This week we finish up the principles for achieving financial independence (see Part 1 and Part 2). Most people will never achieve financial independence. According to the Social Security Administration, 55% of people drawing benefits have no other income and savings of less than $25,000. This is a sad statistic considering Social Security was only designed to supplement a person’s income in retirement.
Principle 6: Build a New Three-Legged Stool™.
Anyone who has ever read a basic investing book or taken a class on investing knows the importance of diversification. It is just as important to diversify the way you save as it is to diversify how you invest. Your savings should be divided into three categories we call the New Three-Legged Stool:
Leg One: Tax-Deferred Savings. This is the money you save pre-tax in a 401(k) or traditional IRA. Saving money in these accounts have immediate tax benefits usually in the form of deductibility. They also provide long-term tax benefits through tax-deferral of the earnings. Unfortunately the tax man must be paid when funds are withdrawn.
Leg Two: After-tax Savings. This is the money you save in a bank or brokerage account that has no tax preferred treatment. Funds are saved after tax and the earnings are taxed each year they are realized. The benefit to you is accessibility and preferred tax treatment when the funds are withdrawn. There is never a tax penalty to access the money.
Leg Three: Tax-Free Savings. The final leg is the Roth IRA and Roth 401(k). The Roth IRA has become a popular way to expand retirement investing for many investors because, although contributions are not tax deductible, Roth distributions can be tax free if certain conditions are met, and the owner is not required to take distributions at age 70½.
The goal is to balance your savings and investments into all three legs. This allows you to take advantage of some immediate tax benefits while putting money away in areas that will benefit your taxes in the future. This is the ultimate in tax efficiency. Too many people only save money in their tax deferred account because they get the current tax deduction. This is short sighted thinking because every dollar they try to spend from these savings will be subject to tax. Tax brackets may never be as low as they are today. A one sided savings plan that relies only on tax-deferred savings could find the owner paying taxes at a higher rate than while they were working.
Principle 7: Embrace the volatility of the stock market.
Most people do not like volatility. They equate volatility to risk and to a large extent, they are correct to do so. I’ve had people tell me they would rather have the relative certainty of a two-percent return from a certificate of deposit (CD) than invest in the stock market, where historic returns average close to 10 percent. Unfortunately, they ignore the fact that inflation has historically averaged nearly four percent. All they’ve guaranteed is a reduction in volatility, not the success of their financial future. Some investors frequently shift their money in and out of the stock market. They will get out when they fear a crash and get back in when they expect a boom. The problem with trying to time the market is that no one can consistently predict the short-term events that push the market up or down.
Investors may be better served to embrace the volatility of the stock market. It’s the volatility that produces the 10-percent-average return. If stock prices were stable, the returns may not be as high. The investing profession calls this a “risk premium.” This simply means that if an investor is to put up with the volatility of his or her portfolio, that investor should be rewarded with a higher return (although there are no guarantees). It makes sense.
Principle 8: Diversify and rebalance to succeed.
Too many people assert that long term investing doesn’t work anymore. They point to the last 10 years and call it the lost decade – a period when no money was made in the market. We believe that a successful long-term investment strategy should be based on broad diversification over all the asset classes with periodic rebalancing to take advantage of market volatility. Allocate your assets across the major asset classes — stocks, bonds, and cash — to help you pursue the optimal returns for the risk level you are willing to undertake. Diversify within each class to take advantage of different investment styles — such as growth and value stocks —and various size companies — such as large cap and small cap stocks.
Rebalance periodically. Market activity can shift the percentages of your portfolio that you have dedicated to each asset class. One of the most common investor mistakes is to sell stocks and/or stock mutual funds once they have gone down in order to ‘avoid’ further losses. A better approach is to buy more stocks after a decline to take advantage of lower prices. For example, let’s assume you have 2 assets that are each 50% of your portfolio. If one declines to 45%, the other has to go up to 55%. If you are trying to maintain 50% in each asset then you need to buy 5% more of the asset that is down to 45%. If you follow this approach with an investment portfolio, in both up and down markets you would be buying low and selling high.
- Always diversify your savings so you have money in all three legs – tax-deferred, after-tax, and tax-free accounts.
- Let market volatility become your friend and not something to be feared.
- Rebalancing allows you to take advantage of the ups and downs of the market. Buying low and selling high is a successful investment strategy.