Bear Markets and the Danger of “Safe” Investing

March 9th, 2017 marked an interesting anniversary in the world of investing.  On this date, we celebrated the eight year anniversary of the current bull market which as of this writing, remains intact. It is the second longest bull market in history (the longest being October 1990 to March 2000) and during this period the US stock market (S&P 500) has returned over 250%!

What’s interesting is just how fearful the investing world seems to be given the crazy news cycle marked by Trump’s latest tweets, constant political wrangling, North Korean missile tests and a Russian conspiracy de jour.    Mix in above average stock valuations (relative to history) and it’s no surprise that we are hearing more and more of our clients indicating they want “safe” investments for what they think will most certainly be a market crash. market-correction-bear

Now we have long believed and written many times that we don’t know what the stock market will do in the next few days, weeks or months.  What we do know is that bull markets do inevitably end, and yes, there will be a bear market (defined as a 20% decline in stocks) again at some point.  We just don’t know exactly when this will happen, when it will end and when we should re-enter the market.

However, we do know that when bear markets do end (with an average return to prior levels of about 3.3 years), it’s best to be invested in order to take advantage of what is typically a strong rebound.

But herein lies the conundrum, if we know a bear market is coming, shouldn’t we invest our portfolio in “safe” assets like 100% bonds?   Quite simply:  No- not if we are investing for the long term.

The reason for this is, as indicated by the oxymoronic title of this blog post, it can be very dangerous to be safe when investing over a long period of time.  By forgoing risk and accepting “safe” returns from say a 100% bond portfolio, we are ironically, taking on even MORE risk by sacrificing the underappreciated magic of compounding returns over the long term.

To illustrate this, we have designed a draconian scenario comparing two basic investment portfolios over a 20 year period.

Here is the scenario:  A 45 year old couple starts with a healthy $750,000 portfolio and wants to retire at age 65 with $3,000,000.  They commit to contributing $15,000 per year to their portfolio.  Since they think we’re going to have a bear market soon, they are concerned they won’t reach their goal.  So in our simplistic scenario, they have two choices The “Safe” Portfolio and the “Dangerous” Portfolio.  Let’s define each:

The “Safe” Portfolio:  100% bonds, comprised of 50% short term US government bonds and 50% intermediate term US government bonds.  The starting point is $750,000 and the investor contributes $15,000 per year as they save for retirement over 20 years.  For annual growth, we will assume historical returns (from 1926 – 2016) of 4.31% per year.

The “Dangerous” Portfolio:  60% stocks (60% large cap US, 20% small cap US, 20% international) and 40% bonds (50% short term US government bonds and 50% intermediate term US government bonds). Again, the starting point is $750,000 and the couple contributes $15,000 per year.  Annual growth in this portfolio is assumed to be the historical growth rate of 8.74%.

The “Bear Markets”:  As you would expect, without the stomach-churning bear markets the higher returning portfolio with stocks will be much higher after 20 years of compounding.  But what if we added two loud and nasty “growls” from the Bear?  What if we added a bear market of a 20% stock market decline (0% decline for the “Safe” portfolio and a 12% decline for the “Dangerous” portfolio) in Year 2 and then another awful bear market in Year 16?  For this awful Bear in Year 16, we’ll assume a repeat of the historically worst annual return of each portfolio in the last 50 years.  For the 100% bond portfolio, it’s a 1.15% decline- not bad at all.  For the “Dangerous” Portfolio it’s a 20% decline- ouch!

The Result:  What might be surprising to some, is that even with two terrible bear markets, the “Dangerous” Portfolio far out performs the “Safe” Portfolio.  Looking at the chart below, we see that our retirement saving couple will NOT reach their goal of a $3,000,000 portfolio in retirement because their “safety” cost them dearly.  In fact, the difference between these portfolios is $935,000 with the “Safe” Portfolio at $2.027 million and the “Dangerous” Portfolio at $2.963 million!  That is VERY expensive safety!!!

safe investing

Now we must temper our conclusions with a few “real world” factors.  First, as our couple moves closer to retirement we would certainly monitor and modify the allocation to align with their retirement date.  Second, we would also implement “psychological firewalls” to help keep the couple fully invested in a growth portfolio.  This typically includes a tailored portfolio of individual high quality bonds, providing assurance of cash flow as retirement approaches.  Third, in order to keep this simple, this scenario does not assume systematic re-balancing of the portfolio, which we also execute for clients.

But the bottom line is this:  No one really knows when the next bear market is coming even though we all know the next bear market IS coming.  But even if it comes in 2018 and even if there’s a worse decline 5 years before retirement (in this scenario), it is still much more beneficial to stay vigilant about keeping a balanced portfolio.  Because the irony is, our attempts to keep a safe & conservative portfolio actually results in taking on much more risk that we thought.  In this case, the “price” for this risk is almost $1,000,000!

The Doctor Test: Your Guide to Evaluating a True Fiduciary

When it comes to providing financial advice, we like to think our advice is not unlike the “treatment” and advice doctors provide for our physical condition.  But, instead of treating a torn achilles, a heart condition or the flu, we provide advice on “healthy” asset allocation, tax strategies and retirement projections, etc.

Recently, the Department of Labor has brought to light a concept known as “the fiduciary standard” which in the most basic terms means “always acting in the client’s best interest”.   So in the medical field, it’s the equivalent of having the assurance that your doctor’s advice and recommendations are what’s best for you and not for them.  On the surface, it makes perfect sense.  Of course, the devil is in the details as it relates to someone who calls themselves a “fiduciary” as this is not a black-and-white question.  Rather – there are shades of grey that must be defined in order for you to know exactly what kind of a fiduciary you are looking for.  And we think the best way to illustrate this is to compare it with how we work with doctors.advisor-taking-money

We call this The Doctor Test and below we detail the four types of fiduciary.  (Note: For a more detailed analysis and background on how these standards developed, feel free to read a recent and comprehensive post from Michael Kitces, a financial planning industry expert.)  In short, we would like to see the financial industry operate with the same high ethics as the medical industry.

Keep in mind, each of the following types of advisors can certainly claim to call themselves “fiduciaries” just like a medical professional earns the right to call themselves a “doctor”.  However, the TYPE of “fiduciary” or the means by which they practice is critical in evaluating whether your definition of a fiduciary aligns with your financial planner’s.

1. The “SEC” or State Registered Investment Advisor (RIA): This type of advisor complies with the Investment Advisors Act of 1940, which states they must not act in any way that is fraudulent or misleading.  Sounds great right?  BUT, this just means they must disclose their conflicts of interest, it doesn’t mean they don’t actually HAVE conflicts of interest.  So they could be paid on commissions for recommending that mutual fund, they just have to disclose it in their filings.  Did you really read the small print in the disclosure they provided?

The “Doctor” Test:  You’re having chest pains and your doctor correctly diagnoses you need to take a particular prescription that would help treat the condition.  He or she recommends an expensive drug even though there’s a generic alternative at a fraction of the cost.  In the paperwork you signed, it says he could get taken on a fishing trip or a nice seminar in Barbados for recommending this drug.  Would you be OK with that? Of course not, and that’s why doctors don’t operate in this manner.

2. The Department of Labor (DoL) Fiduciary: This advisor complies with the new DoL regulation that requires “always operating in clients’ best interest” when providing retirement advice. Again- sounds great.  However, the problem is this standard only applies to investment advice on retirement accounts.  It says nothing about broader financial planning topics and does NOT apply to non-retirement accounts.  This makes no sense.

The “Doctor” Test:  You’ve been experiencing knee pain and turn to a doctor for help.  She evaluates your knee and recommends an effective knee brace (with no financial incentive) to help you alleviate the symptoms.  But then you mention your aching back and while it could be directly related to your knee problems, she doesn’t have to provide the same heightened standard of advice and recommends an expensive, high-risk procedure to be performed by a doctor she gets a referral fee from.  Any doctor we know would never practice like this.  But just like our bodies are one system of interacting components, so are our financial accounts.  It shouldn’t matter if one is classified as a retirement account or one is not!

3. The Certified Financial Planner ® Fiduciary: The CFP certification is an outstanding program as it is comprised of a rigorous series of education requirements, comprehensive (and very long) exam and continuing education which covers almost all aspects of personal financial planning.  We are CFPs here at Magis Wealth Planning so we certainly endorse the high standards the CFP Board requires of its members.  While the certification is a great start in evaluating a planner, it’s not a legal  standard. Which means that to call oneself a CFP, you must pass their exam and agree to adhere to their Code of Ethics.  That’s fine but what if a CFP doesn’t comply?  There is no legal recourse. The CFP Board can’t fine anyone or subpoena anyone or force anyone to testify in a legal matter.  Their only recourse is to strip a violator of the certification.  While this might be detrimental, stripping one of their CFP mark does not preclude them from practicing as a financial planner.

The “Doctor” Test:  Let’s say you’ve heard there is a doctor who has some high-level certification for rotator cuff surgery.  Of course if you need that procedure, you would certainly seek them out.  But what if he hasn’t kept up on the latest & greatest techniques and technologies associated with the surgery.  What’s the risk to him?  Well, he could lose that high-level certification.  But with a solid reputation already established, maybe he might not care.  But you would certainly care.  The point is the downside risk to the doctor is not as equitable to you as it is to him.

4. The “Crystal Clear” Fiduciary: In our minds, this is the most stringent standard that we believe all people seeking financial advice should demand.  These are financial advisors who usually are members of networks of like-minded advisors such as NAPFA & Alliance of Comprehensive Planners (full disclosure:  we are member of both organizations) which actually document and sign a contract with clients which explicitly states on paper they are ONLY compensated by client fees and there are no other means of compensation like commissions, referral fees or golf-junkets to the Bahamas for selling annuities.

The “Doctor” Test:  We wish we could walk into a doctor’s office or a hospital and among all the paperwork we have to fill out (over and over again, it seems), see an explicit declaration that this doctor is only compensated by what we pay them and their medical advice is not “clouded” by potentially more lucrative recommendations from third parties.  We’re confident doctors actually do operate without the conflicts, we just wish the same were true for the financial industry.

The point is this:  The advice business, be it medical or financial, can be confusing enough with all the acronyms and esoteric terminology.  What should be completely transparent is the compensation model that may or may not be driving recommendations from our practitioners.  In short, we would like to see the financial industry held to the same high standards as the medical industry.

We think a great way to cut through the confusion on all the standards, acronyms and certifications is to simply apply the “Doctor Test” when evaluating a financial advisor.  This should go a long way toward aligning your physical health with your financial health.

Optimizing Cash Flow for Retirement – Part 1

Today, we are introducing the first of four articles detailing our unique set of tactics which we believe, when integrated as one cohesive strategy, optimize cash flow for retirees in a tax efficient and cost effective manner.  This is accomplished without conflicts of interest or the exorbitant fees and restrictions of annuities as we do not sell any financial products.

Together, we call our strategy the Cash Flow Optimization for Retirees and it is comprised of “Four Cornerstones”.

  • Bond Ladder Implementation & Management
  • Social Security Optimization
  • Systematic Roth Conversion
  • Tax Efficient Asset Distribution

This strategy is ideally suited for people who are 1 to 15 years from retirement but this can also be very effective for people already in retirement.  It combines low cost investments, tax efficiency and most importantly, peace of mind that our clients’ portfolios are “doing their job” by effectively matching future liabilities (living expenses) with assets (portfolio).cash-flow

While we cannot control the stock and bond markets, we can control our reaction (or lack of reaction) to the markets and our investment costs.  In addition, we believe legally minimizing our client’s tax liability provides extra “alpha”, which could enhance portfolio returns and extend the life of the portfolio in retirement.  While we would never guarantee returns, we believe our strategy maximizes the chance of success, which we define as funding a retiree’s lifestyle without falling victim to high fees and sales commissions paid to an annuity salesman.

Part 1 of our series starts with the Bond Ladder.  Throughout 2017, we will outline the other three strategies.  Again, we believe the combination and coordination of these strategies is unique, differentiated and ideal for individuals or couples either in retirement or anticipating retirement in 15 years or less.

The Bond Ladder

In the simplest terms, a bond ladder is nothing more than a series of individual bonds, each maturing at a specified date in the future.  We believe integrating this seemingly simple concept into a coordinated strategy is a critical component to optimizing the long term cash flow needs for retirees.

What It Is:  The bond ladder is a series of bonds (not bond funds), each with a maturity date that corresponds to a year of living expenses above and beyond pension or social security income.  To build this bond ladder, we first determine how much “income” is needed from the maturing bond each year.  We then purchase (at existing rates) US Treasury STRIPS, which do not pay annual interest but instead are purchased at a discount and then mature at the par value over time. (Income tax is still owed on the “imputed” interest each year).

How It Works: Our sample clients are 58, looking to retire in 5 years at age 63.   They are starting with a portfolio of $2,000,000 and they expect to receive $35,000 / year from Social Security at age 67. They spend $100,000 per year in today’s dollars and we would like to build a 10 year bond ladder to provide peace of mind that their living expenses are covered for 10 years, regardless of stock market fluctuations.  To ensure an inflation adjusted $100,000 “matures” each year from 2022 to 2031, we would need to take $675,928 (or about 1/3 of the portfolio) and invest it in US Treasury STRIPS that mature over that time frame.

This leaves the remaining portfolio (about 66%) eligible to invest in stocks (and even some additional bonds) for long term growth as we won’t have to rely on what will likely be a fluctuating value over the years.  So even if the remaining portfolio were 100% stocks, we wouldn’t worry too much about year-to-year volatility as we have reasonable assurance, based on long term history, that over 10 years a stock portfolio is almost always higher after 10 years!

In fact, a great article in the Wall Street Journal last year (please click HERE for a copy) noted that the average recovery period for the stock market from a bear market (down 20%) to a new high is about 3.3 years!  We all remember 2008.  The recovery period from that terrible bear market was 5.3 years.

Now what happens if it’s 2021 and the stock market were to drop 10%?  The bond matures and their living expenses are funded.  But now we’re not forced to sell any of our portfolio because we know we still have the remaining 9 years for our portfolio to recover and likely, outgrow its current level.  Now, what if (in 2021) the stock market rose only 4%, the client could still fund their living expenses with the bond that matures that year.  We could then sell about $52,000 of stock (the 4% gain of the non-bond ladder funds) and fund another year of living expenses buying a 2032 US Treasury.

Why It Matters:  First and foremost- we must emphasize the implementation of a Bond Ladder is not intended to maximize portfolio returns.  In retirement- that’s not the job of a portfolio!  Instead, we think of the portfolio in risk adjusted terms that must be custom-fit to fit retirees’ cash flow needs.  This is NOT a market-timing, stock picking or “reach for yield” strategy.  Instead, the Bond Ladder provides psychological comfort and insulation from knee-jerk reactions to stock market volatility.  Instead of fearing a bear market, we can have reasonable assurance the client’s lifestyle is protected for up to 10 years without having to liquidate the stock portfolio at fire-sale levels.

In addition, we are effectively self-funding an annuity-like stream of income, without paying egregious up-front commissions (as high as 10%) and annual fees (~3%) to the annuity company.  Using our example client, buying an income stream with an annuity could cost our retirees $67,598 up front and about $20,300 in annual fees!

Finally, the psychological impact of knowing you have 10 years of retirement income fully funded cannot be understated.  As we discussed in our prior post ROI vs. ROS, we’re much more concerned with providing retirees ROS (“Return on Sleep”) than we are taking too much risk for ROI (Return on Investment).

2017 Market Outlook

© Copyright 2010 CorbisCorporation

Yes, it’s that time of year again.  It’s that nostalgic week with Christmas / Hanukkah behind us and the New Year’s Celebration front and center. There is something about flipping the calendar that seems to spark a thoughtful review of the year gone by and to wonder what’s in store for us in the next twelve months.

For some reason, Wall Street prognosticators (who like to refer to themselves as “strategists”) seem inclined to provide readers & clients with their official predictions for the upcoming year as a means to provide the incremental perspective they so often claim to have (and sell).

In that light, we’re happy to jump into the fray and provide our own “official bold prediction” on where stock and bond markets are going in 2017:

“We don’t know.”

Sorry to disappoint you all but if you read our blog posts enough, you should have seen that coming.  We readily acknowledge to NOT being able to accurately predict what’s going to happen in the next twelve months.  But we are happy to admit what many other advisors have so much difficulty admitting:  we don’t know because NO ONE knows.  And anyone that claims to provide you with assurance as to what’s going to happen in calendar year 2017 should be classified in the same category with tarot card readers and astronomers.

Now this doesn’t mean we don’t have an opinion.  But having an opinion on near-term market moves and a long term investment strategy are not the same thing.  In fact, these two mindsets often conflict as knee-jerk reactions to market moves often works to the detriment of building wealth over the long term.

So why don’t we provide predictions?  Two main reasons:

  1. Predictions are almost always wrong: Since 2000, people with important-sounding titles like “Chief Market Strategist” predicted the stock market to go UP every single year by an average of 9.5%. In reality, it was up about 3.9% and actually declined in 5 of the 16 years.  That includes the massive decline in 2008, when the average prediction was for an 11% rise and the S&P 500 declined 38%!  So why are the predictions so biased to be bullish?  That’s because…..
  2. Predictions drive commissions & fees:  In the short term (less than a few years), selling predictions as “market strategy” provides some insight on the mindset of the source. Predictions are usually issued by entities who benefit from trading and gathering assets. Keep in mind who is issuing these forecasts: banks and brokerage houses who make their livelihood on some mix of trading commissions, selling high-fee mutual funds or gathering assets.  A business model with these compensation structures might have their crystal ball clouded up by the potential for a large bonus.  Said differently, these folks are speculators and/or salespeople, not investors. In fact, the louder and more outrageous these predictions are, the more they remind us of the weekly NFL “Vegas Insiders” who claim to have some unique insight as to why the Browns might cover the point spread against the Steelers this week, a dubious bet indeed.

The point is this:  we have no control over the stock and bond markets and while we might sound like a broken record, we have to emphasize again: we all need to focus on the aspects of our financial lives that we can control.  Again, these factors include our risk-adjusted asset allocation, investment fees, savings/spending rate, tax liability, value to employers/clients and most importantly, our emotions.

Over the last century or so, patient investors in the U.S. have been rewarded with owning a piece of the miracle that is capitalism.  This assumes of course, they can keep their heads despite the occasional roller coaster ride of gut-wrenching declines and euphoric increases.

Sure those predictions are fun and you might even find it slightly amusing to hear a market “expert” opine on exactly where the S&P 500 may close 2017.  But we’re in the business of helping our clients maintain and grow wealth.  We are not in the entertainment business.  Ask yourself this:  If someone really knew exactly where things are going, why would they be so generous to let us in on such valuable information?

Best wishes to all for a happy and healthy 2017!

Trump, Taxes and You

By now we should all have digested the surprising results from the most recent election on November 8th.

Some of us may be rejoicing and some of us may be despondent but whatever side of the political spectrum you’re on, it’s now time to deal with the reality of the situation:  Donald Trump will be inaugurated as the 45th President on January 20th, 2017 and the Republican Party will hold majorities in both the House and the Senate for at least two years.

As we wrote in our most recent blog, the best way to deal with the results is to “control what we can control” as it relates to our financial lives.  This means adding value in our careers, optimizing investment strategies & tax strategies, etc.

But now that we know the results of the election- what can we actually do in more tactical terms?  How should we be thinking about 2017 and importantly- should we be doing anything before the close of 2016?Trump & Taxes

We believe the most immediately applicable policies to consider center on taxes. While there are many moving parts and multiple proposals from Trump and the Republican congress, at least we do have some hard numbers that could (we emphasize could) be implemented in 2017.

These are:

  1. Income Tax Rates: Rates on “ordinary income” could be flattened from seven brackets to three (12%, 25% and 33%). The 33% top rate would be lower than the current 39.6%.
  2. Deductions: Both Trump and Paul Ryan (Speaker of the House) have announced plans to limit deductions in size (i.e. put a cap on the total dollar amount that can be deducted) and type (i.e. eliminate what is considered deductible). This could partially offset the impact of lower rates.
  3. Capital Gains: Trump’s plan is to keep the current rates in place (0%, 15% and 20%) while Ryan’s plan raises them slightly.
  4. Alternative Minimum Tax: Both Trump and Ryan propose eliminating the dreaded AMT.

If these tax policies were to become reality, it has a few implications for near term tax planning.

First, for high earners (Married Filing Jointly, above $231,450 in taxable income) this means the value of any deductions could be higher in 2016 than it might be in 2017, all else being equal.  So as you look at your tax projection before year-end, you should seriously consider “pulling forward” any itemized deductions such as charitable donations and real estate taxes as you could have lower rates in 2017.

Second self-employed individuals may want to consider deferring some income (in a legal manner) to 2017 and pulling forward (and deducting) some business expenses so as to reduce 2016 taxable income.

Aside from taxes- what else should we consider?

Trump and the Republicans firmly believe that lower tax rates do not necessarily mean lower tax revenue for the U.S. Treasury, as the lower rates applied to a faster growing economy have historically resulted in higher income for the federal government.    This worked for Kennedy (a Democrat), Reagan and George W. Bush in recent decades.

A faster growing economy could also ignite inflation, which could also mean higher interest rates. In fact, the bond market seems to already be anticipating this scenario as yields on US Treasuries have ascended rapidly since the election.  Unfortunately, the puts-and-takes around interest rates and investments is a whole other topic for another time.

Overall, we view the Trump/Republican agenda as generally pro-growth.  But this could always be countered by some growth constraining policies from a President Trump like a potential trade war (with Trump’s much discussed tariffs) which could dampen growth.  In addition, we are dealing with a truly unique President-elect (never been elected to any office) with a track record of unpredictable and sometimes outrageous behavior.  So there is always the possibility of some out-of-left field action that can’t be blocked by Congress (like crazy treaty negotiations or cancellations) that could have a deleterious market reaction.

Bottom line:  We view the near term political landscape with a positive bias given the pro-growth agenda, underscored by the aggressive tax reform.  In this context, we should all be vigilant in our tax planning for 2016 and into 2017.  Aside from this, we should maintain our focus on what we can control (factoring in the new information) while the politicians slug it out in D.C.


Why Timing is NOT Everything

As we all know, the old phrase “timing is everything” seems to capture the seemingly random, but impactful, chance events which occur throughout life.  Of course these sometimes life-changing events can be either negative or positive.  The examples are innumerable and we all have them:

  • You have to stop for gas on your drive to work and find out you miss a 10-car accident by 2 minutes
  • You run into an old friend, get invited to a cookout the next weekend and end up meeting a future business partner
  • Your son is studying in Italy and runs into a girl from grade school who ends up being your daughter-in-law

We could all rattle off an odd set of circumstances which ended up profoundly impacting us and can be perceived in any number of different ways, depending on one’s belief system.  One person might think their situation was a result of divine providence, another- mathematical chance, still another- a mystic power in the universe or another- just dumb luck.  Regardless of the belief system, it’s almost universally perceived that “timing is everything”.

While that may help rationalize things for us in everyday life, we believe applying this mind-set to investing is at best unprofitable and at worst, downright hazardous to your financial health.  market timing image

Why? Because the financial markets are so unpredictable, it’s almost impossible to accurately time the market in a consistently profitable way.

With the stock market touching new record highs the last few weeks, we seem to be getting more and more questions about whether or not it makes sense to continue investing “at these levels”.  Our immediate question is: “When will you need to use this money?”  We certainly can’t provide appropriate advice without knowing the answer to that question as we always consider each family’s individual circumstances.

But taking it a step further, history suggests missing just a few days of market moves can have dramatic effects on a family’s portfolio.  In fact, a recent study by JP Morgan Bank shows just how volatile markets can be and how for example, missing just 10 of the best trading DAYS out of 20 YEARS of investing would have nearly cut your return in half!  Even more importantly, the study points out that “six of the 10 best days occurred within two weeks of the 10 worst days” (see accompanying chart), which means when things looked their darkest, those that remained invested usually recovered and made healthy profits.  Keep in mind, the typical year has about 252 trading days so 20 years of trading days is over 5,000 days!

market timing graph

Source: J.P. Morgan Asset Management analysis using data from Morningstar Direct

Now those percentages and the dollars shown in the chart may not be too compelling, but what if we applied this using $500,000 instead of $10,000?

The math is certainly the same but the difference in dollars all of a sudden becomes life changing.  Starting with $500,000 and making 8.18% (compounded annually) results in about $2.41 million after 20 years.   If instead, someone missed the 10 best days over the 20 year time period and earned only 4.49% (compounded annually), they would only have $1.2 million – JUST HALF!

Would starting your retirement with an extra $1.2 million would matter to you and your family?

The point is this: investing is critically important to retirement and achieving many other life goals.  But we believe diverse asset allocation, consistent re-balancing and keeping investing expenses low are the key strategies to employ – NOT market timing.

Too often, families are “sold” on the idea that some market wizard has a crystal ball and can predict the future.  But the fact is, no one knows the future.  And as demonstrated by missing 10 days out of 5,000 trading days, timing is certainly NOT everything.

What Einstein Would Say About Investment Fees

It’s pretty well known by most people that Albert Einstein was a pretty sharp guy.  Without getting into a summary of his Theory of Relativity (which I would get wrong anyway), one of his more famous and wise statements was:

“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”

While he was specifically referring to interest payments or interest income, the theory applies to growth of just about anything in percentage terms.  In short, it’s the “growth on the growth” year after year that is mathematically astounding over a longer period of time.einstein

Most people think of this concept in terms of wealth accumulation and that certainly applies.  But what often gets overlooked is that this concept cuts both ways and it can cost people millions (and I mean millions) of dollars over 20 or 30 years.

How?  Excessive fees paid for financial advice and investment management.

I know, I know – there are some of you out there that might be saying “but I’m not paying anything!” or “the insurance company pays my advisor” but we should all know there’s no free lunch! You are paying whether you see the fees explicitly listed on your statement or not.  Next time those investment statements come in, take a look at your mutual funds and do a Google search on the expense ratio of the ticker of the fund.  It should take you about 10 seconds to get a good estimate of the fund fees.  Then, if you are working with an advisor, ask them how much their AUM (asset under management) fee is, in addition to the mutual fund fees they recommended.

Some might be saying: “So what?  I’m paying for performance.” But the dirty little secret there is that almost all actively managed (i.e. expensive) funds actually under-perform their much less expensive index-fund peers!  For more detail and empirical evidence on this check out my blog More Than Luck.

The issue is not that financial advice is very, very valuable (yes, I’m biased in that regard), it certainly is.  But true value can only be judged when you know the accompanying price.  If you don’t know the price, you cannot judge the value!

This is why our firm tells all clients and prospects up front exactly how much they are paying in fees.  The first reason is that we remain completely objective in that no one pays us except our clients.  We accept no commissions, referral fees or even the occasional branded coffee mug.  The second reason, is that we’ve found our fees (while not cheap) plus low expense ratios on passive funds actually saves our clients substantial sums of money.  This is over and above the conflict-free advice we provide on just about everything financial.

Think that’s hyperbole?  Check out the chart below.  The chart compares the growth of a $1,000,000 portfolio, starting in 2016 and going out 20 years and 30 years.   The average growth rate of the portfolio before fees is 8% per year, compounded which is the average of a 50% equity / 50% bond portfolio from 1926 to 2015.

We have in our chart 3 scenarios:

  1. Portfolio growth with a 1.5% per year in total fees (which is a good approximation of asset management and fund fees) after 20 and 30 years
  2. Portfolio growth with a 2.0% per year in total fees after 20 and 30 years
  3. Portfolio growth with an example fee of $7,500 average annual retainer fee plus 0.20% fee on the portfolio (for passive fund expenses) (PLEASE NOTE: This is an estimate, our annual fee can range higher or lower than $7,500)

Chart JPEG

As you can see, the difference is astounding.  In short- if a 55 year old couple started with $1,000,000 and lived 30 years, they could SAVE between $2 million – $3 million by the time they reach 85 by NOT paying the 1.5% or 2.0% annual fees.

Of course, the cynics might say we are “talking our book” and trumpeting our own model.  We won’t deny that, but the math is indisputable.  The point is, even if you never hire us for advice, we strongly urge you to seek out a financial planner who uses a retainer based model.  Not only will you usually get objective advice on all aspects of your financial life, your portfolio will most likely grow to a point where it dwarfs a similar portfolio using a high-fee model!

Remember – the second part of Einstein’s statement is the most important- “…..He who understands it, earns it … he who doesn’t … pays it.”  Now you understand – don’t be the one that “pays it”.