Are You Self-Destructive?

“A lot of people with high IQ’s are terrible investors because they’ve got terrible temperaments. You need to keep raw irrational emotion under control.”

Charles Munger, Vice-Chairman of Berkshire Hathaway, is right. You could be the smartest person in the world, but you might end up being a self-destructive investor.

If you flash back to last week’s post, I talked about why dollar cost averaging was important, and how you’re able to take advantage of stock sales when the market is down. I also said that when you invest in the market monthly or periodically, you’re more likely to stick with investing. That all makes sense, right?

Prospective clients come into the office too many times with an account they’ve decided to manage themselves. If you’re an investor, you want what’s best for your account. Your emotions can get in the way of that though.

I saw this graph and wanted to share it with you. It compares the average stock fund return to the return of the average stock fund investor. The average stock fund investor is getting a 5.2% return annually. This might not seem bad, you might even be saying, “Well that’s a lot more than what my savings account earns.” You’re right! But that average stock fund investor missed out on an additional 3.9% return. I would be willing to bet that if they could go back and stick with a stock fund, and get that additional 3.9%, they would.

I think it’s safe to say we would all rather have a 9.1% annual return than a 5.2% annual return.

Stock Investor

There are some skeptics out there, I’m sure. They think they’re great investors and they don’t fit into the chart. They think that they effectively time the market, and they can chase hot investments. They feel like they can do better by doing it themselves. This next paragraph is for the skeptics.

The market goes up and down. You know how you feel when that happens. For most investors, when the market makes a comeback from a low point, they start to get excited. They typically buy stocks or add money into stock funds. Things are looking up, and they’re investing in the market. The market keeps climbing and they’re thinking “Wow, I’m the smartest person in the world.” The market hits it’s peak. They’re ecstatic. Know what happens after something peaks? It starts to drop again. Now that investor has anxiety. Most of the time they’ll deny the drop, and the market keeps going down. They’re thinking “This was a horrible decision, I should get out before it bottoms out.” Enter panic mode. They sell. They say they’re never investing again. Market hits bottom and they think, “Good thing I got out when I did!” Do you know what happens next? The market makes a comeback. Now they’re upset. The market grinds higher and they want back in.

Do you see the problem here? When the typical investor feels excited about the market and thinks they’ve made the best decision ever, the market is getting to its peak. This is when investors have the most risk of loss. When the market is down and the investor is glad they got out before rock bottom, they missed out on the largest potential to earn.

This is why the average stock fund investor ends up doing worse than the average stock fund return. You should buy when the market is low, and sell when the market is high. Most investors do exactly the opposite.

Being an investor is hard. Your emotions can and most of the times will get the best of you. Having a plan and sticking to it is one of the most important things to do as an investor. If you make systematic investments, you are more likely to outperform the market. A financial advisor can help you stick to your plan when the market is fluctuating, reassure you when volatility is high, and help you stay disciplined and focused on your long term goals.

Instead of a sweet treat this week, I’m going to share a client story with you. With their permission of course.

Client XXX was getting ready for their first child. They knew how expensive college was and how important it was to have money set aside.

Their goal? Save for college. Their plan? $250 a month.

They opened a 529 account for their daughter and contributed $250 a month, every month, on the 20th. Baby number two came around not too long after and they put the same amount of money into another 529 on the same date of the month, every month.

The client contributed this way for eighteen and a half years per child. Let’s do the math together. 18.5 years times 12 months in a year times 250 dollars equals a grand total of $55,500 per account.

Do you want to know how much money they had in each 529 after eighteen and a half years? It was upwards of $300,000. By the time their children went to school, they didn’t care whether they went in state or out of state, and they didn’t have to worry about not having the resources to pay for it. Because they stuck to their plan, they were prepared for whatever might happen.

That is the power behind having a plan and sticking to it. When you make a plan to systematically invest and you don’t try to time the market on your own, odds are you will end up doing better than you otherwise would.

Don’t let your emotions get in the way of your investments. Need a plan or help sticking to it? You might want to consider a financial advisor.

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No 401(k)? No problem.

401(k)s are the most efficient retirement plan. Recapping my last post, if you have a 401(k), take advantage of it. Especially the before tax contributions. Tax deferred compounded growth is incredible over time, some might say it’s magical.

“What if I don’t have a 401(k)?”

There are other retirement plans out there- don’t worry. Employers have other types of sponsored plans and you can always set up your own. In this post, I will focus on the traditional Individual Retirement Account, also known as an IRA.

If your company doesn’t offer you a retirement plan like a 401(k) or a 403(b), you can open and contribute to an IRA.

Some things you need to know about an IRA:

  • You can contribute a maximum of $5,500 a year
  • You can contribute until you are 70.5
  • If you are not covered by a qualified plan, your contributions are tax deductible
  • When you take money out of your IRA at retirement, you will be taxed on the distribution
  • If you take a distribution before you are 59.5, you will incur a 10% penalty
  • You are required to take a minimum distribution from this account starting at age 70.5

Downside to an IRA? If you put more than $5,500 a year in, you will incur a 6% annual penalty tax on the excess amount. You will keep getting taxed as long as that excess stays in the account.

New tax law changes allow individuals over 50 years to contribute an additional $1,000 a year without getting hit by the penalty tax. This is known as the “Catch Up” provision. If you start saving for retirement early, you probably won’t need the Catch Up provision. If you don’t think about retirement until you’re 50, then this can be a useful tool.

Another type of IRA is the Roth IRA.

Some things you need to know about Roth IRA:

  • You can contribute a maximum of $5,500 a year
  • There is no age limit for contributions into this account
  • There is no tax deduction up front
  • Withdrawals are tax free (as long as the money is kept in the account for five years and you are 59.5)
  • There is no requirement to take a minimum distribution from the account when you are 70.5.

Downside to a Roth IRA? High income earners (over $131,000) can’t contribute to it.

If you have an employer sponsored retirement plan, you can still open up an IRA and contribute to it. You could have both a  Roth IRA and a traditional IRA if you wanted. Disclaimer with having a Roth and a traditional IRA: you can only contribute a total of $5,500 into the two accounts yearly.

When should I invest?

If you open an IRA, I strongly suggest putting money into that account monthly. Sure, you could put a lump sum in all at once if you wanted to, but you will miss out on sales. Who doesn’t love a good sale?

If you put $100 into your IRA monthly and the market is down, you’re taking advantage of the market and buying more shares at a lower price. Most investors are too scared to invest when the market is down. They don’t get to take advantage of the market like systematic investors do.

Systematic investors outperform the market over time because they remove their emotions from investing.

When you invest the same dollar amount monthly or periodically in fund shares, you’re using an investment method known as dollar cost averaging. As long as prices fluctuate fairly evenly, dollar cost averaging always results in slightly more shares being purchased, resulting in a lower average cost.

You get more for your money this way. You worked hard to invest that money, make sure you’re getting all you can from it.

Another reason I suggest systematic investing? Maxing out your IRA in one or two transactions is overwhelming. Especially if you are just starting out. By investing smaller monthly amounts, you are able to take advantage of dollar cost averaging and you aren’t left with a big hole in your pocket that month.

How do you eat an elephant? One bite at a time.

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Speaking of bites…this week’s sweet is one of my favorites, hummingbird cake.

Disclaimer: no birds were harmed in the making of this cake.

Pineapple, pecans, bananas, and cinnamon go so well together. Instead of using crushed pineapples, I like to cut the pineapple into larger chunks. I think it’s nice getting a larger piece of fruit, it makes the whole cake eating thing seem a little healthier. Seem being the key word here.

I was pretty rushed on time, so I decided to try the rosette frosting technique again. I finally got it right- starting from the inside and working my way outside. I think it looks a lot better than the last one!

It’s safe to say that this cake will also be making an appearance at Easter dinner.

That’s all for this week, folks! If you have a question on which retirement plan is right for you, why dollar cost averaging is a great investment method, or anything else, shoot me an email at bcchesney@wbjackson.com.

Thanks for reading!