Eight guarantees retirees can count on
Reprinted courtesy of MarketWatch.com
Published: May 22, 2013
To read the original article click here
Investors do all sorts of foolish things in search of “guaranteed” returns. But the bigger fools are those who fail to take advantage (in some cases) and beware of (in other cases) things that really are guaranteed.
I’ve made a list of eight for you to think about.
By “guarantee,” I mean a promise or assurance that something will happen, that the outcome is certain. Of course I know that nothing in life is absolutely certain (although death and taxes come pretty close), but I believe the following guarantees are 99.9% reliable.
One: I guarantee you will get more money from a bank certificate of deposit that pays a higher rate than one paying a lower rate. As obvious as this is, millions of investors ignore it.
Washington Federal pays 1.5% on five-year standard (non-jumbo) CDs; at Bank of America, the rate is 0.35%. Both CDs are covered by the FDIC guarantee. A $25,000 account will pay nearly $1,500 more in five years at Washington Federal. So why do retirees keep their money at Bank of America? Other than laziness, it beats me.
For the 50 or 60 minutes it might take to find and deal with the higher-paying bank, you could earn almost $1,500. Where else can you make that much money per hour?
The same is true of interest-bearing checking accounts, savings accounts and money-market funds.
Two: I guarantee that nobody knows the future. So why do so many retirees squander their savings and their common sense following salespeople or gurus (or neighbors for that matter) who claim to know what’s ahead?
The next time somebody assures you that you “can’t miss” on some investment, remember the sad story of a man I know who, based on that “guarantee,” put his life savings, and those of his wife and their kids, into stock of an individual company. A few weeks later that company declared bankruptcy.
Three: Wall Street doesn’t want you to know this, but if you have any money invested in equities, I guarantee that you will lose money at some point. Investors are always eager to hear about my guarantees, but when I tell them this one, they react as if I am speaking a foreign language.
The good news is that it’s relatively easy to build a portfolio that includes equity funds and is still likely to limit your losses. The bad news is that if you don’t do that, you may engage in panic selling, locking in those losses forever.
Four: If you use index funds, you’re guaranteed to get above-average returns. This seems to defy logic, but most of the time, the majority of active managers underperform their benchmark indexes. The main reasons are higher expenses and mistakes of timing and stock selection.
Over long periods of time, 10 to 20 years, index funds’ returns are almost always in the top 10% in their respective asset classes.
Five: Within any asset class, a diversified portfolio is guaranteed to have less risk than a concentrated portfolio. Own a handful of stocks, and there’s a reasonable (even if small) probability that one of them will get into serious trouble and pull down the overall return. But if you own 1,000 stocks, there’s almost no chance that one or two will drag down the rest. (Of course, the entire asset class could decline in value, but that’s a different topic.)
Six: If you pay a load or sales commission to buy a mutual fund, you are guaranteed to have lower returns than if you bought the same fund on a no-load basis. Pure mathematics makes this inevitable, and the longer you own the fund, the greater the real cost of the load.
If you invest $10,000 and pay a 5% front-end load, your account is worth only $9,500 at the end of the first day. If the fund earns 10% a year, after 25 years the account is worth $102,930. Had your entire $10,000 been invested, it would have been worth $108,347. The difference, $5,417, is entirely the result of the load, and it amounts to more than half your entire original investment.
Seven: Whether or not you pay a sales commission, if two funds have identical portfolios and management, the one with lower expenses is guaranteed to have a higher return.
This is most obvious with index funds. I have been unable to find any case of two comparable index funds in which the one with higher expenses also had a higher return. In the 10 years ended March 31, 2013, the Vanguard 500 Index Fund VFINX, +1.00% had a compound return of 8.42%. The DWS S&P 500 Fund SCPIX, +1.00% returned 8.15%. Most of the difference came from the two funds’ expense ratios: 0.17% for the Vanguard fund versus 0.38% for the other.
Eight: Inflation is guaranteed over time to erode the spending power of every dollar you have when you retire. The future may include occasional periods of deflation, but over time there is no place to hide.
In addition, I guarantee that nearly every retiree underestimates inflation’s long-term effect.
Over the past half century, U.S. inflation was approximately 4%. What you could buy for $100 50 years ago would cost about $700 now. Many people retire with at least 25 years left to go. At this 4% rate, that means they will someday have to pay $266 for the things that cost $100 at retirement.
Richard Buck contributed to this article.
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