How I Learned to Love the Bond


In case you haven’t figured this out yet, I spend a lot of time thinking about financial things and how money works.  I think about the effects that raising the minimum wage would have on low-wage workers (they aren’t good).  I think about why our healthcare payment system is so messed up (you don’t have clear prices, plus everyone is trying to get more than they pay for, so you don’t have an efficient, competitive market).  I also think about things like when using an annuity would be good (normally when you don’t really have enough to live on in retirement through investing).

One conviction I’ve had for a long time is that you should always be 100% invested in stocks (with maybe a little invested in REITs) unless you cannot afford a 50% loss or bonds are paying really high interest rates.  I reasoned that the return on bonds is always a few percentage points less than the return from stocks, so why should you give up a 10% return for a 6 or 8% return?  Having a 50-50 stock/bond portfolio when you’re 60-years-old will help protect you should the stock market decide to drop 40% like it did in 2008, but if you were worth $10M and could live perfectly well with $5 M, why would you want to own 50% bonds?

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And then I kept thinking and started to realize an issue with my convictions: While it is very unlikely that you will lose money in stocks if you hold them for more than 5 years, and very, very unlikely that you will lose money if you hold stocks for more than 10 years, that does not mean that stocks will always do better than bonds over a given five or ten-year period.  While the average return from a stock portfolio is 10-15% per year, that includes some great periods like the 1940’s-1950’s and the 1980’s-1990’s that really goosed the averages up.

A chart showing the annualized returns (the kind of return you would need to get each year at a fixed rate to end up with the same return) for the stock market (the Dow Jones Industrial Average – DJIA) during different decades is given below.  If you held the DJIA stocks from 2000 through 2009, sure you would be up, but your average rate of return would only be 1.07%.  If you held the DJIA stocks through the 1930’s, you would have actually seen a negative average return of -0.63% per year.

(Source of data:  http://www.stockpickssystem.com/historical-rate-of-return/)

During most 20-year periods, you would have been better off in the DJIA stocks than you would have been in bonds, assume a rate-of-return of 6%.  This is only true for seven of the twelve 10-year periods shown.  Of course, during periods like the 1930’s, many of your bonds would have defaulted, so being in bonds during that period would not necessarily have saved you either.  During the 2000’s, however, bonds returned about 6% annualized.  You would have therefore fared better in bonds from 2000 to 2010, but not as well as you would have in DJIA stocks from 1990 through 2010. For the period from 2000 through 2018 so far, you would be about even, but we’re seeing extraordinary returns right now, so the next few years may well cause stocks to outperform bonds again for the 20-year period from 2000 through 2020.

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So what does this mean?  If you have at least 20 years until you need the money, I would stay 100% invested in stocks.  A twenty-year-old who is just starting a 401k account should therefore be 100% in stocks, assuming she can handle the market fluctuations that such a portfolio would provide.  (If you can’t handle the fluctuations, consider adding 20-30% bonds, which will help to stabilize things a bit but not hurt long-term returns too badly.)  If you’re sixty-years-old and planning to start living off of your portfolio over the next few years, you might want to consider a 60-40 stock-bond portfolio even if you have a lot more money than you need in your portfolio and therefore could stand a big decline in the stock market without falling short of spending cash.  If you make it to eighty, you will probably get a better return from being entirely in stocks,  but you might very well do better with a stock-bond portfolio between now and age seventy than you will if you are entirely in stocks.

What would this look like?  Let’s say that you were invested 50% in Vanguard S&P 500 Fund and 50% in Vanguard Small Cap Fund with a $4 M portfolio at the start of 2017.  If you were to have shifted $800,000 from each fund into the Vanguard Total Bond Market Fund you would then have had $1.2 M in the S&P 500 Fund, $1.2 M in the Small Cap Fund, and $1.6 M in the Total Bond Fund.  In 2017 you would have received $24,400 and $18,350 in dividends from the S&P 500 and the Small Cap Funds, respectively, and $41,000 from the bond fund.  This means you’d have about $84,000 in income from your funds each year.  You would also make substantial capital gains in the stock fund during 2017, making $316,000 from the S&P 500 Fund and $213,000 from the Small Cap Fund.  This would mean that your total return for 2017 would have been about $613,000, or about 14% for 2017.

You would have done better during 2017 if you had been entirely invested in stocks, but if stocks had declined a bit during the year, you would still have $84,000 in income to use as needed while you were waiting for your stock portfolio to recover.  If 2017-2027 looks like 2000-2010, with the meager stock market returns during that period, you would gain about $400,000 over the period with an all-stock portfolio.  If you had the stock-bond portfolio, you would still gain about $1,080,000 through the period due to the dividends and interest payments that you were collecting during the time.  You would have substantial gains from your portfolio, rather than having a lost decade.

So, in conclusion, while you will probably do better with all stocks over long periods of time (two decades or more), you might actually do better if you mix in some bonds for shorter periods of time.  This is because the high stock returns are due to a few short periods, while bond returns are fairly steady and constant.  So don’t fear the bond.  Learn to love it for the steady returns it provides.

Have a burning investing question you’d like answered?  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Is an Annuity Right for Part of Your Retirement Funding?


This is part of a series of posts for an online class on how to use your investments to fund your retirement.  To find other posts in the series, select the category  “Retirement Investment Class” under “Retirement Investing” at the top.  The posts will appear in reverse order, with the newest post first. 

I have recently gained a new appreciation for annuities, or at least the promise that an annuity holds.  At one point I swore off annuities entirely and there are good reasons to do so.  These include:

  1. You can do better investing the money yourself.
  2. The fees can be high.
  3. You generally have little flexibility once you have made the purchase, and may need to pay a big fee to receive any of the money back.

But then I realized the true purpose of an annuity is the same as it is for any insurance product:

To shift your risk to the insurance company in exchange for the cost paid.

All annuities pay you a specified amount of money for a specified period of time in exchange for you handing over a load of money to the insurance company.  For example, you give them $100,000 and they agree to pay you $500 per month for the rest of your life.  In many ways this is like a pension plan where you receive payments, except this is from an insurance company instead of an employer.  In fact, many employers that still have pension plans use annuities to make the payments once individuals retire so that they don’t need to worry about it.  They just buy an annuity that pays the former employee whatever is needed when they retire and then the employer’s part is done.  You can create your own pension using an annuity if you commit your 401k funds or other retirement savings.

Now while there are probably as many different kinds of annuities as there are stars in the sky, since they are all just insurance polices and the types are only limited by the imagination of the companies that create them, there are really only two types of annuities that should hold any interest for you.  These are immediate annuities and deferred annuities.  And here we just want the plain vanilla types – no bells and whistles.

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Immediate annuities are just that – you give them money and they immediately start making payments to you.  These are used to provide regular income without needing to worry about what the markets are doing, buying and selling mutual funds, or performing other actions.  Deferred annuities pay after you reach some certain date, for example, starting to pay you $5,000 per month after you reach age 85.  These are used as insurance against outliving your money.

So why are annuities not as good as investing yourself, in general?  The reason is both that they charge fees (which can be big) and the return you get from an annuity, including fees, will not be as great as you would get if you had invested yourself.  For example, if you were to invest $1 M at age 65 in a balanced stock and bond portfolio, you would be able to receive about $40,000 per year, indexed for inflation, until you were age 95.  At that point you would have on average about $2 M in the account and have received about $1.8 M in payments during that time.  The $2 M would be able to buy about what $1 M can buy today, so you would effectively have all of the money you started with, plus have received an income to fund a $40,000 (in year 2018 dollars) per year lifestyle.

If instead you were to put the money into an immediate annuity, you might start getting paid about $75,000 per year, fixed.  If you then died at age 95, you would have received about $2.25 M during that period.  This sounds better than the $1.8 M you received from the investment portfolio, but the insurance company would keep the money you gave them when you died, leaving nothing for you to pass on to your heirs or from which to pay for your final expenses.  You would have gotten $450,000 less in income from investing, but would have $2 M in savings remaining instead of nothing.  Because an account can withstand about a 4% withdrawal rate without declining in value over time, spending at this rate can be done essentially forever, assuming no black swan market event occurs.

In addition, while you would start out better with the annuity, receiving $75,000 per year instead of $40,000 per year from the investment account, by the time you were 95 you would be receiving about $80,000 per year from the investment account where you would only be receiving $75,000 per year from the annuity.  While your spending power would start out greater with the annuity, the payments from the investing account would pass it up along the way and you’d be having a little more trouble meeting expenses with the annuity near the end.

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So why would you want to have an annuity instead of just investing yourself?  The beauty of the annuity is that you would (nearly) eliminate the risk of a market drop affecting your income.  Annuities also help protect you in the case that you live longer than average since many of them pay income until you die.  In fact, you’ll be able to utilize more of your money while you are alive using an annuity than you would investing yourself because, while you would need to limit your withdrawals to make sure you didn’t run out of money before you die if you’re investing yourself, the insurance company knows that if they sell 10,000 annuities, the average age at which people will die and distribution of ages is predictable and they can determine with a fair amount of certainty how much they’ll need to pay out.  They are therefore able to provide a higher payout per month than they could if they were just insuring a single person who might live to be 115.  If they know from historic data that the average person would live to age 84, for example, and how many people will live longer, they can determine the maximum payout they can make and not lose money.

Note that if you die young, say at age 66 when you buy the annuity at age 65, the insurance company would probably keep your whole $1 M.  This makes up for the people who live to be 100 and withdrawal more than the insurance company can make from their investment.  This is the nature if insurance – some people pay for more than they use to make up for those who pay for less than they use.     

And therein lies the reason that some people would want to use an annuity and others should invest for themselves.  If you are interested in leaving a lot of money to your kids or a favorite cause and you have enough money saved to allow you to generate enough income for expenses using 3-4% of the value of your savings each year, invest yourself.  If you don’t want to leave money, yet you don’t want to risk running out of money either, use an annuity.  You could also do a little of both, using an annuity for a portion of your savings to gain the additional income, but keep some invested in stocks to provide growth to allow you to increase your income should you live a long time and inflation starts really affecting the buying power of your annuity payments.

As far as what an annuity can and should pay you. realize that the insurance company will invest the money, probably mostly in common stocks if they don’t use the money to underwrite other insurance policies,.  The most they could pay would therefore be equal to the withdrawal rate they could make for the average life expectancy and have the money last.  As an example, if a person who is 65 buys and $1 M annuity and the insurance company figures out that the average person in the buyers risk-pool is likely to live 30 years, they could pay about $5368 per month or $64,418 per year if they were able to make an annualized rate-of-return of 5%, or about $7337 per month or $88,050 per year if they were able to make an annualized rate-of-return of 8%.

The amount they would offer would be somewhat less than this since they would take a fee off-the-top to pay the person selling you the policy, plus the insurance company would want to make a profit from the policy to make it worth their time, plus they may want to pay a bit lower than they would expect to make in case the markets don’t perform well during the period and don’t return as much as they were expecting.  They might therefore offer you $4500 per month if they were expecting to make 5% instead of the $5368 per month that they were expecting to make investing the money.  If there is ample competition (and you should shop around to make sure you get the maximum pay-out you can while still using a solid provider), you should get a reasonable return and their profit should be reasonable for the risk they are taking and their costs.

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Annuities are also a great choice if you have not saved as much as you really should have.  For example, if you have only saved up $250,000 by retirement, plus you have a home worth $500,000, you could maybe downsize or move to a lower-cost area and pull $350,000 out of your home.  (You could also possibly use a reverse-mortgage if you wanted to stay in your home, but again you would be paying a lot of fees in doing so.)  You could then take the $600,000 you had available and maybe buy an annuity paying $3,000 per month, or $36,000 per year.  Combined with Social Security, you should be able to make it through, although it might get tight if you live a long time after retirement.  You should therefore work as long as you can and build up all that you are able before you retire.  This will both increase your possible pay-out and reduce the number of years you’ll be in retirement.

But what if you want to have a good chance of spending most of your money, but want to get a better return that you will from an annuity?  If you have saved enough to fund your monthly expenses from investment returns, there is a way that you can invest yourself and still use more of your money than you will if you limit yourself to a 3-4% withdrawal, yet still have a low chance you will outlive your money.  The secret is to start out conservative, but then increase your withdrawal rate as you go.

For example, if you had $1 M and retired when you were 65, you would start out at 4%, or $40,000 per year.  At this rate there is a good chance your portfolio value will not drop at all (in inflation-adjusted terms).  If you wanted to be even more conservative, you could limit yourself to 3%.  After five years, at age 70, you could start spending at a rate that would exhaust your savings in 30 years, assuming some reasonable rate-of-return.  For example, as shown before, a 5% rate-of-return would result in a yearly payment of $64,418 as shown before.  Because your chances of living to 100 are fairly low (depending on the ages of your parents when they died, your current health, and other factors), you are fairly safe increasing your spending and starting to spend down your savings at this rate.

If you are still worried, you could also take some of the money and buy a deferred annuity that kicks in at age 90 or something.  Since it is unlikely that the insurance  company would expect you to receive many (or any) payments from this policy, the amount you would need to contribute to receive enough income for expenses at age 90 and beyond would be fairly low.  Plus, your expenses at age 90 if you live that long will likely be fairly modest.

Have a burning investing question you’d like answered?  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

How Every 16 Year-Old with a Job Can Retire a Millionaire


I’ve been encouraging a couple of twins who I’ve known since they were five to start an IRA since they are now 17 and working a job at a grocery store.  An IRA, or individual retirement account, is a little gift from the government that allows individuals to save money either tax-deferred or tax-free.  They come in two flavors: Traditional and Roth.    A traditional IRA is tax-deferred, meaning you pay no taxes on the money you invest or any of the money you make in the account until you withdraw it at retirement age.  With a Roth IRA, you pay taxes on the money you invest, but then pay no taxes on the money you withdraw or the interest it earns.

So how would these little wonders turn a 16 year-old into a millionaire at retirement?  Well, if one of the twins were to open an IRA and put $4,000 in it, and then invest entirely in a diversified stock mutual fund like the Vanguard Total Stock Market Fund, it would double in value about every six years. Because it would double eight times between the time they were 16 and 65, every dollar they put into it would be worth $256 when they reached 65.  This means that $4,000 would be worth about  $1 M at retirement age, even if he invested nothing else after putting the original $4,000 away.

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If he invested in a traditional IRA, he would also save on the taxes on the year he put the money into the IRA.  If he were in the 10% tax bracket, he would get to keep $400 more of his money right now, so it is like he gets extra money for making the investment.  Went he withdrew the money from the IRA at age 65, however, he would be taxed on the money he was withdrawing.  If he were in the 25% tax bracket during retirement, this would mean that he would actually only get $750,000 after taxes.

If he invested in a Roth IRA, he would not get a tax break now, so he would pay $400 more in taxes now.  But when he withdrew money at age 65, he would get to keep all of the money he earned, tax-free.  This means he would get to keep the whole $1 M.  The only catch is that he would need to find the extra $400 to invest.  (In fact, if he invested that extra $400 he got to keep from taxes when he invested in the traditional IRA, putting in $4,400 instead of $4,000, he would end up with the same amount of money after taxes as he would have had with a Roth IRA if his tax rate at retirement were the same as it was when he was working.)

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For the twins, I’m advising they go to Charles Schwab since they offer an IRA account with a $1 minimum investment.  This means they could put whatever they can this year, even if it is only $100, an then add to it as they can.  If they could get used to putting in $20 per paycheck, that would get them to a little over $1,000 per year.  They could also go to Vanguard, but they require a $1,000 minimum to start.  Both are great companies with a wide selection of funds to choose from for investments.

Filling out the paperwork and opening the account only takes 15 minutes or so online.  Because they are minors, the twins would need to have a parent be a custodian on the account until they turn 18.  After opening the account, they would just need to send in a check or send money from a bank account electronically, then choose investments.  At Schwab, I would start with the Schwab Total Stock Market Index Fund (SWTSX).  At Vanguard, I would buy the Vanguard Total Stock Market Index Fund if I had the minimum $3000 to invest, otherwise I would choose the 2065 Target Date Retirement Fund which only has a $1000 minimum.

 

So what else do you need to know about IRAs?  Well, there are some important rules:

  1.  You must have earned income equal to or exceeding the money you put into the IRA during the year you put the money in.  This means you need to make at least $4,000 from a job or from running a business in 2018 if you want to put $4,000 in an IRA this year.
  2. Right now you can put in up to $5,500 per year.  If you were to put $5,500 away each year between age 16 and age 35, you would be absolutely set for retirement, no matter what else you did financially.  (Lone exception, you must not touch the money in the IRA and it must stay invested in a diversified stock portfolio your whole working life.
  3. If you take the money out early (before retirement age), you’ll pay a penalty plus you’ll need to pay taxes on the money.  (Actually, there are a couple of exceptions with the Roth IRA, but why would you want to raid your retirement funds? Just stay invested.)
  4. With a traditional IRA, you’ll be forced to start taking the money out when you’re about 70 1/2 years old, so you may need to pay some hefty taxes then, especially if you invested a lot more than the original $4,000 and have several million dollars in the account.  With a Roth IRA, there is no need requirement to take the money out ever, so you could let it grow for another 30 years and leave it all to your heirs, if you wished.

Have a burning investing question you’d like answered?  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.