Why You Need To Put the Personal in Your Personal Finances

Tim Maurer, a Charleston, S.C.-based Certified Financial Planner and Forbes contributor who just wrote the book Simple Money: A No-Nonsense Guide to Personal Finance has an enlightening, if unconventional notion. To Maurer, personal finance is more personal than finance.

“As I looked at the landscape of personal finance books, there is almost a shtick they have developed into: Here’s what you need to do and now go and do it,” Maurer told me. “But from my perspective, there hasn’t been enough about motivation — why people need to do things. There’s been very little on the emotional aspect, which is more nuanced. It’s the behavioral finance end of it.”

That makes sense to me, so I had a conversation with the bow-tied iconoclast to hear his personal finance advice, particularly for people in their 50s and 60s.

Maurer’s day job is a wealth adviser and director of personal finance for Buckingham Asset Management and the BAM Alliance. The married father of two sons told me he wrote the book because “I wanted to see what would it look like if we looked at personal finance through the Why. It’s the semi-rebellious spirit in me that never liked people telling me a handful of things I was supposed to do and a whole bunch not to do.

In our talk, Maurer discussed how he and his financially polar opposite wife Andrea manage to manage their money together; why we need to get over our excessive fear of rocky stock markets and what he considers the No. 1 financial move people need to make.

Next Avenue: You write that when setting money goals, it’s important to appeal to both the elephant and the rider. What do you mean?

Tim Maurer: The elephant and rider is an analogy used to describe what Daniel Kahneman, the psychologist and author of the bestseller Thinking Fast and Slow, calls System 1 and System 2 thinking to make financial decisions.

System 1 is our gut; it’s reflexive, immediate, fast thinking that many describe as emotional. It’s what we use to make the vast majority of our financial decisions. It’s the elephant. System 2 is the more reflective thinking part of our brain, the logical part that thinks things through. System 2 is the rider we use to rationalize the decisions we just made.

So you want to ask yourself: What makes you think and function the way you do? Is it the elephant directing or the rider?

We shouldn’t assume the elephant is the bad guy and the rider is the good guy. I fear that is the perception of financial advisers and the predominant realm of personal finance. It’s almost as if the personal finance universe said: ‘Take your emotions and throw them aside.’ But that doesn’t work. The elephant can be an incredible source of positive growth if unified with the rider.

You think many people don’t set money goals well. What do people in their 50s and 60s do wrong and what should they do instead?

One challenge we all have is what’s called hyperbolic discounting. It says the money I have to spend today is far more valuable to me than money I won’t get to spend until well down the road. That’s why it’s such a challenge to save for the future.

An awful lot of people in their 50s and 60s say ‘I’m already behind, what do I do now?’ Then, the only options available are unpleasurable: ‘I’m going to have to save so much, I can’t enjoy the five or 10 years prior to retirement or I’ll have to subject myself to a miserable retirement because I won’t have enough money.’

You need to reorder how you see yourself. If you’re in the majority without enough money in retirement savings, I try to offer encouraging words to give some hope. It’s not just about tightening your belt to the point where you can’t breathe; it may be about reshaping the way you look at life and work.

How?

It may mean you’ll work to 70 or 75; that puts you in pretty good company. If you know you will need to, then is it possible to make a career shift that would reduce your income in the short term but could lead to a more satisfying career that you’d be happy to do longer?

Or you might reshape your idea of what retirement looks like.

How can you do that?

Downsizing is often about as appealing as budgeting because people look at the negative versions. But you could envision an almost adventurous form of retirement where you take your assets and transfer them to a completely different geographic location with a lower cost of living.

That doesn’t work for everybody, of course. But there are so many neat cities around the country. If you build up a nest egg in the Northeast or in Silicon Valley, you can pick and choose any number of college towns where the cost of housing will let you buy a home that’s the same or nicer than what you had. That starts to provide you with an awful lot of options.

You say that it seems like you and your wife Andrea are polar opposites sometimes when it comes to money. So how do you deal with it and how should other couples in the same situation?

The first step is acknowledging how each of you became who you are — to write your personal money story.

My dad and my wife’s dad grew up in relative poverty and each interpreted that in different ways. My dad became extremely frugal; he felt exposing his children to want would be a good thing. My wife’s father, a phenomenal guy, decided he didn’t want to make his children feel a sense of being deprived and made decisions that were quite different from ones my dad made. That means my wife and I have two different approaches to looking at money.

I could demonize her for spending too much and she could see me as loving money more than I love her. But by acknowledging who we are, that takes pressure off each other and makes it easier to make joint financial decisions.

You take issue with some conventional rules of thumb, such as how much people should have in emergency savings. Often they’re told it should be three months of living expenses. What do you say?

I feel in general that the notion of having three months of living expenses in cash is absolutely a good thing. But statistically, the vast majority of people don’t have that much. I try to say: What’s a start? Getting to one month’s expenses, so the money that comes in today isn’t used up this month, has an incredibly positive impact.

And you say that every homeowner who doesn’t have a debt problem but has home equity should have a home equity line of credit. Why?

Because a bank is never going to give you credit when you really need it. So opening a line of credit doesn’t mean you’ve actually taken on debt. It does mean you have access to a line of credit with a relatively low interest rate — about the prime rate plus 1% — and that’s a good thing to have. Businesses function that way, so there’s no reason households shouldn’t treat their finances the same way.

(More: Bottom Line on Home Equity Lines)

When it comes to investing, you recommend what you call the Simple Money Portfolio. How does that work?

The Simple Money Portfolio is a three-factor model.

The first factor is that stocks make more money than bonds over time, although bonds provide an incredibly beneficial stabilizing force in your portfolio. The second factor is size: small companies have outperformed large ones over time. The third factor is that value stocks have outperformed growth stocks over time. It uses the Warren Buffett mindset to buy stocks when they are on sale.

The path to make it work is owning low-expense index funds or ETFs (Exchange Traded Funds) to keep your costs down over time.

What do you tell people who are worried about the stock market’s recent volatility?

It’s completely understandable that they’re worried. We feel the pain of investment losses twice as much as the pleasure of investment gains. So why do I encourage people to stick with it? The primary reason we expect stocks to make more than bonds or cash over time is precisely because they are volatile. If we didn’t go through many periods where stocks scare us, we wouldn’t make any more in stocks than with bonds.

But it’s really important not to overexpose your portfolio to stocks and get greedy. The Simple Money Portfolio starts with 60% in stocks and 40% in bonds.

Remember: the point of investing isn’t to make money. It’s to have a better life.

You suggest that people in their 60s give themselves a Retirement Stress Test. How do they do it?

It’s very simple. Add a projection of the amount you expect to receive from pensions and the amount you expect to receive from Social Security. Then take the balance of your savings and multiply it by .04 — 4% is a good starting point on how much you can responsibly take out of savings on an annual basis. Then add that amount to your pension and Social Security. Is that enough to live off of in retirement?

If the answer is yes, or it’s more than enough, you passed the stress test. If it’s meaningfully below what you anticipate your retirement needs will be, you’ve got some work to do.

You also suggest phasing into retirement in stages to reduce the stress of retirement. Why is that a good idea and how do you do it?

It puts less stress on your portfolio. If you retired in 2008 or 2001 or January of this year, when you would see your portfolio taking a meaningful dip, and you then took money out, that could compound the negative effect of volatility. That’s why it’s generally helpful to ease into retirement by working part-time or whatever it takes to take less money out of the portfolio.

Psychologically, this makes even more sense. Retirement is one of the most stressful things in life. It really stresses people out to turn off the spigot of income creation.

What do you think about buying long-term care insurance in your 50s or 60s?

I think long-term care insurance is oversold and my fear is that has dissuaded people from getting coverage that’s beneficial. They’re pitched bells and whistles that make the policies look way too expensive so they wind up getting nothing.

Instead, I think most people should partially insure through long-term care insurance but without those bells and whistles. They could buy maybe fifty to sixty percent of the coverage of that policy.

You’re not big on traditional IRAs. Why?

The traditional IRA is an excellent tool, but a Roth IRA is superior for most people. The traditional IRA reduces taxes today; the Roth reduces taxes in the future. And there are also income caps on traditional IRAs that are lower than for Roth IRAs.

Estate planning is at the top of your list of financial planning moves for people. Why is that?

Because the majority of us don’t have adequate estate planning documents; 80 percent of people don’t have a basic will. People think ‘I don’t have an estate; I’m not rich.’

But the No. 1 priority for virtually every adult, especially if you have minor children, is your will. The frightening implications of not planning for your demise puts it in the top financial priority spot.

This commentary originally appeared March 9 on Forbes.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2016, The BAM ALLIANCE

Simple Portfolio That Has Beaten the Pros

The financial industry would prefer you to believe that you can’t be a successful investor without it. That’s good for business but it’s not exactly true.

In fact, it may be truer to suggest that a layperson with a reasonable grasp of middle school math—combined with the rarer traits of discipline, grit and humility—is capable of building a portfolio that could beat the majority of professional stock pickers over the long-term.

Please note I’m not suggesting that most individual investors are likely to beat the pros. Indeed, statistics suggest just the opposite, as individual investors regularly underperform the very investments—mutual funds, run by professionals—that they own.

But the vast majority of professional money managers actively attempting to beat their respective benchmarks also have demonstrated a persistent propensity to underperform. In other words, they don’t “beat the market.” Therefore, the individual willing and able to effectively capture market returns should indeed beat the pros. It is surprisingly simple, but it is not easy.

So, just “buy the market,” then? Perhaps, but which one?

The S&P 500, the benchmark of benchmarks, tracks the 500 largest publicly traded U.S. companies. It’s “the market,” although not an investment in and of itself, and it’s the bogey that most stock fund managers are chasing. Since 1927, the index has earned an annualized return of 10.1% with an annualized standard deviation of 20.2%.

The annualized return gives you an idea of how much you’d have earned per year over that stretch. But it wasn’t as smooth a ride as any of us would prefer, as evidenced by the second figure. The annualized standard deviation is a more intimidating statistic, but you don’t need to fully understand in order to grasp its importance. In short, it’s a measurement of volatility or risk, the degree to which an investment would have deviated from its average return over a given timeframe.

An investor certainly could buy an index mutual fund or exchange-traded fund designed to mimic the S&P 500 and call it a day. Doing so, however, would likely expose that investor to more risk—and interestingly, less return—than might otherwise be optimal. Let’s use the S&P 500 as a starting point, and then build a DIY portfolio from there in three steps.

 

1927-2014 Annualized Return Annual Standard Deviation
S&P 500 10.1% 20.2%

 

Step 1: Add fixed income to lower portfolio volatility.

The market was good to the patient investor between 1927 and 2014. $10,000 invested at the beginning of that period would have grown to nearly $47.6 million. But most could not have weathered the volatility associated with that investment along the way. The worst single year was down 43%, and the worst three-year stretch resulted in a 61% decline.

The antidote to stock volatility is fixed income, or bonds. We invest in stocks to make money, but we invest in bonds to keep us invested in stocks when volatility threatens to derail us from our long-term financial plan. Yes, a well-diversified, all-stock portfolio should certainly earn more than a balanced portfolio over your lifetime. But if you abandon your portfolio due to high volatility in the worst of times, it’s all for naught.

And since the primary purpose of investing in bonds is to stabilize a portfolio and keep us invested in stocks, consider purchasing only the stable-est of the stable, such as U.S Treasuries or FDIC-insured CDs. For our purposes, we’ll take 40% of our previous allocation to large-cap stocks and invest it in five-year U.S. Treasuries. Here’s what happens:

Portfolio 1:

60% – S&P 500 Index

40% – 5-Year Treasuries

 

1927-2014 Annualized Return Annual Standard Deviation
S&P 500 10.1% 20.2%
Portfolio 1 8.7% 12.3%

 

What’s most interesting to me about the change in the numbers from the S&P 500-only investment to the results we see from Portfolio 1 is that our measurement of risk drops a relative 39.1%, proportionately far more than our return, which falls a relative 13.8%. But what if large U.S. company stocks weren’t the only equities in which we invested? How might the complexion of this portfolio change further?

Step 2: Add small company stocks, to increase return.

Small company stocks historically have provided higher returns than large company stocks. That probably doesn’t come as a surprise, right? Smaller companies are hungrier, nimbler and have more room to grow. But it also probably doesn’t come as a surprise that they are riskier and less predictable. Let’s see what the portfolio looks like if we take half of the allocation we’ve dedicated to large companies and devote it to small companies. In order to do so, we’re relying on the research of two Nobel prize-winning economists, Eugene Fama and Kenneth French.

Portfolio 2

30% – S&P 500 Index

30% – Fama/French US Small Cap Index

40% – 5 Year Treasuries

 

1927-2014 Annualized Return Annual Standard Deviation
S&P 500 10.1% 20.2%
Portfolio 1 8.7% 12.3%
Portfolio 2 9.6% 14.6%

 

Step 3: Add undervalued company stocks, to further increase returns.

Fama and French are credited with the “three-factor model” of investing. Instead of relying on hunches and predictions, they ran the numbers and found statistical evidence that stocks return more than bonds, small companies return more than larger companies and, furthermore, that undervalued—or value—companies return more than growth companies.

This sounds counterintuitive, because the word “growth” looks more dynamic. Value companies, however, are firms whose stock price has been beaten down relative to the company’s earnings or “book value,” ironically giving them more room to grow than growth stocks. These “distressed” companies, of course, also come with a catch—increased risk and higher volatility. Still, by adding this third “factor” to our portfolio, we arrive at one that has for the past 88 years posted the same rate of return as the all-stock S&P 500, and that with 20.7% less relative volatility.

Portfolio 3

15% – S&P 500 Index

15% – Fama/French US Large Value

15% – Fama/French US Small Cap Index

15% – Fama/French US Small Value

40% – 5 Year Treasuries

 

1927-2014 Annualized Return Annual Standard Deviation
S&P 500 10.1% 20.2%
Portfolio 1 8.7% 12.3%
Portfolio 2 9.6% 14.6%
Portfolio 3 10.1% 16%

 

The “three factors” I’ve mentioned aren’t the only ones to be considered in portfolio construction, but they are the most influential. An additional consideration is the introduction of international stocks. Besides seeming like a generally good idea to consider the economic output of the other 95% of the Earth’s seven billion inhabitants and about half the world’s market capitalization of stocks, international stocks also diversify the economic and geopolitical risks of investing in only the U.S.

The Simple Money Portfolio

This brings us to the Simple Money Portfolio (so named because it is the central focus of the investing guidance in my forthcoming personal finance book, Simple Money). Using the analysis above, it translates the various appropriate indices (in which you can’t actually invest) into those in which you can:

How, you should ask, can a simple, index-based portfolio outperform most professional investors while taking less risk?

  • It diversifies the stock-based investments across a broad range of asset classes that historically have rewarded investors with higher returns than the broader market (small cap stocks and value stocks).
  • It diversifies half of the stock exposure beyond the U.S. and Canada into the international landscape. This exposes the portfolio to many opportunities beyond our borders.
  • It lowers overall risk by investing 40 percent of the portfolio in fixed-income instruments, like bonds.
  • It limits the negative impact of riskier fixed-income implements by only investing in the most conservative bonds (or bond equivalents) available.

Modifications

This is a moderate portfolio, one that for many investors may appear too cautious with 40% allocated to decidedly conservative fixed income. There is a reason for this: Behavioral science has taught us that losing hurts more than winning helps. In fact, we tend to feel the pain of a decline twice as hard as the joy we experience when everything is on the rise. In essence, we’re more conservative than we think, and therefore would do well to err on the side of conservatism in portfolio construction. Please note that the equity, or stock, allocations in this portfolio are, in and of themselves, more volatile than the U.S. large cap market alone.

But it may be entirely appropriate to adjust your allocation to better suit your ability, willingness and need to take risk. This can be easily done by calibrating the stock-to-bond ratio to reflect a more aggressive or conservative posture while maintaining the relative ratios between the equity asset classes.

Some investors may also be concerned about having 50% of their stock exposure allocated to international companies. I understand this concern, in part because I share it. I don’t understand languages, cultures, economies and markets around the world in the same way that I do in my home country—but I recognize this as a personal bias, not necessarily reflective of the data. Nonetheless, if you feel overexposed internationally, reduce the internationally oriented stock ratio from 50% to 40% or even 25%, but I encourage you not to eliminate it entirely.

Ongoing Maintenance

Is this a set-it-and-forget-it portfolio? No, I don’t want you to be an active trader of your investments, but I do advocate for active ownership. That means rebalancing periodically, bringing your portfolio back to its intended allocation as certain slices of the pie inevitably shrink and swell. This should, over time, actually reduce overall portfolio volatility.

While rebalancing doesn’t always feel safe—taking from the parts of your portfolio that have done well and giving to those that have underperformed—the practice is entirely logical and helps ensure that you are consistently buying relatively low and selling high. Most 401(k)s and other employer-sponsored retirement plans make this an easy, automated process that you can elect when you put your portfolio in place.

Implementation

It will take some work to translate what you’ve read above to your individual situation. Your 401(k) likely only has so many options, so I recommend you try to match up the indices I’ve referenced with the most applicable index fund you can find. If index funds aren’t available to you, look for an equivalent fund that has the lowest expense ratio possible.

If you’re investing outside of an employer-sponsored retirement plan, you may consider utilizing ETFs—exchange-traded funds—although I do caution you that these instruments are often more complex than they initially appear. You could do much worse than to simply build your DIY portfolio with funds from Vanguard, through whom you’ll find access to each of the indices mentioned in the Simple Money Portfolio.

A Word of Caution

I urge you not to take this on unless you have the discipline and grit to build and maintain the portfolio, and the humility to submit yourself to the evidence. The evidence suggests that most investors do not, or would prefer to apply their effort to endeavors more to their liking. I believe, however, that education could inspire the confidence to apply investing discipline, and that the higher allocation to fixed income helps investors to stay the course.

But what about humility? This is where the financial industry fails. The industry has discipline and grit—but its lack of humility has been its undoing. Even though the vast majority of stock pickers don’t beat the market, every stock picker, by definition, thinks he or she can. This is precisely the reason that a dedicated DIY investor can actually beat the majority of pros.

What about having a financial advisor?

Does this mean that there’s no place, or need, for a financial advisor? Hardly. Many, if not most, investors simply feel more comfortable with the guidance of a dedicated professional whose life’s work is to marinate in this stuff. And even though you may have the discipline and the humility to establish a great DIY portfolio, many fewer investors have the grit to survive the most tumultuous market times.

Additionally, a true financial advisor is not solely an investment advisor. This is an important distinction, because a good advisor will help you place your investment strategy within the context of your cash flow, insurance, tax, education, retirement and estate planning. The Certified Financial Planner™ Board has been one of the industry’s foremost advocates in promoting holistic, comprehensive financial planning, and the CFP® credential, while not sufficient, is a good sign that your advisor has the training to view your money within the context of your life.

But the best financial advisor will ensure that all of this financial planning is built on the foundation of your personal priorities and goals. This is imperative because personal finance is more personal than it is finance. In the end, behavior management is more important than financial management. And that’s one critical reason why this financial advisor makes sure to have his own financial advisor.

This commentary originally appeared January 20 on Forbes.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2016, The BAM ALLIANCE

Does an individual bond ladder offer more protection in a rising rate environment than a bond fund?

Quick Take on Fixed Income
February 2016

Q: Does an individual bond ladder offer more protection in a rising rate environment than a bond fund?

A: Many investors are worried about how rising interest rates will affect their fixed income portfolio. Many believe an individual bond ladder better protects them against rising rates because they can see each bond mature. This is a common misnomer. An environment of rising rates will have a similar effect on the value of an individual bond ladder as it will with a bond fund of similar duration and credit quality. Interest rate risk is measured by duration, which measures the sensitivity of a bond’s price to a change in interest rates. For example, a portfolio with a four-year duration will lose 4 percent of its value if interest rates increase by 1 percent (or vice versa).

We view bond ladders and bond funds as interchangeable investments; both have an indefinite life. We use ladders that are built with the assumption that once the one-year bond matures, the money will be reinvested into the new 10-year bond (or the next rung on the ladder). A bond fund operates the same way. Once a maturity or new money arrives, the fund reinvests at the best point on the curve.  No matter if an investor is holding a bond fund or a ladder of individual bonds, both should behave the same assuming the credit quality and duration are equal.

We work with BAM’s Fixed Income department, which views an environment of rising rates as a positive. Rising rates allow investors to reinvest at a new higher rate, increasing the overall yield of the portfolio or fund. The chart below displays a hypothetical yearly 0.50 percent rate increase and how the increase benefits the client. At inception, the federal funds target rate is 0.50 percent.

See Chart

Assumes a constant four-year duration and an even rate increase across the curve (federal fund rate of 0.50 percent).

The gradual increase in yield across the curve is a positive for the investor. Again, no matter if the portfolio is a bond ladder or a bond fund, it will have similar performance. The only difference in performance — keeping duration and credit quality the same — is the fund’s expense ratio.

Copyright © 2016, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.