Category Archives: Investing

Defining Your Investment Style

There are many different approaches an investor can take in managing their money.  Some approaches are hands-off and require little effort to maintain the desired asset allocation.  Other approaches are more time intensive and might require daily or weekly management.  There are other approaches that fall somewhere in-between.

No matter how you decide to invest, you need to have an investment philosophy.  It should be part of your financial plan.  Without having direction, there is just too much noise to misdirect you on a daily basis.  Every hot investment tip will sound like a good idea.  That will lead an investor to try to chase performance.

It is up to you to decide how you want to invest your money.  Some approaches are considered more favorable than others because they are tax efficient, cost very little, and allow investors to capture average market returns.  There are approaches that rely on investment professionals to try to beat the market.  Some investors feel confident that they can manage their own selection of individual securities and want to pick their own stocks.  There are also Robo-Advisors that investors can use to manage their investments.

When it comes to trying to invest to build wealth, there are countless avenues for investors to explore.  There is passive investing, active investing, crowdfunding, and countless other forms of ventures to invest in.  The purpose of this post is to cover some of the most common forms of investing where the transactions can occur with the click of a mouse.

Index Funds

Index funds are what their name implies.  An index fund is a mutual fund that is composed of stocks that track a specific index.  For example, if you buy a share of an S&P 500 index fund, you are buying an investment that is made up of the largest publicly traded U.S. corporations.

There is little actual management and turnover with index funds.  That is what makes them cheap and tax-efficient.  A management team is not required.  There is very little trading and turnover within most index funds.

There are index funds that track large-cap stocks, small-cap stocks, international stocks, and bonds.  There are index funds that hold every publicly traded stock in the world.  There are also index funds that track individual sectors or sub-asset classes such as consumer stables, natural resources, technology stocks, and other sectors.

An investor can keep it simple and buy three index funds like the total U.S. stock fund, total international stock fund, and total bond market fund that would allow them to own every publicly traded stock in the world.  An investor can slice and dice and break it down into many different funds and build a custom portfolio with different tilts.  There truly are limitless possibilities.

Managed Funds

Managed funds are like index funds.  They invest in a basket of different stocks or bonds.  The major difference is that they do not track an index.  They have a fund manager or team of managers who try to beat a benchmark.  For example, a managed large-cap growth stock fund would try to beat the S&P 500 index.

Compared to index funds, managed funds have higher fees.  The average expense ratio for a managed large-cap stock fund is 0.99%.  The expense ratio for the Vanguard S&P 500 is 0.04%.  That is almost one whole basis point.

The goal of the fund manager is to outperform its benchmark.  Based on the difference in fees, the fund manager must outperform the S&P 500 by almost 1% per year to just break even.  That is very difficult to do.  It is getting even harder as the result of the shrinking alpha.

For the fund manager to try to beat their respective benchmark, they need to make trades.  They are paid to buy stocks within the fund that they think will outperform.  They also must identify the stocks that they think will underperform and sell them.

All of that buying and selling is called turnover.  Some managed funds have a turnover ratio of 90% or more of their portfolio annually.  If a managed fund is held in a taxable account, all those trades trigger capital gains that are passed on to the investor.

Most managed funds do not beat their benchmark.  In 2016, only 34% of large-cap mutual funds beat the S&P 500.  It gets worse with time.  Only 10% of large-cap mutual funds beat the S&P 500 over the last 15 years.

What happens to the underperformers?  Usually, a new manager is brought in to right the ship.  If its performance does not improve, it normally merges with another fund.

Individual Stocks

Investing in individual stocks can be rewarding.  If you select the right stock, you will outperform the major indexes.  Just look at Google, Amazon, or even Apple.

The problem with investing in individual stocks is that it is hard.  Most active mutual fund managers who have unlimited resources cannot consistently do it.  It is not likely that an individual investor will outperform the S&P 500 for a decade or longer.

Can an investor get lucky when they buy a few stocks?  Sure, they can.  That, however, is speculation.  Investing is not gambling.

When an investor buys an individual stock, it is a vote of confidence in a company.  It is a vote that they know the stock is undervalued compared to its market price.  They are making a statement that says they know more about the fundamental business operations of the company and they are positive that it is sure to appreciate.

They do not know any of those details.  The individual investor receives their information from the financial media or a stock screener.  They are the last to know anything about the value of a stock.  The professionals, analysists, and insiders know before the media.  They provide the information to the media.  The media informs the individual investor.

Robo Advisors

Robo-Advisors are the new frontier for individual investors.  Robo-Advisors are financial management platforms that allow investors to manage their investments based on algorithm-based variables.  An investor plugs in their goals, risk profile, and other survey data and Robo-Adviser does the rest.

The technology used by Robo-Advisors is not new.  The investment industry has been using it to rebalance accounts since the early 2000’s.  It is new, however, for individual investors to have access to this type of asset management technology.

Even though it has been around for some time, it is fascinating technology.  Since it is automated and based off an algorithm, there is not much room for human error.  Not only can it be used for investment selection, but it can also be used for more sophisticated processes like tax-loss harvesting.

There are some nice benefits to using a Robo-Advisor.  They are a much more affordable option than having to hire a human Financial Advisor.  The annual fee to use a Robo-Advisor is between 0.2% to 0.5%.  That is much more affordable than must shell out up to 2% for a human financial advisor.  The minimum amount that is required to invest with a Robo-Advisor is much lower than the standard six-figure minimum that many traditional human financial advisors require.

Conclusion

The above investment styles are just a few of the more popular methods for individual investors.  Over the years, my portfolio has become primarily made up of a few index funds.  I have invested in a few managed funds but sold off all except one.  As far as individual stocks, I have only bought and sold five individual stocks since I started investing.  I have not owned any individual stocks since 2004.  Many investors in the financial independence community use individual stocks as part of their dividend strategy.  As for the Rob-Advisors, I have invested using that technology, but do see its value for tax-loss-harvesting in a retirement account.

What is your approach to investing?

Do you follow any of the methods that I covered or a blend of a few different approaches?

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How Bonds are Impacted by Interest Rates

There are many different economic factors that can change interest rates.  The Federal Reserve can act to change interest rates.  Interest rates can be lowered to increase borrowing and spending during a slumping economy.  Interest rates are also used to manage inflation.

No matter what causes the change in interest rates, the change has a direct impact on how bonds are priced.  When interest rates increase, the value of existing bonds decreases.  The opposite occurs when interest rates are reduced.  When that happens, the value of an existing bond would increase in value.

Not all bonds are the same.  Bonds have different maturity dates.  There are different issuers such as the Treasury, corporations, and municipalities.  Different bonds have different coupon rates.

With bonds, the value of a dollar today is worth more than a dollar tomorrow.  Today’s price of a bond is based on the total of future cash flows.  The value is discounted because they are not available today.  When there are changes in interest rates, all bonds are impacted.  Not all bonds, however, are impacted equally.

The price of a short-term bond is affected less by the increase in interest rates than a longer-term bond. Long-term bonds maturity value and interest are paid with future cash flows.  They are paid in the distant future.  When there is an increase in interest rates, the long-term bonds become discounted and decrease dramatically in value.

The interest rates are also known as the coupon rate that is periodically paid also impact the bond price volatility.  The higher the coupon rate, the more cash that is paid in interest to the investor prior to the maturity date.  When interest rates increase, the future cash flows are discounted at a higher rate.  The lower coupon bond will have more cash flow in the future.  The maturity value of the bond represents a larger portion of the total cash flow.  The current value of the bond will fall.

To determine the risk of a bond, an investor needs to look at maturity and coupon rates.  The most volatile bonds have lower coupons and longer maturities.  Less risky bonds are shorter until they reach maturity and have a high coupon rate.

Most individual investors use bonds to reduce the volatility of their overall portfolio and for income.  If you are using the bond portion of your asset allocation to reduce the overall volatility of your portfolio, consider bonds that have maturities that are shorter than five years.  Also, avoid zero-coupon bonds.

How much do bond prices change?  The prices of bonds do change, but not as drastically as with stocks.  What you can lose in bonds in one year, you can lose in stocks in one day.  Even though bonds are less volatile than stocks, it is still important to understand how interest rates affect them.

For example, assume that you have a bond with a 30-year maturity and a 6% coupon rate.  How much would the value of the bond change if there was a 2% drop in percentage points from 6% to 4%?  The bond would increase in value by almost 35%.  A bond that had a face value of $500 prior to the interest rate decrease would climb to $674.

What about if there was an increase in the interest rate from 6% to 8%.  The bond would decrease in value by almost 23%.  That $500 bond would have a loss of $113 in value.

The only way to reduce the price volatility of the bond portion of a portfolio is to consider shorter maturities.  When looking at mutual funds that invest in thousands of different bonds, look at the average maturity and the average coupon rate.  That will give you a ballpark of what the price volatility of the overall portfolio would be.  Below are a few examples of Vanguard Bond Funds:

Vanguard Total Bond Market Fund (VBMFX)

Average Maturity: 8.4 years

Average Coupon: 3%

Vanguard Long-Term Bond Index Fund (VBLTX)

Average Maturity: 24 years

Average Coupon: 4.4%

Vanguard Short-Term Bond Index Fund (VBIRX)

Average Maturity: 2.9 years

Average Coupon: 2%

Mutual fund managers keep a keen eye on interest rates and other economic factors.  They can adjust their portfolio by buying or selling bonds with shorten or longer maturities based on projected interest rate changes.  Fund managers are limited as to what they can buy and sell based on the fund’s investment objective statement found in the prospectus.  For example, a short-term fund cannot increase its holding in long-term bonds just because interest rates might be falling.

There is also a quality factor to consider.  When interest rates are increasing, lower-rated bonds tend to fall in price faster than high-quality bonds.  Bonds with a higher default risk fall the fastest.

If the economy was in a recession, a rise in interest rates would drop the price of a high-yield (junk) bond with a low rating.  A double or triple-A rated corporate bond with the same maturity would also fall in price, but not as quickly as the lower quality bond.  U.S. Government bonds have historically been rated as the highest quality bonds.

It is just as difficult to try to time changes in interest rates as it is to time the stock market.  There has been speculation of raising interest rates for many years and they are just starting to occur.  Economics and fund managers can make predictions as to where interest rates are heading, but nobody truly knows for sure.

When you are building the bond portion of your asset allocation, keep in mind why you are buying bonds.  Be aware how interest rates affect how bonds perform.  If you want to be more conservative, focus on high-quality government, corporate, and municipal bonds.  A risk-averse investor should also stick with short-term bonds or bond funds.

If you want to take on more risk, do so in the stock portion of your asset allocation.  That is not what bonds are intended for in an individual investor’s portfolio.  Bonds should be used to reduce risk and provide income, not add to the overall risk of a portfolio.

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Dumping Stocks at Retirement

Have you ever considered selling all your stocks or stock mutual funds when you retire?  Who wants to have to deal with the ups and downs of the markets when you are no longer dollar-cost-averaging?  Are you afraid of a major market crash when you are drawing down your portfolio?

The market is near its all-time high.  With retirement right around the corner, are you tempted to sell all your stock holdings and call it a day?  It might sound tempting.  This market cannot keep going up, can it?

Every investor has the right to feel exactly how they feel about all of the scary things that are going on in the world.  Don’t lose your head.  The world has always been a volatile place and unfortunately, it always will be.  If it is not one thing, it is something else.

Yes, it might be tempting to pull the trigger and sell high.  You would walk away as a winner.  Before you do that.  Let’s look at how an all-bond portfolio might serve you in retirement.

For this exercise, let us assume that you are now sitting on $1,000,000 in your 401K.  At retirement, you want to draw down 4% per year.  How would an asset allocation of 100% in bonds hold up over the course of 30 years?  To find out, I am going to run this test based on the Monte Carlo method by using the Vanguard Retirement Nest Egg Calculator.

There is a 69% chance that your savings will last 30 years.  I do not like those odds.  I especially do not like them for a person who retires early.

What about if a person wants that $1,000,000 to last 40 years?  The percentages are getting much worse.  There is now only a 36% chance that money will last 40 years.

Could you imagine going broke after being retired for 40 years?  What would you do?  Would you go back to work?  Who would hire you at such an advanced age?  Sure, employers cannot discriminate, but let’s be honest about the opportunities for someone who has been unemployed for that long.

What could an investor do to improve the chances of their savings lasting 30 years or even 40 years for those who enter early retirement?  In Benjamin Graham’s book The Intelligent Investor, he gave a few suggestions for defensive investors.  He suggests that a balanced portfolio made up of 50 in equities and 50% in bonds is a good place to start.  He also suggested that an investor should never exceed an asset allocation of 75/25.  In other words, an investor should never have more than 75% or less than 25% in equities or bonds.

I know that you are seriously considering selling your equity holdings and exchanging them for bonds.  You have told yourself that you are finished with the market.  Volatility is no longer for you.  You want to enjoy your retirement without having to worry about how stocks are performing.  If you do that, the odds are still not in your favor of not running out of money.

How would your $1,000,000 fair if you followed what the late Benjamin Graham suggested in his classic investment book?  How would keeping only 25% in equities change the projected outcome?  Would adding a more volatile asset class help or hurt the likely hood of running out of money?

By keeping 25% in equities, the percentages have dramatically improved.  There is now a 78% chance that your money will not run out over the course of 30 years with a 4% drawdown rate.  Over the course of 40 years, there is 57% chance that your money will last.  By keeping 25% of the portfolio in stocks, there was an improvement of 9% over the course of 30 years and an improvement of 21% for 40 years.

Holding a small allocation of equities sure goes a long way.  What about if you took it a step further and went with a mix of 50% in stocks and 50% in bonds?  I know, I know. You are finished with stocks.  Keeping 25% of your money in stocks is one thing, but going to 50% is just too aggressive for your retirement account.

I understand how you feel.  You do not want to own stocks when the next recession occurs.  A long stock market correction can be scary.

During a drawdown period, how does having 100% in bonds compare to an asset allocation of 50% in stocks and 50% in bonds?  Over the course of 30 years, the 50/50 mix has an 85% chance of success.  Over the course of 40 years, the 50/50 mix has a projected success rate of 74%.  Compared to the portfolio made up of 100% in bonds, the 50/50 mix has a 16% better chance to not run out of money over the course of 30 years.  For the period of 40 years, the 50/50 mix has a 38% better chance of not running out of money.

There are many factors to consider when selecting the asset allocation that is right for your retirement.  How old will you be at the time of retirement?  How long does your money have to last?  How will RMDs impact your drawdown?  What type of lifestyle do you want to live during retirement?  Are you planning on leaving a legacy?

I am not trying to convince you on how you should allocate your portfolio during retirement.  That is ultimately your decision.  Everyone has a unique financial situation.  The purpose of this post was to examine how different conservative portfolios might perform during the drawdown period.  I am just trying to convince you to do your due diligence before you rush to any financial decisions that will impact your quality of life down the road.

After reviewing these results, it shows that diversification is still important during the drawdown period.  Just as holding 100% in stocks is too aggressive for most investors during their working years, holding 100% in bonds might be too conservative for investors during the drawdown period.  When an investor is working on building their wealth, holding a percentage of bonds helps to reduce the impact of how stock market volatility impacts a portfolio.  During the drawdown period, holding a small percentage of equities greatly improves the likelihood of not running out of money in retirement.

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Should Millennials Contribute to a 401K?

No, that is not a rhetorical question.  I was having lunch the other day with my co-worker Jill.  Jill is an exceptional young woman.  Jill’s parents divorced when she was young, so she grew up in a broken home.  That did not stand in the way of her excelling in school.  She went on to earn a BA in Psychology from one of the best state universities in the country.  She is also considering going back to graduate school for a Master’s Degree in Public Administration.

Jill and I have worked together for almost one year.  Jill was lucky because she was hired just a few months after she graduated from college.  She is a great employee, person, and is highly ambitious.

She told me that she developed her work ethic as a young teenager.  She said that growing up without a dad around, she had to work to help her mom pay the bills.  Jill started working at age 14 and has always had a job during high school and while in college.

When we were talking, she told me that when her parents divorced they had an agreement to give each child $40,000 towards their college education.  Her brother went to Notre Dame and the money he received from his parents covered about one year of his education.  Jill opted for a state university that was only a 2-hour drive away from her Mother.

Jill’s education cost her parents $30,000.  Her parents tried to be fair about the dollar amount.  After graduating college, her parents also bought her a used car for $10,000.  Even though she did not get to watch the Fighting Irish play football in South Bend, she still made out well.

During our lunch, she told me that she feels bad for her current roommates.  Most come from families that are more affluent than her family. However, they all have student loan payments that cost $700 or more every month.

She asked me my opinion about her situation.  Should she feel bad?  What should she do with the extra money she has compared to what her roommates have?  She said that she did not grow up with much and does not want to waste it.

I told her that she is in a fortunate situation.  She has a unique opportunity to save a great amount of money since she does not have any debt and her only large bill is her monthly rent.  I suggested that she pretends that she has as much student loan debt as her roommates and to contribute $700 per month to our employer’s retirement plan.

She asked me “Should Millennials contribute to a 401K”?

I told her that millennials should absolutely contribute to a 401K.  I said that she especially should because she does not have any debt to pay back or major bills.  These are the reasons why she should start contributing:

  • She is 22 years old and by starting at that age, she can be well on her way toward financial independence (FI) in 15 years or less
  • Our plan offers low-cost index funds
  • Our employer matches 100% up to the first 5% an employee contributes
  • The contributions lower her taxable income
  • The money grows tax-free and is not taxed until she withdraws it at retirement
  • She can take advantage of dollar-cost-averaging
  • She can enjoy the benefit of compound interest
  • If she gets a different job, she can take the money with her and roll it over into an IRA
  • Even though I would advise against it, she can borrow against her account if need be

I explained to her that time goes by very quickly and she has a golden opportunity to build some serious wealth for herself.  Unless she lands a government job, she will not have a pension.  She will need this money to support herself in the future.

Jill has a unique situation.  She is a young millennial without any debt.  What makes her even more unique is that she is a new college graduate without any student loan debt.

If you have student loans, you should still contribute to your employers 401K account.  Even if it is just enough to get the match.  After you pay down your debt, take the dollar amount that you were paying towards your loans and direct it to your 401K.

You might not get to Financial Independence as quickly as Jill does.  You will, however, get there if you take a few steps.  If you have debt, pay off your debt and don’t create new debt.  Save as much as possible.  Sign up for your employers 401K plan as soon as you are eligible.

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Note: This post was originally published as a guest post.  The post was moved here because it was not available to be read on dollardiligence.com. That site is no longer active.

Early Retirement: Removing Barriers

Many people dream of reaching early retirement.  Few people, however, are willing to do what it takes to make it a reality.  In most cases, to reach early retirement, a person must live differently from how the masses live.  People generally don’t want to be viewed as being different from their fellows.

The masses are living for the day, spending most of what they earn, landing in debt, and are in denial about their personal finances.  They have high hopes that their financial future will be secure.  Hope, however, is not a strategy.

To reach early retirement, a strategy is needed.  That strategy will require action and more action.  The primary objective of that strategy will be to first reach financial independence.  Financial independence is what enables people to retire early.  If a person is no longer working, the money to sustain their lifestyle needs to come from somewhere.  For most early retirees, that somewhere is their passive investments.

The path to being able to retire early is full of barriers.  Many are external like being able to maintain a budget while marketers are doing everything they can to get you to break your budget and buy whatever it is they are selling.  Some barriers are mental.  The purpose of this post is to identify a few of these barriers and to establish a plan of action to avoid them.

Ignorance

Most people are unaware of what is required when it comes to planning for an early retirement.  That is even true for those who have attended college.  People who hold a 4-year degree or beyond still struggle with doing what is required to escape having to work for a living.

When it comes to establishing a financial plan, many people truly do not understand what is required.  They feel that things will just work out like they have in other areas of their life like landing a good job or getting a mortgage to buy a house.  They are generally in denial about what is required to build a large enough net worth to sustain their desired lifestyle once they are no longer working.

The good news is that once a person decides to learn more about personal finance, there is an abundance of great information.  Once a person takes that first step towards learning about budgeting, saving, and investing, they have removed one barrier.  Once that barrier has been removed, they will discover that the basics can carry a person a long way.  The basics alone might be enough to carry some people to financial independence.

Procrastinating

Procrastinating is another barrier that stands in the way of reaching early retirement.  Not knowing about a topic is one thing.  Knowing and not doing anything is another.  To reach early retirement, it takes many years of earning a salary, saving a large percentage of that income, and investing it wisely.

The longer a person waits to start this process, the harder it becomes.  That is based on compound interest.  Let’s assume that an investor needs to have $1,000,000 saved to declare financial independence.  They also want to reach this milestone by age 50.

Based on an 8% percent return, if an investor starts to save $1,800 per month at age 30, it will take 20 years to reach their goal.   If they wait until age 40 to start saving, they will have to save almost $6,000 per month.  If they started at age 22, however, they would only have to save $900 per month.

When you are young, time is on your side.  The older you get, the harder it becomes.  Don’t procrastinate if your goal is to reach early retirement.

Not investing in stocks

To receive a return close to 8%, an investor will need to have a large percentage of stocks in their asset allocation.  Based on how investments are projected to perform for the next 10 years, an 8% return might not be reasonable.  Large-cap stocks are projected to earn 6.7% threw 2026.  For that same period, investment grade bonds are projected to earn 3.1%.

The average person has the tendency to shy away from stocks.  In the short-term, they are volatile.  Over long periods of time, they are one of the best wealth building investments for individual investors.

Instead of parking your money in a money market that returns 1%, consider adding stocks to your asset allocation.  A good place to start is to look at a balanced portfolio of 60% stocks and 40% in bonds.  This allocation is popular because it provides growth from the stock allocation and the bond allocation reduces volatility when the stock market has a correction.  Another general rule of thumb is to invest (110 minus your age in stocks).  If you are age 25, you might want to consider having around 85% of your asset allocation in stocks.

Lifestyle Creep

Lifestyle creep is a form of inflation.   As a person advances in their career and their earnings increase, it is natural for their spending to increase.  As raises and promotions pile up, people have the tendency to upgrade their lifestyle.  Instead of saving more of their earnings, people buy bigger houses, fancier cars, and go on expensive vacations.

If there is lifestyle creep in your life, it is a major barrier between reaching early retirement and being stuck as a wage earner.  Lifestyle creep inflates how much money you need in your retirement account before you can retire.  In contrast, if you keep your monthly expenses low, the less you will need to be able to retire.

If you plan on withdrawing 4% from your retirement account, have $100,000 in annual expenses, you will need $2,500,000 in retirement savings.  For those who only have $40,000 in annual expenses, they just need to save $1,000,000.  The higher your annual expenses are, the more you need to have in retirement savings.

To avoid lifestyle creep, some management is required.  A solid budget is needed.  A financial plan is also a vital tool.  First, focus on the big expenses.  Keep your housing, transportation, taxes, and education costs low.  For example, live in your starter house forever, buy an economical car, live in an area that does not have high taxes, and take advantage of public schools and state universities.

If you can avoid lifestyle creep on the major expenses, you will have more money for savings.  This will also lead to less financial stress.  Instead of stressing to cover your bills that are always increasing, you will be able to better enjoy your life because there will be less demand for having to earn more and more.

Conclusion

For most people, the road to early retirement takes a long time.  It generally takes a couple decades of solid earnings, a high savings rate, and compound interest.  To achieve this ambitus goal, there are barriers that need to be identified and managed.

To be successful with personal finance, education is required.  The great news is that there is an abundance of good books, blogs, and forums that provide unlimited information.  A good place to start is the Resources page on this blog.

There is no such thing as an overnight success.  Most overnight success stories have been a fifteen-year work in progress.  If you want to be financially successful and retire early, start today.  It is not an overnight endeavor.

Without some risk, there will only be a little return.  Identify the correct mix of stocks and bonds for your situation.  Be sure to take your age and risk tolerance into consideration.

Manage your expenses.  The greater your expenses, the more money you must save and grow.  By keeping your expenses low, the less money you will need in retirement.

There will always be barriers that stand in the way of reaching early retirement.  Once they are identified, they can be managed and overcome.  Keep your eyes open for other barriers that might pop-up.  Be vigilant and stay focused and you will be sure to reach financial independence and retire early.

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Funding Retirement with the Bucket Approach

Have you ever considered separating the money that you plan on drawing down during your retirement based on the phases of your retirement?  A common approach is to allocate different piles of money in separate buckets based on when you plan on using the money.  The Bucket Approach was made popular by Raymond J. Lucia, CFP as the result of his book Buckets of Money.  The theory is based on building a diversified portfolio and spreading the risk out across different buckets of money.

A common approach is to use three buckets, however, more buckets can be used:

Bucket A – Money that will be used for the first few years of retirement (years 2 – 5)

Bucket B – Money that will be used for the second period of retirement (years 3  – 10)

Bucket C – Money that will be used to fund the remaining years of retirement (years 11 – 25 and beyond)

Asset Allocation for Each Bucket

Since Bucket A is going to be the first source of retirement funding, it is suggested that this portion of the asset allocation be ultra conservative.  That is to prevent a major stock market sell-off or recession to deplete the money that will be used to cover the first 2 – 5 years of retirement expenses.  In this bucket, the assets should be invested in CD’s, money market accounts, short-term bonds, or FDIC insured savings accounts.  By always having between 2 – 5 years worth of expenses in liquid assets that are easy to access, it helps from having to sell-off stocks when they have gone down in value.

Bucket B is going to be constructed of a more moderate asset allocation than Bucket A.  This bucket is designed to produce higher returns than Bucket A.  This bucket should have an asset allocation of around 65% in bonds and 35% in stocks.  The bonds are a low-risk investment that provides higher income than short-term holdings.  The stock portion is used to fuel growth and stay ahead of inflation.  The bond allocation could be made up of both an intermediate-term bond fund and a TIPS fund.  A large-cap index fund or large-cap dividend fund are good options for the stock portion of Bucket B.

Bucket C is going to have a more aggressive asset allocation than Bucket A and B.  This bucket of money will be used for long-term growth.  It will be made up of an asset allocation of 75% in stocks and 25% in bonds.  By keeping a portion in bonds, an investor can rebalance annually.  This practice of buying low and selling high improves the long-term performance and reduces the risk of this asset allocation.  For the bond allocation, a total bond market fund is a good option.  For the stock allocation, a more diversified mix of large-cap, small-cap, and international stock funds are used in this portion of the bucket for aggressive growth.

Refilling the Buckets

With a more traditional approach to asset allocation, a portfolio is viewed as a whole and not fragmented into different categories based on when the money will be needed.  For example, a balanced portfolio might be made up of 40% in bonds and 60% in stocks.  If stocks have a good year and the new asset allocation is 65% stocks and 35% bonds, the investor simply sells the stocks high and rebalances back to the desired asset allocation.

With the bucket approach, there is rebalancing within each bucket as well as replenishing between buckets.  Bucket A has 2- 5 years worth of living expenses.  When Bucket A has 1 years worth of living expenses drawn down, the difference will be replenished from Bucket B.  The same process applies between Bucket B and Bucket C.  When money is moved from Bucket B to Bucket A, Bucket B must be replenished from Bucket C.

Buckets vs Systematic Drawdown

Some financial advisors favor the buckets approach for the psychological benefits it provides investors.  When an investor is faced with a major market decline, they feel more confident because they know they have 5 years of living expenses in cash.  That financial cushion helps to prevent investors from selling stocks when they are at or near the bottom of a market.  Bucket A provides a level of comfort during good times and bad.

Other financial advisors prefer a systematic drawdown approach.  It is viewed as an easy approach for investors to understand and apply.  They feel that it is less complicated for an investor to view their portfolio as a whole and to use a safe withdrawal rate of 3 – 4% from a conservative portfolio of 50% in stocks and 50% in fixed assets.

There are more similarities between these two approaches than there are differences.  Even though there are three different asset allocations, in the three different buckets, when they are added together, they still can simply add up to the same mix of 50% in stocks and 50% bonds in the portfolio that is applied in a systematic drawdown approach.  It is just a different way of mentally accounting for assets during retirement.

Implementing the Buckets Approach

The buckets approach should be considered by people who are planning on retiring early.  Many people save up substantial resources in their 401K, but cannot access their money until age 60.  The buckets approach can be an alternative to a Roth conversion.  This approach just has to be planned years in advance because it requires an investor to build up substantial savings in their taxable account along with their tax-deferred accounts.

For this example, let’s assume that a person wants to retire at age 50, requires $50,000 per year for living expenses, and has $500,000 of their $1.5 million-dollar portfolio in taxable savings.  This scenario would be ideal for the buckets approach:

Bucket A – $250,000 in taxable savings (age 50-55)

Bucket B – $250,000 in a taxable account (tax-free bonds, age 56-60), the remaining mix of assets in an IRA or 401K to be drawn down after age 60

Bucket C – All in an IRA or 401K

Conclusion

The buckets approach is slightly more complex than a systematic drawdown strategy.  The main benefit is that it helps to keep the mind of the investor more at ease during all market conditions.  If managed correctly, the theory is that an investor will always feel secure because they always have 2 – 5 years of cash to fund the next few years of expenses.

The buckets approach is customizable to your unique situation.  The three buckets approach is the most common strategy.  It is the most ideal for a retiree who has at least 25 years of living expenses in savings.

More buckets can be added.  For example, if you have more than 25 years worth of projected living expenses in savings, you can add more buckets to extend your savings further out into the future. You also must take into consideration if you have a taxable account, a 401K with RMD’s (Required Minimum Distributions) at age 70, a Roth IRA account that does not require RMD’s, and Health Savings Account (HSA) to cover future medical bills.

If you are looking at establishing a conservative drawdown strategy, a buckets approach is worth considering.  It requires a little more work than a standard systematic strategy.  However, if you enjoy the mental accounting, the extra work might add to your peace of mind.  Just as when you were working towards building your wealth, the best plan is the one that you can follow.

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Is Investing Like Gambling?

Over the years, I have heard people compare investing to gambling.  It normally occurs during periods when the stock market is experiencing negative returns. People will make comments comparing investing in stocks to casino gaming.  Those who market alternative investment products will use heavy rhetoric and refer to conventional investments as the Wall Street Casino.

There are a few similarities between investing and gambling.  Investing and gambling both require money.  Both can be profitable.  Both can cause you to lose money.  Both require consideration.  Gamblers and speculators who trade frequently will look for favorable odds and try to come up with their own strategy to capitalize on what they think is a sure thing. That is basically where the similarities end.

Gambling is a game of chance.  Gambling is based on greed.  It involves a wager on an uncertain outcome.  Gambling comes in many different forms.  A gambler can bet on a sporting event like a football game or horse race.  Gamblers can play cards, roll dice, spin a roulette wheel, or play other casino games.  Buying lottery tickets is also a form of gambling.

Some forms of gambling are legal and others are not.  Betting on a horse race at a track like Churchill Downs is legal.  Calling up a bookie to place a bet on the big game is illegal.  The major difference between illegal and legal gambling is based on regulation and taxation.

One of the main differences between gambling and investing is that gambling is quite often based on immediate results.  For example, the results from a scratch-off lottery ticket are known as soon it is scratched off.  Some forms of gambling have longer waiting periods to know the outcome based on the results of a future sporting contest.  With all gambling, once the results are in, the outcome is known.

Investing is not a game of chance.  It is not a game of probability.  Investing is based on being prudent.  When you buy a mutual fund, it is not similar to hoping your number will come up when you roll dice.  By the way, you have a 2.778% chance of winning at rolling two dice and the casino has a 97% chance of taking your money.  Those are not favorable odds.

To invest in the stock of a company is to buy ownership in that company.   That company produces a product or service.  It is an entity that has financial statements and records.  Those records generally reflect why the stock price is worth its current value.

A mutual fund or ETF is a basket of different stocks.  By owning more than one stock in a fund, it helps to reduce risk and increase the likelihood of better returns. That is known as diversification and is based on the efficient frontier.

Diversification does not improve the odds when it comes to gambling.  It does not matter how many times you roll the dice.  The odds of rolling a pair of 6 sided dice will always be 2.778%.  The best you can do to improve your odds with games of chance is a switch from rolling dice to flipping a coin.  That would improve your odds to a 50% chance of winning.

Bonds can also be used to improve investment returns.  When stocks go down in price, bonds tend to go in the opposite direction.  Bonds are a loan to the government or corporation.  Some are guaranteed by the government.  They have a quality grade and risk associated with the term length.  Generally speaking, the shorter the term, the less risk.  Bonds are used for offsetting the risks of stocks or for income.

Stocks and bonds are also different from gambling when it comes to time.  Gambling is bound to time.  When the game is over, it is over.  There is just one opportunity to win or lose with gambling.

When an investment such as a stock is purchased, the amount of time that an investor has to earn a profit is based on how long they own the stock.  It can be a profitable investment for many years.  It can also lose money, but recover and become profitable again.  It is a time rewarding activity.  That is why many financial experts suggest a buy and hold approach.

Another key factor that separates investing and gambling are dividends.  Ben Carlson writes about this in his book A Wealth of Common Sense.  By investing in investments that pay a dividend, investors are rewarded for putting their dollars at risk based on market performance.  By holding on to a stock, a company will continue to pay a dividend.  Dividends are a key factor for making money in stocks over long periods of time.  There are not any dividends with gambling.

Investing also uses the power of compound interest.  This is another time rewarding aspect of investing that does not apply to a one-time wager.  For example, if you invest $100 and it has a 10% annual return, the following year the investment is worth $110.  If the investment is held for 25 years and continues to have a 10% annual return, the final amount of money will be $1,205.

Not only are gambling and investing different, they are totally different.  Every form of gambling is a game.  It is a game of probability.  The probability is always in favor of the house because of the vigorish.  It is a one-time chance to place a wager that might have a payout.

Investing in stocks is a business transaction.  It does not matter if you buy stock in a single company or buy hundreds of different stocks in a mutual fund.  It is a business transaction because the investor is buying ownership in a company or group of companies.  It is only a small fraction of ownership, but it is ownership never the less.

With investing, there are ways to improve performance and reduce risk.  An investor can buy stocks that pay dividends.  An investor can hold on to their investments and let compound interest work its mathematical magic.  The short-term market risks of owning stocks can be offset by also owning bonds.  By owning both stocks and bonds, an investor can rebalance their holding and always be buying low and selling high.

With gambling, the odds do not change.  As I explained with the dice example, there will always just be a less than 3% chance of winning.  The odds will always be in favor of the house.

During the next major market correction, you are likely to hear people say that you are better off taking your money to the nearest horse track or gaming parlor than to put it at risk in the stock market.  Yes, in the short-term, investing in stocks can be volatile.  Over the long-term, however, stocks are the greatest wealth building investment for the individual investor.  When they decline in value, look at it as a buying opportunity.  Gambling is based on a one-time event and the odds favor the house.  As long as you invest wisely and have patience, the odds are far greater in your favor than by playing games of chance.

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How to get Started with Airbnb

I am very excited about today’s post.  This is a guest post from my new friend Cubert from AbandonedCubicle.com.  In this post, Cubert shares how he is planning on retiring at age 46 and to abandon his cubicle for good.  As a more passive investor, this post has provided me with great insight into real estate investing as well as an introduction to what is required to operate an Airbnb business.  I hope you enjoy it and find it as educational as I did.

How to get Started with Airbnb

For those of you who don’t know my story, here’s a little primer. I go by the pseudonym Cubert to keep a little anonymity on my blog, AbandonedCubicle.com. I’ve been a student of early retirement since the fall of 2014.

Around that time I discovered that it is possible to retire early with very little actual sacrifice and much to gain. That’s a good thing. See, we’d had our first kids – twins – just a year earlier. If life wasn’t crazy enough with work, the home front changes pushed us over the line.

I’m now within a year and a half of ending my cubical days for good. I’ll be 46, which is nowhere near as exciting as others who’ve reached that milestone in their 30s. But then, I have no regrets. And honestly, who can complain about being done working for the man a good 15 or 20 years before Fidelity says you should?

My Plan

It’s interesting how life-changes sometimes come in bunches. Within a span of two years, we started a real estate rental business, changed jobs, had twins, and then locked in on early retirement. Whew. Makes my head spin just thinking about it!

The real estate rental business turned out to be crucial in our wealth building progress. We definitely went out on a limb, but with the help of a good friend already in the business, I had enough confidence to buy our first rental – a short sale single family house.

We weren’t flush with cash. I had to take out a home equity line of credit on our primary residence to afford the down payment. Once we closed, the list of improvements grew to a tally of almost $5,000. Man, what had we gotten ourselves in to?!?

Long story short – this first house got rented out within two months of closing. Rent checks started flowing in. We closed on our second rental just six months later, right around the time we welcomed our twins into the world. Rentals three and four followed in 2015 and 2016.

Ultimately, each of our four long-term rentals have paid off handsomely. Thanks to a strong market here in Minneapolis, we can command good rents. Plus, the tenants we attract have been great to work with. Never a late payment, and often they’ll put their own money into small improvements. We clear about $500 in net profit per house, per month.

1 Our First Rental – “Rental A”

How Airbnb Came into the Picture

In 2017, the pickins were slim. The housing market had really taken off in the Twin Cities. Houses that once sold for $100,000 were now going for $150,000. In my quest for our fifth rental, I kept running into windmills. Cash-on-cash returns just weren’t adding up on the overpriced dumps that were available.

About ready to give up, we visited my folks in Charlevoix, Michigan last August. I was perusing the local paper and decided to take a peek at the real estate listings on the back page. I noticed a condo for sale in the same development where my parent’s spend their summers. It was bare bones, with zero updates since having been built in 2005.

I figured, at $125,000 list price, what could it hurt to have a look? This area is a great summertime destination. A new vacation rental option started to dance around in my head.

What is Airbnb?

For those uninitiated (which included yours truly until a few years back), from Wikipedia:

Airbnb is an American company which hosts an online marketplace and hospitality service, for people to lease or rent short-term lodging including vacation rentals, apartment rentals, homestays, hostel beds, or hotel rooms. The company does not own any lodging; it is a broker which receives percentage service fees from both guests and hosts in conjunction with every booking. In January 2018 the company had over 3,000,000 lodging listings in 65,000 cities and 191 countries.

For a company that started nine years ago, that’s a pretty impressive number of lodgings. How long did it take Hilton to build that many rooms? All Airbnb’s founders had to do was harness the Internet, create the marketplace, and take their 3% cut from each booking. Genius.

As we worked through the offer process and closing on the condo this past fall, I was also digging into my research. We’d stayed at a couple of Airbnbs, but we sure as heck hadn’t hosted any. A few helpful sources: Pinterest (see Financial Panther) and a very helpful book called “Get Paid for Your Pad” by Jasper Ribbers and Huzefa Kapadia.

The Easy Parts

Setting up your digs, whether it’s a spare room in your house, or a wholly furnished separate dwelling is pretty straightforward on Airbnb’s interface. I give them credit for creating a highly intuitive experience for hosts.

I will warn, however, that there are a LOT of variables that come with hosting. You don’t just set your nightly price, upload a bunch of pics and wait (and hope!) Nope. You’ve got to figure out check-in, check-out times. You need to create a house manual.

There’s more. Do you want to set a strict or flexible cancellation policy? Do you want to include a security deposit? How much will you charge guests for cleaning? This is where that handy book “Get Paid…” was a real life-saver.

1 So many variables to set!

Once you do get everything all set up, there’s a certain amount of apprehension that sets in. You have ZERO ratings. Who in their right mind would rent from you? This is why it’s super important to channel your inner marketing skills.

Study this sh*t out of your area Airbnb market. Use the best photos. Make sure your prices are strategically set to account for seasonality and local events. Even after you think you’ve got a handle on everything, be prepared to wait patiently.

I’ve got four whole bookings set for the next 9 months. Once reviews (hopefully 5 stars) start coming in, I’m certain the bookings will ramp up.

The Hard Parts

Then, there’s getting a place ready for prime time. In our case, we had purchased a really solid condominium unit that was not much over 10 years old. As they say with houses, “the bones were good.”

That said, the place was used as a Coast Guard rental. The carpet was original, and the walls were beaten up all to hell. There certainly weren’t any improvements that I could see during that first walk through. All original fixtures, and a lot of wear and tear.

Before…

The bottom line is you’ll likely need to put in some good ol’ fashioned elbow grease to get your property ready for vacation rental use. A LOT of elbow grease. Remember, these types of rentals have to be fully furnished (unlike long-term rentals, where tenants furnish the space.)

After…

Conclusion

I’m really enjoying the journey to my early retirement. Over the past three-plus years of the countdown, I’ve come to appreciate all the trouble I can get into outside of a cubicle. Working on homes and managing properties gets me out of a seated-all-day position. I get to produce something tangible.

We’ll see how the Airbnb Experiment goes. I’m optimistic about its potential, but I’m still learning and researching as much as I can before the high season hits this summer. Just this week, I’ve opted to fire up a listing on VRBO.com. Marketing through more than a single channel is never a bad idea.

I’ll leave you with one last bit of advice: More than anything, I’ve learned that early retirement is simply a means to an end. It should never be just an escape from a bad situation. Instead, “early retirement” is best when you use it as a launch pad for big ideas, projects, and hustles that align with your passion. Endless vacations get a little stale after a while.

Fire Your Financial Adviser

I have been on the journey toward financial independence for a long time.  I started saving and investing to reach financial independence at age 20.  When I decided that I wanted to become wealthy, I knew that I needed to be educated on how to turn this goal into a reality.

While at college, I studied Business Management.  Even though I tried to take as many finance classes as possible, I did not learn much about personal finance.  Sure, I studied financial analysis and other classes, but the content was mostly geared towards learning how to dissect financial statements.  It was taught more from the standpoint of learning how to become an administrator.  Those classes have helped me during my career, but not so much as an individual investor.

My goal was to learn how to invest to receive optimal returns.  There are many mixed messages when it comes to investing.  My focus was to learn how to become a successful investor.  In order to do that, I had to learn how to sift through the noise and to find the most practical content to help me learn how to manage my finances.

Since 1997, I have read almost 100 investing books.  Over the years, I have subscribed to many different personal finance magazines and journals.  Most of the time that I spend online has been reading investing articles, forums, or blogs.

I have read many great financial journalists, bloggers, and random forum posts that have helped me with my financial planning.  There has been one person, however, who I have always enjoyed reading.  That person is Doctor James Dahle.  Before I knew him by his actual name, I knew him as The White Coat Investor.

The first time that I came across The White Coat Investor was in 2007.  This was a very volatile time for investors.  The Great Recession was on the horizon.  There were many posts on the Bogleheads.org forum from The White Coat Investor that helped me to stay the course, tune out the noise, and to focus on investing for the long-term.  I am thankful for those posts by The White Coast Investor and grateful that I followed his advice.

The White Coat Investor’s target audience is primarily Medical Doctors and other high-income folks.  Most of what The White Coat Investor writes about, however, transcends profession and tax brackets.  His financial advice can be applied to anyone who is working, saving, and investing to reach financial independence.

To help Doctor’s and other high-income professionals reach financial independence, The White Coat Investor has recently launched a new course.  The focus of this online course is to teach high earners how to create a financial plan that is tailored to their unique financial needs.  It is a step-by-step course for creating and implementing a financial plan without having to use a financial advisor.

The course is based on 12 learning modules.  I have reviewed the content.  It is truly a bargain for only $499.

There is a reason why this course is titled Fire Your Financial Advisor.  After you complete this comprehensive course, you will no longer have to pay a financial advisor for their services.  You will be prepared to manage all of your finances by yourself.

This class goes a step beyond what a financial advisor traditionally helps with.  Fire Your Financial Advisor is not just another way to promote passive investing in index funds.  It is tailored to the needs of physicians and other high-income professionals.  After finishing the course, you will be more confident on how to manage your student loans, insurance, taxes, estate planning, legal protection from lawsuits, as well as everything you need to know about managing your investments.

As part of the 12 modules, you are provided with 7 hours of lectures, videos, and screenshots that you can refer to at any time.  As you advance through the material, there are pre-tests, quizzes for each section, and a final exam.  Upon completion, the course is set up to ensure that you have total mastery of the material.

It would take hundreds of hours of independent research to learn what The White Coat Investor provides in Fire Your Financial Advisor.  As a busy professional, do you have the time to read 30 or 40 books on these subjects?  Even if you do, you will not find many where the content has been written by a physician who understands your unique situation.  The White Coat Investor does all the heavy lifting for you.  He provides you with what you only need to know.  There is zero waste in this course.

Another great feature about the Fire Your Financial Advisor course is that there is not any risk.  Buy it and check it out.  If you find that it does not provide you with what you need to optimize your finances, there is a 7 day, risk-free, guarantee to return it.  It would be difficult if not impossible to hire a financial advisor who offers a money back guarantee.

The White Coat Investor is one of the good guys in the world of personal finance.  If you are a doctor and want to take control of your finances, check out Fire Your Financial Advisor.  You truly have nothing to lose other than $10,000 or more in annual fees that your financial advisor will charge you for what you can be doing yourself for free.

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