per year than VONG. Why is this?

 

1) I think it’s the story of AGTHX and American Funds. You can see this video here. You can get a beautiful brochure from a financial advisor that also tells this story. The story is that  American funds will “sometimes lag” when markets are up but the “hand-built” portfolio will decline less when markets decline and “tend to beat the index” for “a history of better outcomes”. (With “tend to beat” and “a history of better outcomes” I’d immediately jump to the conclusion, “That must mean these funds will definitely beat the market over time!”) I see nothing in recent data to say that this is a good bet.

 

 

2) It’s the way AGTHX is sold: through financial advisors – the folks that get all or most all of that 5.75% commission and they also get an annual commission of .25% out of the total Expense Ratio of the fund. American Funds has built a sense of exclusiveness with these advisors. (I remember my friend, Alice, telling me, “I have American Funds,” as if that meant she was in really good funds. She now has four index funds for her total portfolio at a fraction of her prior Investing Cost.)

 

3) It’s a failure to correctly look at the alternative opportunity of selling AGTHX and buying VONG. One has to engage the part of our brain that makes calculations, and that’s hard to do. The intuitive, emotional part of the brain tells folks who own AGTHX two things: 1) hold onto it because we have a taxable gain because we’ve held it for years; we hate paying taxes. 2) Hold onto it because selling AGTHX is throwing away that 5.75% we initially paid; we don’t want to admit that is was a bad decision to have purchased AGTHX in the first place. A cold, hard calculation would say SELL AGTHX and BUY VONG. I’ll explain that calculation in an upcoming post.

 

 

Conclusion: Two actively managed funds dominate all others in terms of assets under management, AGTHX and FCNTX. This post looked at AGTHX to see if the smart money was with AGTHX. Over the past five or ten years did it beat its peer index or an index fund that does its best to mirror the index? The answer in both cases is “No”. AGTHX stacks up poorly when compared to both – lagging in annual return by about 2.5 percentage points per year. That difference compounds over time to a large dollar difference.

 

Are you rich? Where do you rank in income and net worth?

These two articles (here and here) in the New York Times were helpful in giving me an idea of where Patti and I rank in income and net worth. The purpose of this post is to give a bit of explanation and to suggest you use the two links to get an idea of where you stand. In the final analysis, however, I don’t really care where we rank. Patti and I are happy campers: we know what’s safe to pay ourselves from our nest egg. It’s enough. We aren’t – and won’t be – constrained from doing the things we both enjoy for the limited number of years we have left. That makes us rich.

 

== Income rank ==

 

The worksheet “Are you Rich? This Income-Rank Quiz Might Change How You See Yourself” shows where you rank by income for your age. I didn’t find the results that helpful. There are too many variables to make this useful for someone who is retired. Commenters to this article went nuts. “You say I’m rich for my age, but I have enormous college debt. I don’t at all feel rich.”

 

We retirees largely decide what to pay ourselves from our nest egg. For those of us with a nest egg, this pay is going to be the largest part of our income. (Those of us over age 70½ must take pay – RMD – from our retirement accounts.) Patti and I choose to pay ourselves our calculated, annual Safe Spending Amount (SSA) (See Chapter 2, Nest Egg Care.), and SSA will always be greater than RMD. So, we may just have greater income than retirees who pay themselves too little, because they have no idea of what’s safe to pay themselves.

 

I also don’t find it useful to understand how we rank among “earners in your area”. From this table below, Pittsburgh – our home – ranks low in income relative to other areas and also ranks low to others in cost of living. Cincinnati is close in cost of living, but this table would tell me that there are more folks there with money than here. I don’t know what to conclude from this.

 

 

== Net Worth Rank ==

 

I find this worksheet more useful, “Are You Rich? Where Does Your Net Worth Rank in America?” You can find your approximate rank in national net worth – the value of your financial assets plus your equity in your house. I’d guess that this excludes a calculation of the value of Social Security and of defined benefit plans.

 

 

I was mystified at first at the graph, “How income and wealth diverge across age.” The graph shows folks +65 and older at the 90th percentile have net worth of about $2.1 million in net worth and income of about $165,000.

 

That makes income a shocking 8% of net worth. Even when I guess the equity value of their home and the part of the $165,000 income that is Social Security, I calculate that the slice of income that comes from their financial nest egg is a far higher rate than one would derive from Nest Egg Care. Somebody age 65, for example, should have an SSR% of about 4%. This says retired folks are spending too much of their nest egg each year! I hope to heck that is not you! The only other explanation is that most of these folks continue to work or have other significant sources of outside income.

 

== $1 million for those over 65 is not rich ==

 

The article implies that “Rich” is in the 90th percentile – about $2 million net worth – and someone or a household headed by someone with a net worth of $1 million is roughly at the 80th percentile.

 

I’d agree than $1 million just isn’t what it used to be. We likely had that number planted in our head decades ago. Inflation has taken its toll. Patti and I started out on our plan for spending in 2015 at an SSR% of 4.40% – $44,000 per $1 million. Perhaps $1 million net worth is $800,000 financial assets and $200,000 non-financial assets – equity in your home. You can only pay yourself from your financial assets. $800,000 of financial assets would work out to be less than $35,000 Safe Spending Amount. Adding in Social Security might make annual income $70,000. That’s below the 75th percentile of income. That’s better than most folks but would be about 60% of that “rich” level of income in the previous worksheet.

 

== Investing in stocks makes a big difference ==

 

The text makes the case that folks over age 65 who had the capacity and discipline to invest in stocks are far better off than those without the capacity or who chose not to save and invest in stocks.

 

The primary asset of the rich is stocks. That’s an asset that grows at about 7% real return per year. The primary asset of those at the median or below is their house. That’s an asset that might grow at 1% per year. Those who saved and invested in stocks outdistance those who didn’t.

 

And those with net worth stored in Stocks have money they can spend. Those with net worth stored in their home don’t.

 

== The ultimate Test ==

 

The ultimate test of where Patti and I stand – our happiness rank – is based on knowing that we can pay ourselves enough from our nest egg. We are rich in the sense that we do not feel constrained in what we want do to Enjoy the relatively few years we have left. This happiness is unrelated to exactly where we stand relative to anyone else.

 

And we’re happier than before because we have more to spend than we did at the start of our plan. That’s the result of our annual Recalculation.

 

I think most retired folks are not as happy about their financial situation largely because they have NO IDEA what is safe to spend. They don’t know if they have enough. With the exception of the few at the very top in net worth, they think they will never have enough. They want more. They’re driven to build an even bigger next egg and spend too little to help do that. That’s not a good retirement plan and that’s not happiness to me.

 

 

Conclusion. Two worksheets in the New York Times give you an idea of where you rank in income and net worth. That’s nice information but does not really get us retirees to what we want to know: what’s safe to spend from our nest egg and is it enough that we can enjoy our remaining years. Patti and I got that answer by going through the steps in Nest Egg Care. That’s the only way I know that you can get there with confidence.

What’s a Holding Period and how does that affect your mix of stocks and bonds?

My nephew Rob read last week’s blog. He liked it, but I was not clear enough on the concept of Holding Period and how that affects his choice of mix of stocks and bonds – your choice, too, if you are building your nest egg. The purpose of this post is to explain: What’s a Holding Period and How do I Use Holding Periods to get to a proper mix of stocks and bonds?

 

== For those in the Save and Invest phase ==

 

This blog is most useful for those, like Rob, in the Save and Invest phase of life – those building a nest egg. My point in this post is that it makes sense to think through when you will to sell an investment to get the cash you will spend. When you think it through, you have different time horizons. You decide your mix of stocks and bonds for those different time horizons. That’s how you get to your total mix of stocks and bonds.

 

Most folks just look at their portfolio as one big lump of money without regard to how long parts of it will sit untouched. They’re setting their mix of stocks and bonds for their one big lump. They fret about the ups and downs of the whole lump. This does not make sense to me. Why would I be concerned about what is happening in the stock market now for money that I will not need for spending for decades? Envision your portfolio as divided into groups of Holding Periods, each with a proper mix of stocks and bonds. That’s the way you get to your total mix of stocks and bonds. Also, when you think of your portfolio this way, you’re less alarmed when you see the total decline because you may have parts that have not fallen at all.

 

== It’s different for us retired folks ==

 

For those of us in the Spend and Invest phase of life, the practical matter is that a Retirement Withdrawal Calculator (RWC) tells us a lot more about what we should have as our mix of stocks and bonds. Rob’s building a nest egg. We retirees are trying to spend from it and not deplete it to an unacceptable level. Decisions for our retirement plan are more complex than for Rob: we have to get to a Safe Spending Rate (SSR%) and we only get that from an RWC (See Nest Egg Care). The thinking on Holding Periods is not precise enough to tell us what’s Safe to Spend, and that’s the biggest factor for safety of our retirement plan.

 

An RWC also tells us how mix (and Investing Cost) affects our portfolio over time. I picked mix for us at the start of our plan and will keep the one I picked for the rest of our lives. Each December, however, I like to recast or envision our portfolio by three Holding Periods. I see the parts are behaving exactly as one would expect.

 

== What’s a Holding Period ==

 

A Holding Period is the length of time that you hold onto an investment before you sell it for spending. The most obvious example is the contribution Rob will make – ideally – to his Retirement Account this year – his 401k at work and perhaps also to his Roth or Traditional IRA. Rob is 25. He will not sell securities from his Retirement Account for at least 35 years. Rob’s contribution this year – let’s assume $6,000 – will compound and grow for 35 years. That’s his holding period for this year’s investment. He actually could open an account just for this year’s contribution and nickname it. (This would fit in the nickname space on my Fidelity portfolio page.)

 

 

He could open a new account in his master Retirement Account every year and similarly nickname each. It would be clear: each year’s contribution would have at least a 35-year Holding Period. This can get cumbersome, but you get the idea.

 

 

Here’s a different one: Rob thinks about his future spending needs and thinks he will spend $20,000 for a new car three years from now. He could actually open an account at his brokerage house – it wouldn’t be part of his Retirement Accounts – and nickname it, “For my new car in summer 2022.” He has some saved now and puts that in this account. He’ll add to that to get to the $20,000. This means the amount he has now has a Holding Period of three years. The amount he adds next month will have a holding period of 35 months. Next is 34 months. And so on. Let’s group all those into one 0-to-3 year Holding Period.

 

== Long Holding Periods and Mix ==

 

The mix of stocks and bonds for a 35-year Holding Period is really obvious. Over that long of period, nothing will beat stocks. Bonds won’t come close. At expected returns, stocks will pound bonds. Stocks at 7.1% will compound to roughly 11X in spending power. Bonds at 2.3% will compound to roughly 2X.

 

 

Both stocks and bonds are variable in returns. Both have had long periods of returns well below their expected return rates. For a 35-year Holding Period, though, bond returns never have surpassed stock returns. The conclusion is clear. Rob’s investment this year into his Retirement Acccount has to be 100% stocks and 0% bonds. His investment next year – with the plan for another 35-year holding period – has to be 100% stocks. The sum of the two is 100% stocks. This pattern repeats for MANY years.

 

Actually, Holding Periods less than 35 years should be 100% stocks. We whittle the 35 years down in two steps.

 

1. We can first cut the years Rob should be 100% stocks in half. At about 17 years – 17-year Holding Period – stocks are LESS variable in return rate than bonds.* You get a sense of this from this graph: historically bonds have departed much farther below their long-term average return line than stocks.

 

 

To restate, for a Holding Period of ≥17 years stocks are 3X better in expected annual return and are less variable in annual return rate than bonds. That’s a clear mark: Holding Period ≥17 years HAS to be 100% stocks.

 

2. Now we get to a judgment on your choice – your bet – for mix of stocks vs. bonds based on less obvious probabilities. I conclude that Holding Periods of 10-years or more should be 100% stocks. The future chances that bonds will outperform stocks for a 10-year holding period is very small. And the amount that bonds may outperform is small. All the other times – when bonds don’t outperform – stocks will compound to much greater value than bonds.

 

Stocks don’t always outperform bonds over ten-year Holding Periods. Historically bonds have outperformed stocks over ten years about 20% of the time. But most all these occasions occurred in periods from the 1980s when inflation fell from its high of 13% to about 2%. Bond prices move opposite to the direction of interest rates. Prices of bonds rose dramatically with that dramatic fall in interest rates. You see that effect in the graph above: the steep increase in bond returns starting in about 1980. Today interest rates can’t fall like that and prices can’t rise like that in the future. The chance that bonds outperform stocks over a 10-year Holding Period in the future is a lot less than 20%. (Also see NEC, End Notes Part 2.)

 

== Short Holding Periods and Mix ==

 

The mix for a 0 to 3 year Holding Period is a bit more complex. Stocks are much more variable than bonds for one-year return periods. for example, a bad 1-in-10- year event for stocks is -16% or worse real return. When stocks have a negative return like that, bond returns have been much better. Rob wants that money for the car to be there in three years, so he would tend to conclude, “Easy: I want 100% cash and bonds for that.”

 

That’s a good choice, but not exactly the best choice. A good thing happens when you mix a little bit of stocks in with the cash and bonds: you get less variation in return and you get greater expected return. You get less variation because the peaks and troughs of the real returns for the two don’t align. Enough of the upswings of stocks cancel enough of the downswings of bonds and vice versa to result in a smoother, more predictable total ride. And it’s a better ride because that bit of stocks increases the expected return to more than you would get from bonds only. More predictable return and better return. You have to like that. The math guys work the details on how peaks and troughs offset and tell us a really good mix for this Holding Period works out to be 80% bonds and 20% stocks. I buy that.

 

== In between ==

 

If a Holding Period of 0 to 3 years is 80% bond and 20% stock and a holding period of ten years and longer is 100% stock, what comes in between?

 

You basically want a transition that goes from 80% bond to 0% bond from years four to ten. Sketch that out on a graph, and it averages out to 60% stock and 40% bond over that period. The math guys also say that 60% stock and 40% bond mix is good for this band of Holding Period.

 

== My matrix and look =

 

Each December 15 I recast my portfolio into these three Holding Periods with those mixes. (I keep spending for the upcoming year in cash.)

 

 

I know my stock and bond returns by the way I’ve organized our accounts. For a mix of 80% bond and 20% stocks I should see lower returns over time but less variation in return. For my Holding Periods that are 100% stocks I should see greater returns over time but much more variation. And the in between should be, well, in between. That’s what has happened over the four years I’ve been doing this.

 

 

 

Conclusion: When your are building your nest egg, think about Holding Periods: how long you will hold onto an investment before you sell it for spending. Estimate your spending needs into Holding Periods. Each period should have a proper mix of stocks and bonds. I like this as Holding Periods: A) upcoming year (basically all cash), B) following years 2 and 3, C) years 4-10, and D) over 10. When you do this, you will get to a proper total mix of stocks and bonds.

 

* See Chapter 6, Stocks for the Long Run. Jeremy Siegel. This is an excellent discussion of “Risk, Returns, and Portfolio Allocation”.

 

What would be your advice to someone building their nest egg?

My nephew Rob, age 25, asked me for some of my thoughts on investing. I gave him a few quick thoughts but then decided to describe what I think I’ve learned over the decades. This post is my advice to someone age 25. I would hope that Rob could be a self-reliant, highly efficient, and very successful investor. It’s not hard to do. Really! As I think about it, this advice is really for someone at any age who is building their nest egg. They’re in the save and invest phase. Not my spend and invest phase. Would this track with your thoughts?

 

== Imagine 8X. Even 16X. Save and Invest. ==

 

Why save and invest? Because when you store your savings in stocks you will build multiples more spending power in the future. Imagine: “What can I do with $1,000 now?” and ask, “Would I be happier if I had 8 times – maybe 16 times – this amount of spending power in the future?” This is a real choice because of the earning power of stocks and the power of compounding of returns.

 

 

== Think Real: avoid the distortion from inflation ==

 

We want to understand what happens to our money in real spending power. We make better financial choices when we think in terms of real return rates and real growth in future spending power.

 

Inflation shrinks the spending power of our money. The number of dollars we have today has less spending power than the same number of dollars we had in prior years. Inflation can lead us to conclude we are doing better than we really are. Inflation has a way to make the difference in return rates from stocks and bonds look less important than it really is.

 

== Store and build wealth in stocks ==

 

I can’t think of any investment that has a greater long-run return rate than stocks. Stocks average more than 7% real annual return. The next best, bonds, have averaged 3.1%. Your home – real estate – won’t increase in value much faster than inflation; after all, real estate is a component of the calculation for inflation. The value of homes Patti and I have owned increased by no more than 1% in real value per year when I adjust for inflation and all that we invested to improve them. Money market and bank savings accounts earn about 1% real return. Cash earns less than 0% because of inflation.

 

Stocks therefore are powerful earners and have 2.3X the real, long-term return rate of the next best alternative.

 

 

 

== Compound growth expands returns ==

 

Compound growth means you earn money on your original investment and on all the accumulated amounts in prior years. Small differences in annual return rates compound to big dollar differences in growth. The growth of stocks in one year is 2.3X that of bonds, but over time that difference expands to more than 6X.

 

You can understand this by applying the Rule of 72. That Rule gives you a good estimate as to the number of years it takes for an investment to double. You divide the investment return rate into 72: an investment at 8% will double in 9 years. At a shade over 7% real return, an investment in stocks will double in spending power in 10 years. (That’s close enough.) At 3.1% real return, an investment in bonds – the next best alternative – will double in 23 years.

 

 

You have many years to let compound growth work its magic. Let’s assume 40. (Your life expectancy approaches 60!) For stocks that’s four doublings or 16X. Over that same period bonds will muster about 1.7 doublings and grow to about 3.4X. When you just look at the growth portion of the two, the difference is more dramatic.

 

 

 

== Tax-Fee Growth! You Can’t Beat It! ==

 

Tax-free growth is a wonderful thing. Always contribute to your retirement plan at work to get your employer’s match; that’s free money to you. Contribute more if you can to that retirement plan and to a Roth or Traditional IRA: $6,000 per year now. If you ever have a High Deductible Health Plan, contribute to a Health Savings Account: it’s the best ever.

 

== Investing Costs Cut. VERY DEEPLY. ==

 

It’s this simple: do you want your investments to grow at a rate of, say, 7.0% or 5.7%? In this example below, would you rather have $56,000 more in spending power or not? Tough choice, eh? Most investors surprisingly choose the high cost option and earn at 5.7% giving up that $56,000. Huh? They don’t readily see and understand their investing costs (The financial industry doesn’t make it super clear.), and they don’t correctly think through the effect of high costs over ten, twenty, thirty or forty years.

 

 

We all incur investing costs. These costs are a net reduction from market returns. Investing costs are the sum of a fund’s Expense Ratio plus any fees you pay to a financial advisor. Ideally you are self-reliant and don’t incur advisor fees. Investors who incur fees from Actively Managed Funds pay roughly 1.4% of the value of their portfolio per year. That’s the direct reduction in their annual returns: 7.1% before costs less 1.4% = 5.7% net to you). Self-reliant investors no more than .10% (7.1% less .1% = 7.0% net to you). You will be hurt in the future – not do as well as you could have – if you fail to be an efficient, self-reliant investor. The good news is that it’s easy to be efficient and self-reliant.

 

== You can be in top 6% of all investors ==

 

You’ll be a winner when you predictably keep more of market returns. You keep more when you pay financial folks less. When you pay less you will be in the very top ranks of investors. The secret: only invest in broad-based, rock-bottom cost Index Funds. That’s easy to do today.

 

I own four Index Funds or ETFs equivalent to funds that in turn own a total of 24,400 securities – the great part of all the securities traded in the world. My total weighted investing cost is less than 5% of 1% of my total portfolio – .05%, and my costs have declined twice in the last year even though I didn’t change a thing in my portfolio.

 

 

Your chances to win are slim to none when you try to beat the market. That’s what Actively Managed funds try to do and basically why people hire financial advisors: they think those smart, hardworking folks can steer them to the funds that will earn more than market returns. It’s mathematically impossible for Actively Managed funds in aggregate to outperform Index Funds. Some funds do beat their peer index in a year, but over 10 years, it’s only about 6% who do, and it’s impossible to predict the future winners. You have more than a 40-year time horizon; that means it will be fewer than 6% who will outperform. You know you will be in the top 6% of all investors when you stick with index funds – and you’ll likely rank much higher than that.

 

I think the human brain is wired to tell us we can beat the market. We tell ourselves we are really smart, above average, and competitive. Investing in Index Funds means we are accepting that we will take a tiny bit less than what the market gives all investors and never beat the market. That just doesn’t fit who we are. I had to shift my thinking from “beating the market” to being a “champion investor” – focusing on how I likely will rank compared to other investors. Top 6% is good enough for me! That wasn’t an easy transition. It took me several years to get over my bad habit of investing in Actively Managed funds or taking flyers on stocks friends of mine would recommend. (Almost all those flyers were disasters.)

 

== You win by staying the course ==

 

Stocks and bonds have their ups and downs. Over your lifetime it is 99% certain that you will experience a year with -17% or worse return of stocks. Do not falter and change course. I invested $2,000 in a stock Index Fund in my IRA in 1982. It declined by 20% in one day (!) in 1987. It declined by -42% real return over three years starting in 2000. It declined by -36% return in 2008. When I sold that specific investment in January 2018 (in effect) it had grown 19.7X of that original spending power; that’s more than I’d calculate from the Rule of 72 (36 years would be 3.6 doublings and close to 12X) because the real return rate over that period was greater than 7% per year. (With inflation thrown in, my $2,000 turned into $102,800.)

 

== You just need to own four funds ==

 

You need no more than four Index Funds and you will own pieces of almost all the stocks and bonds in the world. That’s really all you need to do to be self-reliant and efficient. You saw the ones I own above. You can find these and similar funds or ETFs at Fidelity,Vanguard, Blackrock, or State Street.

 

== Use Holding Periods to set your mix ==

 

A Holding Period is the number of years you hold an investment before you sell it for cash to spend. Money you put in your IRA this year will likely sit there for 40 years before you sell securities for your spending. That’s a 40-year holding period. Stocks always outperform bonds by a wide margin for that length of time. That tells you what you should invest in: only stocks for that many years.

 

You will have other needs for spending with much shorter holding periods. You may have a need to save and invest to spend on a car four years from now. Or you want to save for a downpayment for a house. Those will clearly have short holding periods relative to your retirement accounts. In these cases you want to hold a mix of stocks and bonds. Bonds are insurance against the chance that stocks nosedive. When stocks have cratered – the ten worst years since 1926 average -27% real return – bonds don’t. You’ll be happier having held a bonds for short Holding Periods. You can see here that I annually take a snapshot of our portfolio arranged by Holding Period. Short holding period: mostly cash, money market, CDs or bonds. Long Holding Period: all stocks.

 

 

== Keep it Simple ==

 

Over time you want to keep your money in one place so you can keep it really simple as to what you own and how you are invested. Your accounts and holdings can get spread out and hard to follow with retirement plans from different employers and different kinds of IRAs. I have all my money at Fidelity. I like Fidelity’s web site and service. You cannot beat Fidelity’s cost for Index Funds.

 

 

Conclusion: You can be a winner in the top ranks of all investors. The first key is to Save and Invest as much as you can. You’ll most likely have 8X to 16X more in spending power from your investment in stocks in your retirement accounts, for example. The second key is to be Super-Efficient (and effective) by only investing in Index Funds: you only need to hold four. The third key is to Stay the Course: the value of your portfolio will vary; you’ll see periods of big downswings. But keep in mind that you have many years before you will need to sell any of it for your spending. You reduce uncertainty of the amount that will be there when you want to sell securities for your spending by estimating your spending needs by Holding Periods – how long you’ll hold on to an investment before you sell it. For short Holding Periods you’ll want mostly cash, CDs or bonds. Long Holding Periods should be all stocks.

 

 

What would you do if your Safe Spending Amount increased by 50%?

How would your life change if your annual Safe Spending Amount (SSA) – your annual pay from your nest egg – increased in real spending power by 50% in the future?  How would you live your life differently? Buckle up. You have to think about this, because this is what most likely will happen to your SSA: in a decade you’ll most likely be paying yourself roughly 50% more from your nest egg than at the start of your plan. Over your lifetime: double. This post explains why you will see an increase like this if future returns for stocks and bonds match their historical real returns.

 

== SSA is SSR% * Investment Portfolio ==

 

Let’s go back to the basics. Your SSA is the constant dollar amount – constant spending-power amount – that you can spend each year and confidently know you will not deplete your financial next egg. Your initial SSA is the multiplication of your Safe Spending Rate (SSR%) and your Investment Portfolio. (You subtract an off-the-top Reserve from your total portfolio to get to your Investment Portfolio for the calculations.) Your SSR% is always low because it is based on zero chance of depleting your portfolio in the face of the Most Horrible sequence of financial returns we might face. Your SSR% is a function of how many years you want for zero chance of depleting your portfolio. More years = Lower SSR%. Fewer Years = Higher SSR%. See Graph 2-7, Nest Egg Care (NEC).

 

== Two factors are at work ==

 

• Factor #1. As we age, we should accept fewer years for zero chance of depleting, and therefore a higher SSR% makes sense. Patti and I started out almost five years ago and set 19 years for zero chance of depleting our portfolio. If we stick to the same logic that got us to 19 years, we need 16 years now. In five years it will be 12 years. See Chapters 2 and 3 and Appendix G NEC.

 

• Factor #2. Your SSA will increase at expected returns because your expected return rate exceeds your SSR% for many years. Rather than finding the median sequence of returns with its variation in annual returns to show what happens, I simply use steady real expected returns – 7.1% for stocks and 2.3% for bonds. You can see the expected real return on Patti’s and my Investment Portfolio is 6.38% per year for our 85-15 mix.

 

 

These two factors are analogous to the factors that will result in doubling of your RMD at expected returns for stocks and bonds.

 

== How much will SSA increase? ==

 

Punchline with details to follow: it most likely will at least double in your lifetime.

 

I display in this table what happens for five years at that steady 6.38% real return rate for our portfolio. I use a 4.40% SSR% – the rate Patti and I started with at the start of our plan. The table assumes a starting Investment Portfolio of $1 million. Over the five years SSA increases in real spending power by about 14%. (We’re not close to double, but just wait.) Portfolio value increases each year.

 

 

Let’s walk through two years to see how this works. Also see discussion in Chapter 9, NEC.

 

• Spending Year #1: 2015. In late December 2014, we withdraw $44,000 (4.40%) for spending for the upcoming year. We start January 1, 2015 with $956,000 in our Investment Portfolio.

 

We spend or gift all the $44,000 that we withdrew for spending. We did not save one dime. We threw nothing back into the pot. We earn the expected 6.38% that year on the $956,000 and incur the assumed Investing Cost. We have $1,015,200 at the end of the year right before our next withdrawal. That’s obviously more than the $1,000,000 we started with. That means we have more than enough to support our current SSA. We can step up to the SSR% appropriate to the fact that we are one year older: 4.50%. We withdraw 4.50% of $1,015,200: $45,700 SSA. That leaves $969,500 for the start of the next year.

 

• Spending Year #2: 2016. We start January 1, 2016 with $969,500. We again spend or gift all the $45,700 that we withdrew. We again earn 6.38%. We have $1,029,500 right before the next withdrawal. That again is more than we had right before the last withdrawal. We again have more than enough for our current SSA and can step up to the 4.60% SSR% due to the fact we’re another year older. We withdraw 4.60% of $1,029,500: $47,400 SSA. That leaves $982,100 for the start of the next year.

 

This pattern repeats. SSA increases every year or every other year. Portfolio Value only stops growing when our SSR% bumps into our 6.38% expected return. That happens for us in December 2024, Patti’s age 77 and my age 80. That does not mean our SSA declines thereafter, though.

 

== SSA continues to increase ==

 

I continued the table for a total of 20 years, and I plot SSA. The graph tells me in 15 years from now – 20 years from the start of our plan – our SSA will be double the spending power we started with in 2015: start of $44,000 for spending – or gifting – in 2015 and +$88,000 spending in 2034. There’s our doubling! Both are measured in the same spending power.

 

 

 

== Patti and I are ahead of expected ==

 

I add the plot what has really happened to our SSA given the actual ups and downs in returns so far. (You can see the details of this calculation here and here.) Patti and I are ahead of our expected SSA because of the high returns in 2016 and 2017. (You also would be ahead of your expected SSA had you started your plan before 2017.) I conclude that we may have to wait a few years before the next increase.

 

 

== Another $14,500 in just five years ==

 

Our SSA is $8,800 per year – times our multiplier of the assumed $1 million initial value – more than our starting amount. We could expect $14,500 more per year in five years. And another $14,000 in another five years. What a problem to have!

 

 

== What’s this mean for us? ==

 

Knowing that significant increases in our SSA are very likely gives me more confidence in our current SSA. We do this anyway, but Patti and I are more comfortable in fully spending (or gifting) it TOTALLY in the year.

 

Patti and I were very happy at $44,000 and now we pay ourselves $8,800 more in that same spending power. How will another $14,500 per year change our lives? And another $14,000 after that?

 

What more can we spend to Enjoy More Now? Travel is our biggest discretionary expense. We certainly are not holding back on the amount we travel, and we don’t hold back on expenses when we travel. I’d spend more on home maintenance so the house and yard looks great all the time, but that really isn’t a lot more. I honestly don’t think we can spend very much of that extra on ourselves. Much of the increases has to go to Giving to those we care about. We really like that idea. That will make us happier.

 

 

Conclusion. If you’re like Patti and me, you gear your spending to be ultra-conservative. Nest Egg Care gets us to our Safe Spending Amount assuming we face the Most Horrible sequence of financial returns. We almost certainly won’t ride a sequence like that. We need to think through what happens to our SSA when we don’t face Most Horrible. If future stock and bond returns match history, our SSA – your SSA – will increase by 50% in a decade and by 100% over our lifetimes. Patti and I are already ahead of that pace. We need to think through what that means for us: how do we think about our spending now? How will we spend – or gift – differently as our SSA increases?

Are chances increasing for a Big and Painful market correction?

Blog reader Bill is starting out on his plan. He’s figured out what he can pay himself from his financial nest egg and asks, “We now have a long string of years without a major market decline. Are we ripe for one? Should I start out spending less than my calculated SSA?” Good question! I wrestled with that question four – almost five – years ago when I started my plan. And that thought crosses my mind in early December when I Recalculate for next year’s Safe Spending Amount (SSA). (See Nest Egg Care (NEC), Chapter 9.) This post expands on my basic answer: I don’t think we are close to conditions that would lead to a huge market decline that sinks your portfolio. But if it makes you feel better and safer, increase your Reserve (See Chapter 7, NEC); that has the same effect as lowering your SSA – your paychecks from your nest egg.

 

Here are some basic reminders.

 

== Your plan always assumes the worst ==

 

The key planning assumption for NEC is that we retirees will face the MOST HORRIBLE of financial returns in history essentially starting TOMORROW. This most horrible sequence of returns will have a devastating effect on our portfolio, but we can take actions that assure zero chance of depleting our portfolio for many, many years.

 

The key action we take is to have a low Safe Spending Rate (SSR%) and that results in a low Safe Spending Amount (SSA). (Maybe we could debate: is being a low cost investor more important than this action or just a prerequisite?) I found the SSR% for Patti and me at the start of our plan – for 19 years with zero chance for depletion of our portfolio – was 4.40%. (See Chapter 2, NEC.) That equates to LESS THAN 0% real annual return over 19 years. If we had assumed 0%, our spending rate would be 1/19 or 5.25%.

 

The fact that our SSR% is based on less than zero cumulative return reflects the ugly annual declines in returns within the long sequences of 0% cumulative return for stocks (18 years) and for bonds (48 years!).

 

== The worst is REALLY BAD. And rare. ==

 

The worst sequences of returns that sinks your portfolio – basically for any mix of stocks and bonds – includes a few years of SHARP, NEGATIVE stock returns that eat up roughly 45% of the spending power of your stock portfolio. This damaging decline from stocks has to hit you in within the first five or six years of your retirement to have its most devastating effect. That’s when a large percentage decline eats the most dollars relative to your starting portfolio value. When you combine the effect of withdrawing for spending, it gets really hard to replace those dollar losses even when returns improve. Bonds have not been golden: they’ve cratered and eaten 41% of spending power over a five-year period.

 

We’ve had VERY UGLY real declines for stocks three times in the 92 years since 1926 – that equates to a 1-in-30 year event. (It’s a 1-in-50 year event had I considered the return data from 1871.) Those steep declines don’t have to hit us right at that start of our retirement to really hurt us, meaning the chance that we’ll suffer a major decline in our portfolio within a few years from the start of our formal retirement plan is greater than 1-in-30. It’s still fairly rare. You can see more scary periods of historical returns for stocks here and read about the worst sequence that drives our spending rate to a low level here. That sequence has the two-year -49% real decline from stocks and the five-year -41% real decline from bonds! Wow.

 

 

== Your Reserve buys a layer of Safety ==

 

Nest Egg Care adds a layer of safety to your plan by asking you to take 5% off the top of your total portfolio – roughly one year of spending. (See Chapter 7, NEC.) In effect, you stick that Reserve under a mattress and try not to think it even exists. You base your calculation for your Safe Spending Amount (SSA) on the net, which I call your Investment Portfolio. The 5% Reserve lowers the dollar value you’re using to get to your SSA and that lowers your SSA by 5%.

 

 

Hopefully you will never have the need to tap your Reserve, but you will use it for your spending when we hit an annual return or several years of return that are really scary. We are not selling securities – especially stocks – from our Investment Portfolio. We’re giving ourselves a shot for stocks to rebound, side-stepping severe damage to our portfolio.

 

==== Do I think MOST HORRIBLE is near? ====

 

No, I don’t.

 

• Statistically a bad 1-in-10 year event is a real decline of -17% or greater. We’ve not had a year like that for more than ten years. But that does not mean the chance of a really bad year is increasing. Our last year like that was 2008, and it was much worse than -17%; 2002 was another year; we have to stretch back 27 years to 1974 to find the next prior year.

 

• I think it’s the economy that will drive the next steep decline: recession, depression, or out of control inflation. We combined several recessions and very high inflation averaging over 7% per year for the 15 years starting in 1969 – that’s the start of the Most Horrible sequence of return that we use to set our SSR%. I don’t see any conditions that suggest we are close to those conditions. Do you?

 

• The other concern is an over-heated market or over-priced stocks. All three of the years that kicked off declines (1930, 1969, 2000) came after a period of very high stock returns. You can see those run-ups as deviations well above the long-term trend line in the graph below. They even look like bubbles. When I look at the pattern of stock returns now, I don’t see a deviation – a bubble above the long-term trend line.

 

== We make decisions based on emotion ==

 

We make decisions by emotion and not by logic. We’re human! I can completely understand that if Nest Egg Care tells me a spending rate is safe then by gosh I’m going to do something to make it even safer. It’s just too important. I can do two things that are logical for greater safety:

 

#1) Lower my spending rate. Bill’s absolutely right. That’s the number one lever to increase safety by far. Lower spending BY JUST A LITTLE means a longer shaft length of your hockey stick – the years with zero chance of depleting your portfolio. (See Chapter 2, NEC.)

 

 

That’s essentially what Patti and I did at the start of our plan. (See NEC, The Patti and Tom File at the end of Part 2.) Patti wanted two – no three – years of spending in Reserve. We negotiated: I put two years into Reserve. That lowered our SSA by another 5%. That is what I would recommend to you: increase your Reserve. That means you are lowering your SSA. I like this approach better than just spending less than your calculated SSA. You don’t want to get into the habit of “Saving” part of your calculated SSA. That simply means you aren’t enjoying (and giving) as much as you should.

 

#2) Lower my Investing Cost to less than that assumed in Nest Egg Care (NEC) – .18%. Lower cost is always a good move, but lowering to less than .18% is a small lever: it does not come close to #1 in lengthening the shaft of your hockey stick. Our Investing Cost is less than one-fourth that assumed in NEC. That took no work: fund companies have continually lowered their Expense Ratio for the funds Patti and I own.

 

Those two ARE the options. It is not logical in my mind to have a low mix of stocks. Or to throw other kinds of investments than stocks and bonds into your mix; those actions aren’t buying you added safety that you otherwise would get from #1 and #2. Anything less than 75% stocks makes NO SENSE to me. Nothing about less than 75% stocks is “more conservative” in my mind. See Chapter 8, NEC.

 

 == Drop that extra Reserve? ==

 

Over time Bill will Recalculate (Part 3, NEC), hopefully, to a greater real SSA. Then he can rethink the need for that extra Reserve. Patti and I started at SSA of $44,000 per $1 million of Investment Portfolio. Now our SSA is 20% greater in real spending power. I have not lowered that original two-year Reserve, though. Doing that would immediately boost our SSA by 5% because it would immediately increase our Investment Portfolio. But I have no big urge to do that. No urge to explain why I want to lower the Reserve to Patti. Maybe I’ll do that the next time I Recalculate to the next real increase in SSA. Maybe not.

 

 

 

 

Conclusion. We all worry that we aren’t being conservative enough for our financial retirement plan. I assert that the Safe Spending Amount (SSA) that you get from Nest Egg Care is darn conservative. But it’s human nature to be more conservative than what someone else recommends. If you want to be more conservative, increase your off-the-top Reserve – the amount that is not part of the math to get to your SSA. In effect you are lowering your SSA. That has the effect of adding years of zero chance of depleting your portfolio.

How much do higher fees eat from expected growth of your portfolio?

Neighbors Bill and Mary, nice folks age 50, told me that they just signed on with a financial advisor. He’s going to manage $800,000 for them. He said his fee is 1%, so they conclude they are spending $8,000 per year for his advice and help. His help may be valuable to them, but I calculate that over 15 years Bill and Mary give up to nearly 30% of the expected growth of their portfolio – a total cost of nearly $450,000. By the 15th year, they are giving up the value of a Mercedes Benz SUV per year. That’s clearly not what I think they have in mind from “1%”. The purpose of this post is to explain the discrepancy between 1% and 30% and that $450,000 and the Mercedes SUV per year.

 

In fairness to the advisor, Bill and Mary are not confident in making financial decisions. They don’t have much knowledge about investing. It sounds complex to them. They don’t have a will, and the advisor said he would help them get that task completed. They want to decide on disability insurance. He’ll help with that.

 

== Total Investing Costs ==

 

The advisor did not mention the internal fund costs they would incur for their portfolio, the weighted Expense Ratio for all the mutual funds, ETFs and securities he would select for them. I’ll guesstimate this at .6% of the value of their portfolio, which is below the average for actively managed funds.

 

We have to conclude that Bill and Mary’s resulting Investing Cost of 1.6% per year with their advisor is, in essence, a direct reduction of the annual return rate that they get to keep. That’s their Investing Cost. We can not assume the actively managed funds their advisor picks will outperform the market before deduction of those fund costs and result in a lower net cost than 1.6%. The chance of a mix of actively managed funds doing that is just too darn low. That’s clear from many, many studies and the thorough one described here.

 

== Compare two options over 15 years ==

 

We need to clearly think through the two options. It isn’t a one-year comparison of cost. I’m measuring their cost as the difference in the amount they would have in a future year, not simply the annual differences in fees that they pay. This is the right way to look at it, don’t you think?

 

Here we go: I pick 15 years as the time period we want to look at. I assume $800,000 now and that Bill and Mary contribute $15,000 in today’s spending power to their investment account each year. Here are two options.

 

Option #1. Spend $10,000 now on a consultant to help them construct the will, pay the legal fees for the will, and a hire a consultant to help them sort and recommend disability insurance. ($10,000 sounds like too much to me for these tasks, but let’s go with it.) Invest the $790,000 balance themselves at low Investing Cost. Let’s use 6% of 1% or .06% as the Investing Cost for a simple portfolio in this case of just two funds that own all the stocks in the world. As reference, my Investing Cost is a shade over 4% of 1% or .04%.

 

Option #2. Invest the $800,000 with the advisor. I’ll assume he actually pays the legal fees for their will, but that would not be usual from my experience. Investing Cost is 1.6% per year.

 

I compare the growth of their portfolio for the two options. The difference between the two is their cost. I use Excel’s Future Value Calculation, but you can also see the same result in more detail on this spreadsheet.

 

 

Wow! Bill and Mary start with $800,000 and the difference in the two options in 15 years is nearly $450,000. That sounds almost mathematically impossible, but it isn’t. Option #2 costs them $450,000 more than Option #1!

 

The average cost works out to be about $30,000 per year ($448,000/15 years). In the early years, the cost penalty for Option #2 is about $12,000 per year, but that grows every year eventually to about $58,000 in the 15th year. The percentage penalty in annual growth from Option #2 also increases. Both dollar penalty and percentage penalty will increase each year thereafter. On average Bill and Mary bought the equivalent of a $30,000 new car each year for their financial help: their advisor, his firm, and fund managers. In later years, they are buying them a luxury SUV every year.

 

 

== Results with different Expected Returns ==

 

In the example above, I used a 100% stock portfolio for Bill and Mary. I assume that 15 years is their holding period: they won’t sell any of that before they glide into their formal retirement plan somewhat after 15 years. That may be too ambitious for them. I can run this same analysis using a lower mix of stocks and greater mix of bonds.

 

 

A mix of more bonds (less stocks) results in lower portfolio expected annual returns and less of a dollar difference between the two options. But this surprised me: the percentage penalty of Option #2 increases as the mix of Bonds increases. Option #2 is relatively worse for them with a greater mix of bonds. The penalty of Option #2 is 25% at a mix of 0% bonds (100% stocks). The penalty of Option #2 is nearly 30% at a mix of 35% bonds (65% stocks). That’s primarily because the advisor fee of 1% cuts much deeper – a much greater percentage reduction – into the expected return for bonds: if you have more bonds you’ll suffer a deeper cut of your total expected portfolio return.

 

 

== Will they ever know? ==

 

When Bill and Mary go down the path of Option #2, will they ever reach a point of understanding that their returns could be so much more? I doubt it. In our initial example of an all stock portfolio, at expected returns they would see their $800,000 portfolio and their annual additions grow to $2.1 million in 15 years. They’d feel very good about that. Will the financial reports from their advisor clearly show that their returns lag market returns or a benchmark return for their mix of stocks and bonds? They’ll never see that comparison. They’d have to do the work to understand. They’d have to do the calculations or by run a side by side experiment using low cost index funds with a portion of their portfolio.

 

 

 

Conclusion. Investing costs are in essence a direct reduction of your net returns in your portfolio. My Investing Costs are a low .04%. That means I get to keep about 99.4% of the expected real return on my portfolio of 85% stocks and 15% bonds (6.34%/6.38%). If I incurred investing cost of 1.6% I’d get to keep about 75% (4.78%/6.38%). When you measure the growth in portfolio value for different net returns that you keep, the difference between high cost and low cost is ENORMOUS: in 15 years an initial $800,000 portfolio invested with high Investing Cost could be $450,000 less than the same portfolio invested with low Investing Cost.