By Dr. James M. Dahle, WCI Founder
My interpretation of the finance and investing literature is that the best way to invest is to primarily use a low-cost, broadly diversified, fixed asset allocation of equity and fixed income index funds tilted to small and value factors. Coupled with starting early, smart use of tax-advantaged accounts, an appropriate level of risk for the investor AND her goals, a reasonable investing temperament, and an adequate savings rate, this strategy is highly likely to allow a high-income professional to meet all of her reasonable financial goals.
However, I am often “challenged” by people who have selected a different way to invest. It might involve a little tweaking around the edges (which I do as well with asset classes like direct and syndicated real estate or Peer to Peer Loans), a total market strategy, a dividend based strategy, an individual stock (or bond) based strategy, a tactical asset allocation strategy, a primarily real estate based strategy, or even a significant reliance on the various types of permanent life insurance. The truth is, as Taylor Larimore, one of the authors of The Bogleheads Guide to Investing, frequently states, “There are many roads to Dublin.” Some things matter more than others when it comes to investing and frankly, I couldn't care less how you choose to invest.
In my view, the following are the most important factors in reaching your investing goals.
#1 Setting Appropriate Financial Goals
Far too many investors have no financial goals. Without a goal of some type, you can't even start formulating an investing plan. Uncertainty about the future bothers a lot of investors. Perhaps its the fact that I have to deal with a great deal of uncertainty in my daily work (1/2 of patients coming to the ED with abdominal pain leave without a definitive diagnosis), but I'm just fine with it. With investing, it is far better to have a plan that you know you will have to change and tweak as the years go by than to not have a plan at all.
#2 Taking an Appropriate Amount of Risk
Many investors take too little risk, squirreling their money away solely in bank accounts, CDs, muni bonds, whole life insurance, gold, or burying it in the back yard. Their portfolio never grows enough to meet their goals. Other investors take on too much risk, becoming overleveraged or using a portfolio they can't stick with when the inevitable downturn comes. Still, other investors take on the wrong kinds of risk and aren't even compensated over the long term for doing so. Examples of this include using a “black hole asset class” like small growth stocks, or gambling on one or several individual stocks.
#3 An Adequate Savings Rate
I generally recommend docs put 20% of their gross income toward retirement. There is data behind that recommendation, but depending on your goals and investment methods, you may need anywhere from 10-30%. However, 5% isn't going to cut it. It doesn't matter what your investment return is if you don't have much money invested. It takes a certain amount of brute force savings simply to “get in the game.”
The things that really matter most.
#4 Starting Early
You're not going to win a football game if your offense doesn't arrive at the stadium before the 4th quarter. Likewise, it's unlikely you'll reach reasonable retirement goals if you leave all your retirement savings for your last decade. Even the difference between starting at 30 instead of 40 can be very significant. Imagine a doc who wants to retire at 55 with $2 Million. If he earns 8% on his money and starts at age 30, he needs to save $25K a year. If he starts at 40, he needs to save $68K a year, almost 3 times as much.
#5 Broad Diversification
The future is not the past, and might not even resemble it. Diversification protects you against what you don't know and what you can't know. The best way to “shorten your tails” (making the distribution of possible outcomes more narrow) is to invest in many different securities, asset classes, and factors. Even if your chosen investment vehicle is something like real estate or life insurance, get as much diversification as possible by buying multiple properties of different types in various locations managed by different people. Or in the case of insurance, use policies from different companies of different types. Putting all your eggs in one basket is a recipe for disaster.
#6 Keep Your Costs Low
Every dollar you pay in commissions, loads, expense ratios, bid-ask spreads, insurance costs, hedging costs, advisory fees, etc is a dollar out of your pocket. Small numbers add up to very large numbers over long periods of time. The reason index funds work is primarily due to their low cost. Active managers can often beat the indexes. They just can't do it once they subtract out the costs of doing so.
#7 Pay Attention to Taxes
One of the most significant expenses for investors is their associated tax bill. Become familiar with the tax benefits of tax-deferred accounts, Roth accounts, tax-loss harvesting, tax-gain harvesting, qualified dividends, long-term capital gains, the step-up in basis at death, life insurance, annuities, UGMA/UTMAs, 529s, ESAs, etc. Nearly every doctor feels like she pays too much in taxes. Most of them are right. If you are not intimately familiar with the tax rules associated with each of these types of investment accounts, a little education on the matter has a very high yield.
#8 Staying the Course
Once you have developed any reasonable investing plan highly likely to reach your goals, it is far more important that you stick to it than what the actual plan is. Bailing out of stocks in the depths of a bear market is a retirement killer. So is frequent buying and selling of real estate due to the transaction costs and associated tax bill. Eliminating emotions (both fear and greed) from your plan is critical for success.
As I mentioned at the beginning, I don't really care how you invest. There is zero benefit to me if you choose to invest the same way I do. In fact, I am nearly 100% certain that not one of my readers invests exactly the way I do. But if you want to be successful, I suggest you make sure your investment plan, whatever it is, incorporates each of these critical factors into it.
What do you think? Did I miss anything important? If you had to write a #9 and a #10 to this list, what would they be? Comment below!
Excellent post. Thanks!
Fantastic entry. Very simple but not easy. Almost like staying in good shape: simple (just eat less, exercise more), but very difficult to achieve. All comes down to discipline. Factor #8 can’t be emphasized enough. Once you have #1-#7, strap yourself to the mast, turn off CNBC, don’t read the WSJ, don’t talk stocks/strategies at work, don’t check you account every 2 seconds, etc… Instead, focus on “investing” in your core competency instead, whatever that may be (ie being a good doc).
If I had to add a #9, it would be that if you feel the urge to try to be a “stock picker,” treat investing as a “fun game”, or find difficulty sticking to your system/plan, open a SMALL account on the side to “play with” and have “fun” with that—do not use your retirement account or monies that will be needed to reach financial goals.
Marginal utility of wealth-when you reach your goal take measures to preserve
A big down slide is devastating versus the upside of high equity allocations
Can you tolerate losing half just before retirement
9. Always remember “the why” of your personal investing. It helps guide your risk tolerance and investing decisions over time.
10. Continually educate yourself. I very much appreciate how WCI allows himself to be “challenged” on his site. I learn a great deal from ideas that challenge how I think about finance.
#9 Make It Automatic
Set up all IRAs, 401(k)s and any taxable savings with automatic deductions from pay or your checking account at the same time every month. This removes the daily, or even monthly, need to play around with it. Some game plans may require annual rebalancing and possibly things like Backdoor Roth conversions, but the monthly contributions should be automatic.
#10 Consider Your Retirement A Regular Bill
Your retirement and savings contributions should be considered a bill based on your goals. Combined with making them automatic payments you learn to live on the remainder of the money you have instead of spending your money and then deciding how much you have left to save.
I like these. Paying yourself first is huge. If it’s never there to spend you are set. The government does this with taxes. They know that if they wait until April 15th to take it, there won’t be any. But, if they take a little each paycheck, it is’t missed and then suddenly everyone is so happy on April 15th when they get a tax refund.
Imagine retiring and finding out you paid to much on that retirement bill and now you have a refund coming to you. Guess you just might have to spend a little more!
You might want to mention divorce, probably the most common way to lose more investments than all others combined (but I’m just guessing).
One house, one spouse, one job etc
#9 Definitely put as much as possible on autopilot. That is easy to do for payroll deductions but also easy to do for IRAs and taxable savings by simply setting up an automatic monthly withdrawal. Related to this is the concept of paying yourself first. Savings comes off the top before you do any other spending rather than at the end.
#10. Keep family and friends at bay. This might be especially good advice for doctors who are often perceived as being the highest earners or most wealthy in their circles of family and friends. Say thanks but no thanks to all the investment “opportunities” that come your way from family and friends, and have a plan for those loan requests or co-sign loan requests.
Thanks for the excellent article. What exactly do you mean by “black hole asset class” and why do you consider small growth asset class one of those? I’d love to get educated on this. Thanks
An asset class that simply shouldn’t be included in a portfolio is a black hole asset class. Historical returns of small growth are worse than large growth and small value. Seems silly to overweight that asset class. In fact, underweighting it may be wise (of course, past performance is no indication blah blah blah).
Of course, recent performance of small growth has been pretty good, so perhaps it isn’t a black hole at all. At any rate, here’s something from Larry Swedroe on it:
http://www.cbsnews.com/news/avoid-the-black-hole-of-investing/
I would echo that. Small-cap growth combines higher volatility with sharply lower long-term returns. It is one of several obvious contradictions to efficient market theory.
One explanation for the lousy risk/reward ratio is that the economic returns of small-cap growth (mostly tech) are captured in the venture capital stage, and ownership becomes available in the public markets only at inflated new-issue prices.
Thanks Jim for Larry’s article that you attached. It’s an interesting reading. I’ve read 3 of Larry’s books and in the last one, he was actually recpmmeding International Small Caps as an asset class one should add (to a Total International Stock market) to get more diversification and better returns. I cannot recall him making this argument about small cap growth being a black hole. However the statistics he provided is quite impressive. You keep learning everyday.
His statistics are impressive, but I’ve seen similar ones that aren’t as impressive. Like look at VG SV vs SG for the last 15 years or so. Not impressive.
Yeah, that’s what I thought too. The Vanguard SG beats the Vanguard SV over the last 10 years by more than 1%, though over the last 17 years since their inception, it’s a wash. Sometimes I feel like anybody can make a case of a fund they’re in favor of by selecting time intervals that help them make the case. At the end of the day, the important point is what you said: select your own style and stay the course. There are many roads to Dublin.
Reminds me of Fiedler’s quote “Ask five economists a question and you’ll get five different answers – six if one went to Harvard.”
Harry Truman once said, “Every time I ask an economist a question, he tells me, ‘Well, on the one hand…but on the other hand…’ What I need is a one-armed economist.”
The issue implicit here is end-of-period bias. IMHO, the fact that SCG has outperformed SCV, something that almost never happens, is powerful suggestive evidence that we are at the end of a growth cycle. Think late 1999, when LCG (especially tech) had outperformed over every trailing period shorter than a quarter-century. And remember the crash in growth/tech that followed.
This is an excellent list. I would add the same #9 as Kent. As a financial advisor, I’m a huge fan of making savings and debt paydown as automatic as possible.
What this list does not capture (cannot capture, I would argue) is the issue of temperament. This is the issue where I’m, at least indirectly,somewhat in disagreement with Jim Dahle. If your innate psychology is in tension with the patience and humility needed to succeed as a long-term investor, the best objective strategy may not lead to success. As Dr. Dahle says, if you panic in a bear market, it is an irrecoverable error. (A “retirement killer,” as he puts it.)
My observation is that fewer than one in ten investors has the psychology necessary for long-term investment success. This number can be increased somewhat by delegation (find a competent advisor and delegate your investing to him/her), which may save you from your own potentially costly mistakes.
I disagree entirely with Ken’s implicit idea that you should change your portfolio at retirement. The day before you retire at age 67, your life expectancy (highly-educated, highly-compensated, assume married) is more than two decades. The day after you retire? The same two decades. The real risk is not volatility. The risk is outliving your capital. Any low-volatility strategy will almost inevitably cause you to exhaust capital during your lifetime. (Read Warren Buffett’s Letter to Shareholders for great discussions of this issue.)
If you reach your goal in NOMINAL dollars at age 67, that is great. But you then need to preserve your purchasing power in REAL dollars through age 90 or 100. Cash and bonds won’t do that. You need equity or (with key caveats) real estate to do that.
You say we disagree, but I’m not sure where. In order to be a successful investor without an advisor, you need desire, knowledge, and discipline/temperament. Take any of those three out and you will be better off paying a fair price to a good advisor. 1 out of 10 might be an overstatement (I wouldn’t be surprised if it is 1 out of 100), but places like the Bogleheads forum and this blog have a selection bias, so the percentage is probably quite a bit higher than 10% for people on those types of sites. If you’re already here, you’ve probably got the desire. If you stay long, you’ll have the knowledge. Discipline/temperament can be learned by many, although admittedly not all. However, an adequate knowledge of market history goes a long way toward building the right temperament. For those who have it, it seems silly that there are people who don’t, but it’s true nonetheless. The worst part is there are advisors out there who don’t have the right temperament! How sad is it that some people hire an advisor and end up with one who can’t stay the course in a bear! Although I have admittedly found it a lot easier to stay the course with someone else’s money (parents’ portfolio or my kids’ 529s) than with my own.
I think where we partially disagree is in the importance of investor behavior, and the potential to change it through instruction. I’d draw an analogy to medically-supervised weight loss. We know ways to do it in theory, and surely some individuals succeed at losing large amounts and keeping it off, but in practice the functioning of the human brain makes the necessary behavioral changes very hard. Most people stay fat, despite their physician’s best advice.
You raise a great point. You are absolutely, entirely, categorically correct about advisors with the wrong temperament. I know many advisors who lost their nerve and sold out in 2008-2009. That is an irrecoverable error.
The problem with (many or most) advisors is not that they are unethical or uncaring. In my experience, most care deeply about their clients. (Well, not necessarily the insurance/annuity guys.) They simply have no investment skill, and don’t ever evaluate their actual performance against a benchmark, so they literally do not understand that they have no skill.
That’s a very fatalistic/deterministic/cynical belief that happens to coincide with an increased need for your professional services. Could be correct, of course, and I’m not sure a high quality study to determine how many people can become better investors through instruction/education is even possible, so we’ll probably never know.
Education matters. Low cost matters. Even if a person does not want to manage her finances herself, she is capable of learning enough to know what she is willing to pay for someone to manage them for her. By clicking on your name, I got to your fees which were very eye opening…
http://www.tgsfinancial.com/pdfs/ScheduleServicesandFees_271010.pdf
Surprised that caused you to open your eyes. While those aren’t the cheapest fees out there, and might even be slightly more expensive than average, that’s pretty typical and is far from the 2.5-3% a year I’ve seen for bad advice! (that opens my eyes!) I’d guess average would be 1% AUM, but they wouldn’t take you until $1M. Certainly it’s wise to shop around and negotiate financial planning and investment management fees. As I recently wrote, it’s certainly a profitable hobby if you’re willing to take the time to learn how to do it well yourself (and as discussed above, have the temperament to do it yourself.) I doubt most long-term WCI readers would be willing to pay even average investment management fees though. The docs who hire investment managers for 1%+ a year aren’t the same ones reading every post on this blog.
I stopped looking for an advisor years ago so haven’t paid attention to their fees. Although you see them as typical, his fees would cost me more than I pay annually for one year of college tuition, room and board for one of my kids. I would be curious to see 1, 3, 5, and 10 year returns on their “proprietary contrarian” portfolio net of fees for an 80/20 and 60/40 Stock/Bond mix. They were not easily found on the site.
You’re preaching to the choir about fees. That’s the main reason I do my own financial planning and investment management. However, that doesn’t change the fact that the fees are typical. I know of less than a handful of flat fee advisors, and most AUM based fee advisors who charge less than 1% won’t take you until you’ve got $1M (I can think of less than a handful that don’t.) Those “physician specific firms” that will take you with less than $1 Million also tend to charge more than 1% on that first million. If you know of high quality advisors who charge less than 1% on assets under a million, or less than $5K a year as a flat fee, I’d love to hear about them.
What do you think of Vanguard’s Personal Advisor Service (0.30% AUM) or Schwab’s new roboadvising option (0.25%) even for small accounts. I can’t recommend them as I don’t personally use them, and I believe if I can learn this financial stuff certainly anyone can. Nonetheless, they are interesting and where I would start if I wanted an advisor.
I think it’s a pretty small jump from a roboadvisor to doing it yourself. It’s a far bigger jump from a full-service advisor to a roboadvisor. But all three options are good for certain people.
Just to clarify, I’m not commenting as an indirect attempt to solicit business. I understand the purpose of this site is to help physicians cooperatively inform themselves and each other about investments. Jim Dahle does a great job of producing content to help that process.
Jim very kindly gave me some excellent feedback on a draft of a book I co-authored. If I can be helpful to him by giving useful feedback from an advisor viewpoint, I’m happy to do so.
Took a look also, ouch…. don’t know if I’d ever get to the 75bp level.
Great article to start the year. Taxes seem to be the area on which I need the most education at the moment. Any books you’d recommend?
According to the author bengen you need 25-65 percent in equities at full retirement to not outlive your money
It really comes down to how much you need to live on
I am 80% bonds age 65 , withdraw 4% and never touch principal
If you over save you can still own equities and not crap in your pants when the mkt tanks
Can you tolerate losing 30-40% of your assets at retirement with no other income streams
Bonds do matter
Thanks for the reply.
I think 80% bonds at age 65 is a big mistake, especially at a time of historically-low interest rates. You may be withdrawing 4%, but (in the long run) you are not leaving principal intact. The reason is the difference between nominal dollars and real dollars. Right now inflation is low (or not, depending on how measured), but over the long-term inflation has averaged over 3% per year. So if you are withdrawing 4%, and nominal-dollar principal is intact, your real (inflation-adjusted) principal is declining by 3% per year. Compound that over a 25-year lifetime in retirement and you can see the inevitable result. (As an advisor, I have seen this in real life many times.) And where are you getting 4% with 10-year Treasuries at 2%? Higher-yield bonds are an especially poor risk/reward bet right now.
If you are 60% stock, and the stock market declines 50%, you have not lost 30%, unless you sell. If your core stock holding is, as Jim Dahle suggests, an S&P 500 Index Fund, you can count on it being 10x to 20x more volatile than the GDP of the U.S. economy. But that fluctuation will occur around the long-term growth potential of the economy, plus dividends. Observe the last seven or so years. The market went down 65% intra-day, then recovered and went on to new highs. The only investors who permanently lost the 30% were those who panicked and sold near the low. Those folks are financially doomed regardless, unless they are incredibly rich or unusually short-lived.
For a great perspective on bonds, Google “Buffett bonds instruments of confiscation.” This will lead you to several of Warren Buffett’s Letters to Shareholders, where he makes the argument against bonds and for stocks more eloquently than I could hope to.
A big reason bond yields are so low is that inflation expectations are also low. Essentially, the bond market is saying that the odds are inflation will be significantly lower than the 3% mentioned as “long-term average.”
In terms of real purchasing power, a 3% bond yield would support a 4% withdrawal rate if inflation was -1%.
As for staying exposed to an equity crash past age 65, you mention “it’s only a loss if you have to sell” — but eventually you will have to sell — and there is no guarantee the market might not have come back quickly enough to bail you out. See Japan for an example of market is still down 25 years after peaking.
You make an important point, and I can’t offer a substantive response within reasonable limits. I may send Jim a guest post that touches on the issues you raise.
At this point, I will simply say that I agree that the sequence of returns is just as important as the average return. I’ll further add that pretty much every asset class (including stocks) has the potential to under-perform for far longer than most investors realize. But I’d argue that applies to bonds just as much as to stocks, especially at current rates.
Who remembers 30 yr treasuries at 17% for 30 yrs or double digit munis
I bought [a bunch]
A bad investment?
I don’t remember them, I was too young. However, as I’ve mentioned before, there never were 17% 30 year treasuries available. 30 year treasuries peaked at 14.68% in 1981. Obviously, nobody still owns any of those as they’ve all matured. The 10 year treasuries peaked a little higher, at 15.32%, but nobody has owned one of those since 1991. The 1 year treasury did get to 16.72%, which I suppose you could round to 17%, but nobody has had one of those since 1982.
http://www.federalreserve.gov/releases/h15/data.htm
Double digit munis are probably still available today somewhere if you’re willing to get into the junk. But for mainstream munis, double digit yields haven’t been available since 83 or 84. Again, nobody owns any anymore.
So you ask if they’re a bad investment. Who cares since you can’t buy them? It’s like asking if Apple in 1985 was a bad investment? Of course not, but you can’t buy it at 1985 prices!
While in these low interest times we all tell ourselves that if 8%+ treasuries become available again we’re all going to load up on them, I’ve seen data somewhere that shows that for someone investing a lump sum each year for the last 30 years actually would have been better off buying equities than bonds, even in the greatest bond bull market in history! This is mostly because only the investments for those first few years were making double digit returns.
Bought lots of CDs around 5% in the prior decade
The last time the average 5 year CD was yielding 5% was ~ 2001 according to Bankrate.com
http://www.bankrate.com/finance/cd-rates-history-0112.aspx
I imagine you might have been able to get close to that around 2007, but certainly not since then.
Bonds are a part of every shrewd investors portfolio
I am rebalancing this week
The bulls have run a long gime
I got into the investment business in 1978, so I remember that period very well. What I also remember is the pain of taking a 10% to 20% loss on bond portfolios every year from 1978 through 1981. So I’m one of the few who has a visceral understanding of the pain of rising rates to a long-term bond investor. One of the benefits of being old, fat, and remembering what happened in the 1970s better than what happened yesterday.
1981 was the beginning of a thirty-year bull market in bonds. That era saw historically high inflation and historically high bond and money market yields. So bonds were an excellent investment, if you bought them at the inflection point or during that long bull run. Today, we are persuasively in exactly the opposite circumstance, with historically low inflation and interest rates.
I agree entirely that the U. S. stock market is very, very expensive. My own preferred hedge is cash, not stocks, given the very low rates on bonds. The potential return landscape on bonds is adversely lognormal. (Borrowed that word from a physicist friend and taking it out for a test ride.) Very limited upside, very large downside. The return landscape on cash is more attractive, IMHO. Low volatility risk, no economic return. Plus dry powder.
[Comment held temporarily. Attempted to send email to commenter, but email was returned. Please email me Sam and I’ll send it again.]
Great stuff here. I would add a few observations that might have been covered. Individuals can learn the appropriate behaviors and grow so if you don’t have discipline you can get it if you want. For those of us who invest in individual stocks picking good management and buying at a good price are essential. Frequently others panic and drive the price of a good company down, then is the time to buy.
Can you tell us more about your syndicated real estate holdings?
I have one through my partnership where I own a share of our business building. The second is an apartment building through Realty Mogul. Part of the agreement on that one doesn’t actually allow me to talk about it, or at least say anything bad about it. Makes it hard to write objectively about it.
Hey Jim,
You have helped me much in the past and I ask for your advice. I am a physician who maxes out, 401k, 457, backdoor roth, and a taxable amount each month. Always considered alternative investments intriguing, but after much research not really looking to add extra stress to my life which already can be stressful as a physician. Because of that am worried about stories i hear about things such as a franchise (rely on other workers), rental (not looking to do landlord work myself as a physician). Was really looking for something completely passive to invest in but be able to get a decent return, and possibly some business tax write offs which would help at my income level. As an employee I don’t have a lot of opportunity for these tax write offs.
I am looking to invest somewhere between 50-100K as of now. I am sure you thought about his too, something to satisfy your entrepreneurial spirit. Not sure if you can help clarify such things as opportunities such as Venture Capitol stuff, real estate groups. Also do you find places like lending tree, or the Realty Mogul a good place to do this? What kind of returns can I expect? Is there any tax benefits?
Hope all is well, thanks in advance for your response
Duke
First, there’s nothing wrong with avoiding all these alternative altogether. They certainly require A LOT more due diligence than buying a handful of index funds and just forgetting about your portfolio until it’s time to put more money in.
Second, the amount of money I have in the alternatives you discuss is quite small. Only 5% in Peer to Peer Loans and about the same in real estate, both directly and via syndications (plus 7.5% in REITs).
Third, my goal in going after these types of alternatives is to boost return primarily by increasing risk. There is significant risk in these, not the least of which is they’ve only been around a few years.
That said, here’s what I’ve written on P2PL:
https://www.whitecoatinvestor.com/still-earning-12-6-with-peer-to-peer-lending/
Read the links at the bottom for more articles.
and here’s a guest post about syndicated real estate investing:
https://www.whitecoatinvestor.com/tag/physician-real-estate-investment/