I recently ran across a very intriguing question posed by a young chap - a Gen Zer - about the risks of investing. And he wasn't just asking about "typical" risks, like investing in a company's stock that goes bust. He, like many members of his generation, are growing up during an era when they are constantly bombarded with frightening scenarios - real and Internet-produced - that have them living slightly on edge. It seems that he had heard we might be on the brink of another "Great Depression." If so, he asked, what happens to all of the money invested in the stock market?
Radio and television personality, Art Linkletter, wrote a bestselling book titled, Kids Say the Darndest Things. The idea for the book was in response to his young son’s comment that he wasn’t going back to school after a disappointing first day in Kindergarten. “Why not?” Art asked. His son, Jack, replied, “Because I can’t read, I can’t write, and they won’t let me talk.”
Youngsters, even older youngsters, often have thought-provoking ways of looking at things… stimulating others to ponder such outlooks. What if another Great Depression comes, wouldn’t all that investing go to waste? Perhaps, but let’s consider the prospect of starting to save and invest while very young. Reminds me of that old adage: The Amazing Power of Compounding. Yeah, I know, you’ve heard me mention it before. But, yes, the younger you start saving and investing, the higher the payoff. For example, if you save and invest $100 per month, earning 7% per annum, compounded annually, here’s the theoretical retirement nest egg you might accumulate by age 65 (before taxes and inflation):
1. Beginning at age 20, you’ll have $357,867 upon reaching age 65.
2. Beginning at age 30, you’ll have $173,177 upon reaching age 65.
3. Beginning at age 40, you’ll have $ 79,290 upon reaching age 65.
Now, if another Great Depression does come, wouldn’t you rather be in the middle of accumulating a nest egg of sizable proportions than not? The longer you wait to save and invest the more financially unprepared you are to experience a depression, a recession, or just the ordinary run-of-the mill economic cycles that constantly bombard the marketplace. And in the event of such setbacks, perhaps you could salvage a portion of your portfolio. Assuming you have a good plan, investing is never a waste of time. (Here's the link to the video below.)
As to the question, “And how does our money just disappear anyway?” Well, in order for it to disappear, you must earn it in the first place. And there are a variety of ways for it to disappear. Million Dollar Habits will get you there about as quick as anything. A poor investment plan or strategy can chew up dollars fairly quickly, too. Just plain bad luck often chews up a chunk. And despite following best investment practices throughout your working career, that ravenous old dude, Izzy the Inflation Monster, and his free-spending sidekick, Uncle Sam, are magicians at making your money disappear.
Previously, I mentioned that if you began saving and investing $100 per month, earning 7% per annum, compounded annually, you would have $357,867 at age 65 before inflation and federal taxes. But what if Uncle Sam taxed you at a marginal rate of 25%, and what if the inflation rate over that 45-year period had averaged 2% per annum? Taxes would transform your ending balance to $212,516 and the distressing combination of taxes and inflation would reduce your spending power to $87,173.
Well, your $357,867 didn’t completely disappear, but once Sam takes his cut and after being subjected to the ravages of Izzy the Inflation Monster, you are left with an anemic purchasing power of $87,173 in retirement. In short, $4 in savings is reduced to $1 in purchasing power.
Perhaps you should start saving and investing at age 10.
Just a thought.
“Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”
― Paul Samuelson
Investing is as complicated as we choose to make it. And investors seem to veer in the direction of complexity in their eternal pursuit of ever higher returns.
As a younger man, I fell victim to that pursuit, too, and it took several years to find my way out of the forest. Like so many young folks who achieve a bit of success, who now have a few extra dollars to invest, and who credit themselves with investment skills not yet learned or that simply don’t exist, it seems to be part of the maturation process. It doesn’t have to be. The hard part of saving and investing is the saving part. But for the moment, let’s talk about the investing part.
There’s a good bit of luck involved in playing the stock market game. Regardless of the amount of time spent researching, it’s very difficult to predict the future variables that affect even a “can’t miss” stock. In my own case, after years of being both right and wrong judging (guessing) market moves, a very cursory study of my success as an investor became self-evident. On balance, to put it kindly, I was barely breaking even. Not being totally muleheaded, I stopped researching individual stocks and started searching for a better investment strategy. One soon caught my eye – a controversial and somewhat revolutionary new product: THE INDEX FUND (click here to play video).
John Bogle, iconic founder of The Vanguard Group in 1974, created the first credible index fund available to the general public. It roared to an most inauspicious beginning. According to Bogle, the fund’s initial public offering (IPO) in August 1976 “may have been the worst underwriting in Wall Street history”. The IPO’s initial target was $250 million. It fell short of that goal by roughly 95%, and for the next decade, struggled for attention. Its results seemed to be attracting more criticism than new investors, but Bogle, being a patient man, believed that the concept could not be long ignored.
Still, a strategy of simply tracking the broad market was almost totally rejected as an investment plan and quickly became known as “Bogle’s folly”. Fidelity’s Edward Johnson scoffed at the thought that most investors would be satisfied with receiving average market returns (I call it "Dare to be Average") on their fund investments. Bogle’s feeling was the exact opposite, that index funds could provide investors, large and small, with the most effective stock market strategy of all time.
In his mind, the strength of the S&P 500 Index investment strategy was to buy a broad stake in American business and hold it forever. And because it was a passive investment requiring little management, it could be held long-term at a very low cost. In short, index fund owners would become that rarity among investors – long-term owners of stock, a valuable counterweight to the prevailing view of most market participants. And that this countervailing market force could be enormously important to small investors as well as to society in general.
In my mind (an oil industry graduate), John Bogle (who died January 16, 2019) was the personal investment industry’s George Mitchell. To those not familiar with George, he was Mitchell Energy’s CEO – a long-time wildcatter whose tenacity reordered the world’s energy dynamic by insisting that crude oil and natural gas entrained in rock could, indeed, be economically recovered. Every time you pull into a gas station, you should thank George for his stubborn streak. And every time you check your Roth IRA balance, thank John Bogle for his own brand of stubbornness.
Bogle, like Mitchell, was a man of vision who thought outside the box. Those studies I mentioned earlier kept revealing an unsettling result to the staid investment industry’s active manager proponents. Low-cost funds kept winning the “yield war”, which began to dispel the collective Wazoos’ notion that investors must pay more to get more…the antithesis of Bogle’s notion “that investors as a group not only don’t get what they pay for, they get precisely what they don’t pay for.” Without question, part of the out-performance of index funds is directly attributable to their lower operating expense ratios. In short, indexing’s low-cost effect means the investor keeps more of what his or her fund earns.
According to Vanguard studies, from 1976 to 2016, indexing saved investors close to $153 billion!
It’s true that 20 percent or so of the managed (active) funds outperform index (passive) funds on an annual basis, but it’s seldom the same 20 percent!
Today, broad market index funds modeled on the original Vanguard fund rule the roost, a general recognition that Dare to be Average has become a more commonly accepted practice among small savers in the investment community. This is why it plays such an outsized and important role in this blog’s strategic model.
I’m not suggesting that you invest exclusively in Index funds. I am suggesting, however, that small investors new to the game use an index fund strategy around which to build a portfolio based on those PDQ Principles – Patience, Diversification and Quality – that I talk so much about. And keep it simple.
The latest dream (occasionally realized) among millennials is to become financially independent and retire early (a movement called FIRE) – a dream about retiring before or by age 40. As I understand it, the plan is to retire from a 9-to-5 regimen, but not to quit working. In short, these folks want to spend the rest of their post-40 lives doing what turns their crank. Of course, this kind of independence from the grindstone requires money. It can be done, but because it does require money, it also requires a huge dose of discipline at a very early age – an ingredient missing in the makeup of many people, including I suspect, quite a few of these potential FIRE devotees.
The easiest path, of course, is for a Millennial or Gen-Zer to carefully select his/her parents. I know! I know! I’m being a bit facetious here, but stick with me. These parents don’t have to be super-wealthy (like, Bill and Melinda Gates wealthy) or even Wall Street or Hollywood rich. However, having financially secure parents who possess an entrepreneurial spirit might help. After all, wouldn’t it be advantageous to have parents who could provide opportunities for kids to generate $6,000 per year (in after-tax income) to fund a Roth IRA – quite the challenge in my rather blithe example since the kid must have the means to generate real “earned” income.
Note to parents: Gifts don’t work. In short, the kid must generate his/her own income, file a federal tax return, and pay tax, if due, on the net earnings.
While we're talking IRAs, here's my synopsis of the SECURE Act recently passed by Congress. As of Jan. 1 of this new year, there are new rules and regs that affect the IRA funds you bequeath kids and grandkids.
What, you exclaim? A baby…a preteen…a teenager earning those kinds of bucks? That’s why I mentioned entrepreneurial parents. It’s not out of the question. If, for example, the family owns a business, they might hire the kid to appear in commercials until said kid can perform other tasks for the company – or for third parties. By the way, an advantage to the family business is that the kid’s income is tax-deductible and more than likely taxed at a kid’s lower rate.
Part of the discipline I mentioned earlier is that the parents work hard at instilling in their kid a “savings mindset” such that the kid will continue setting aside $6,000 (the 2020 IRA limit) of their annual earnings for a Roth contribution. This is important because, as the kid matures, he/she will be able to earn larger amounts of net income, and hopefully, will want to continue to contribute $6,000 of this income stream annually to the Roth IRA.
Now, I know my “parent selection” example is farfetched (after all, it is a fairy tale), but where there’s a will, there’s a way. One thing that works in parents’ favor is a constantly swelling account balance in the child’s Roth IRA. Let’s throw out some fairy tale numbers befitting our fairy tale example, which assumes an annual $6,000 contribution (beginning at birth). Let’s invest it in a Vanguard Total Stock Market Index Fund and further assume a 7% annually compounding rate of interest going forward. All things being equal, this plan will produce $260,500 after 20 years, $1,312,400 after 40 years, and $7,919,400 after 65 years (in each case before inflation). And because this is a Roth IRA, no taxes are due on all distributions from the account (once a kid reaches retirement age). But beware of certain withdrawal penalties that come into play prior to reaching age 59½.
Aside from producing over $1,000,000 by age 40, my example also demonstrates The Amazing Power of Compounding, the “greatest force in the universe”, according to math genius, Albert Einstein. Additionally, it demonstrates the importance of my own PDQ Principles…Patience, Diversification and Quality…and a little bit of parental luck-of-the-draw. Not one in 10 million families will follow this fairy tale example using good and valid excuses, but why agonize over the loss of $7,919,400? It’s only money (and a stress-free retirement).
My fairy tale point is this, a kid has the advantage of time over adults. For this simple reason, even less than maximum contributions to a Roth can expand exponentially due to exposure to The Amazing Power of Compounding for a long period of time. And youngsters who receive parental encouragement to save (like I did) are more likely to develop good financial habits – habits that increase their future chances for financial stability.
In a future blog, I will present a more age-specific and detailed version of how to use a Roth IRA to build wealth for kids. A version that fits my blog’s primary premise: Because time is money and money is time, it’s crucial that young people start saving (and investing) early in life to optimize The Amazing Power of Compounding. Little else matters in personal finance until we learn not to violate this fundamental principle.
Fair warning to parents who don’t encourage their kids to save and to develop good financial habits. In 2017, $86 billion of student loan debt was owed by Americans aged 60 and over (Source: TransUnion). Some of this debt resulted from older folks going back to school for retraining in the wake of the recent Great Recession. But much of it resulted from parents taking out loans to help pay for their kids’ college expenses.
It’s now timely to replace my rather far-fetched fairy tale scenario with a big dose of reality. Which means it’s time, in future blogs, to take a harder look at Index funds and those fantastic IRAs mentioned in this and previous blogs.
Happy holidays! I hope you spent the last few days exactly as you wanted to - with family and friends, holidaying or relaxing, or even working if that is what brings you great joy! WynnSights just celebrated six months of life on Christmas Eve so I want to take this opportunity to thank everyone who has set eyes on this blog, whether it be once or several times, because you are what really brings it to life! If you ever have an idea for a blog post, or a question or subject you'd like me to explore, please email me and I will do my best to oblige!
Now...I am sorry to switch the mood from joyful to somber, but I would be remiss if I did not share and comment on breaking news in the IRA world. Here goes...
Last week Congress passed the Setting Every Community Up for Retirement Enhancement (SECURE) Act that made several changes to retirement account rules. And as the old saying goes, Congress giveth and Congress taketh away. Their year-end spending package will limit a very popular feature of traditional and Roth IRAs – the ability of savers to extend the life of their retirement accounts by leaving unspent balances to much younger heirs (e.g., grandchildren).
After December 31, 2019, certain young heirs will no longer be able to take required withdrawals over their lifetimes, greatly limiting the time they can receive tax-free or tax-deferred compounding. Beginning in 2020, many heirs must withdraw inherited IRA assets within 10 years rather than based on their own life expectancy (called “stretching”).
Even top Republicans, many on the House Ways & Means Committee, including Kevin Brady of Texas, supported this heist. Brady’s reasoning (summarized): Tax-favored retirement funds should be used for the owner and spouse’s retirement security, not as wealth succession management tools.
Don’t you love it when Washington politicians tell you how to plan your financial future, and then change their mind on a whim? Most graciously (sarcasm), they exempted surviving spouses from this revision of the rules – rules that will highjack certain affected IRA beneficiaries of an estimated $16 billion… call it a tax increase if you’d like… over the next decade (Source: Joint Committee on Taxation).
Happy New Year! (It's a Congressional election year, by the way!)
You may recall my August 2019 blog titled “Hypothetical Henry” in which we discussed the benefits of establishing a 529 account for the educational benefit of children and grandchildren. In that blog, I also mentioned that a youngster with earned income might consider opening a Roth IRA retirement fund. Then again, the kid might prefer to utilize that earned income in ways other than for IRA contributions (yah think?). Well, Gramps, it’s the Christmas season… a time for giving. What better opportunity to discuss the subject with your “employed” grandkids… to create Roth IRAs by offering to make the annual contribution or to match any contributions the kid(s) make. Who knows? This benevolence just might gain their short-term awareness despite its long-term implications.
Of course, your total contribution can't exceed a given grandkid’s earned income – or the tightfisted IRS’s annual limit, whichever is smaller ($6,000 in 2019 and also in 2020). In any event, Gramps might consider “matching” up to his grandkid’s earned income amount, effectively making the IRA contribution himself (i.e., if the grandchild earns $6,000 at a qualifying summer job, Gramps can offer to let the grandkid spend his or her money on other things while Gramps contributes a portion or all of the $6,000 IRA contribution limit using his own funds). The IRS doesn’t give a hoot who makes the contribution so long as it doesn’t exceed the child’s qualifying earned income for the year. By the way, those matches are additive to Gramps’s annual gift exclusion limits.
WynnSights' objective is to incentivize grandkids to start saving and investing for the long-term while still young. In short, to develop the discipline to “save and invest early and often”. The ultimate reward can be huge. And Gramps, if you’re able, contribute the total allowable amount. If not able, be as generous as possible with your match. For example, if the grandkid has $6,000 in earned income but only wishes to contribute $2,000 to a Roth, Gramps can match the grandkid’s contribution 2:1 and still stay within the child’s earned income limit and those restrictive IRS rules.
Although saving for retirement is likely the last thing on a youngster’s mind, most grandkids will find it intriguing that a small investment today can grow into a rather sizable nest egg later. Without instruction, grandchildren might not immediately understand the concepts behind compounding, but they will likely appreciate the fact that their Roth IRA balance is growing. It never hurts to provide examples of the Amazing Power of Compounding – how even small contributions can mushroom into large numbers over time. One tight-fisted Grandpa I know contributes $2,000 per year to each of his kids and grandkid (for 25 years in the specific case of the oldest). Let’s assume in the oldest child’s case, that the $2,000 per annum has earned 7% per year compounded annually to date and will continue to do so for another 20 years. What will it be worth at the end of 45-year period (assuming Gramps hangs around those last 20 years)? A cool $693,000 before inflation… not a bad series of Christmas gifts from the old dude. By the way, since a Roth IRA is a retirement account, income levels could affect contribution amounts along the way. Teenagers aren’t likely to reach those high-income thresholds early on, but later in life they might.
Aside from watching the money tree grow, Roth IRA earnings over the long-term will never be taxable, Roth assets are protected from creditors with a few narrow state-specific exceptions, there are no RMDs (required minimum distributions) later in life, and those “compounding” benefits associated with early contributions can be substantial at retirement. These pluses, of course, assume that Congress keeps its mitts off existing IRA rules and regulations during future legislative sessions¹.
By the way, when an adult opens an IRA account for a minor, it must be in the child’s name as well as in the name of the adult custodian (parent, grandparent or guardian), which introduces certain disadvantages and risks. At age 18 that child or grandchild would gain full control of the Roth IRA and might decide to…shall we say…dip into it. Should such early withdrawals occur, the cumulative annual contributions can be withdrawn first with no tax or penalty. After that, all subsequent investment gains withdrawn would be taxable to the child or grandchild, and subject to early withdrawal penalties if they don’t meet certain IRS “qualified distribution” standards.
Aside from those previously mentioned pluses, the value of teaching your children and grandchildren the importance of saving, the basics of investing, and the discipline to leave a quality portfolio (think low-cost, highly diversified index funds) undisturbed until retirement cannot be overstated. What better way to contribute to your progeny’s future financial well-being than by creating and donating to their very own Roth IRA – accompanied with the reasons why you’re doing it.
As I’ve mentioned in prior blogs, according to that gifted intellect, Albert Einstein, the greatest invention in human history was… you guessed it… compound interest. Try it on for size!
Because it can be so consequential to your long term financial health, I want to dedicate another blog to demonstrating the impact of paying too much for mutual fund annual operating expenses. What may seem immaterial in the short run can cost you big bucks over the long haul. If you are have trouble playing the video below, you can access it through this link: https://youtu.be/A0AIcy7xeNwhttps://youtu.be/A0AIcy7xeNw
Jack Bogle, the now deceased Vanguard icon, was known for his famous utterances, among them, that Vanguard’s fund owners and others benefit from “getting what they don’t pay for”. To point out the significance of this statement (using Bankrate’s Mutual Fund Fees Calculator), let’s measure the cost of Vanguard’s average expense ratio, currently 0.11%, against the industry’s 0.62% average, and determine its impact on a 30-year, $100,000 front-end investment yielding 6%.
To summarize how Wazoos can fleece you over time, after investing $100,000 for 30 years at 6% and while paying .11% vs .62% in average annual operating expenses, the hypothetical Vanguard investor would end up with over $79,000 more of value in his/her account by saving $37,000 in fees. This savings would allow the Vanguard investor to earn an additional $42,000 by avoiding the opportunity cost associated with those fees. Over the long haul, fractions of a percent do make a difference. Better to have the difference show up in an investor’s account than in a Wazoo’s wallet. Reminds me of the old saying, “Watch the pennies and the dollars will take care of themselves.”
No wonder the late Mr. Bogle is given credit for savings billions of dollars for millions of large and small investors who are now taking advantage of the lower fees he forced on the financial industry.
By the way, another “opportunity cost” we often impose on ourselves is keeping too much cash in non- or low-interest-bearing bank accounts or with those certain brokerage firms paying next to nothing. It’s estimated that $9 trillion lounge in such accounts paying about 0.09% or less (Source: Crane Data). A quick check of my Vanguard Group taxable Federal Money Market Fund revealed a YTD yield of 2.11% as of 12-11-2019. This spread between what banks and money funds pay is in a constant state of flux so keep an eye on it.
The latest “fad” among many of the brokerage firms (Schwab, TD Ameritrade and E-Trade come to mind), is called free trading. It ain’t free, folks. Many of those firms who advertise free trades make up the difference by sweeping customer cash into lower yielding deposit accounts, investing it at a higher rate for their own account and keeping the spread. In fairness, a couple of the big boys don’t participate in this sleight of hand…Fidelity and Vanguard. Their retailer accounts’ idle cash is swept into higher yielding money market accounts, benefiting their investors.
Of note, money market mutual funds (short-term securities whose value fluctuates very little) aren’t backed by the government, while bank savings accounts are federally insured against loss, generally up to $250,000.