Investing is Not a Competition Between Stocks and Bonds

Jane Young, CFP, EA

Many investors think of investing as a competition between investing in the stock market, interest earning investments and real estate.  Too many people take a strong stance for or against one of these three broad categories rather than embracing the advantages that each one can bring to their portfolio.  A well balanced portfolio should include some of all three with each serving a very different purpose.

All three categories will have their day in the sun depending on the investment climate.  Due to low rates, interest earning investments such as CDs, bonds and savings accounts aren’t getting much love right now.   Despite the current low rates of return, interest earning investments provide a relatively safe place to keep your short term money.  This is money needed to cover living expenses or emergencies over the next several years.  Interest earning investments provide a buffer against more volatile investments in the stock and real estate markets.   Keeping a portion of your portfolio in safer, fixed income investments can give you greater peace of mind and help you stick to your long term plan when the stock market gets rocky.  However, avoid putting too much in interest earning investments; this can make it difficult to keep up with inflation and earn the growth needed to support your retirement goals.

On the other hand, when the stock market is doing well everyone wants to get a piece of the action. Avoid overloading your portfolio with stock when the market is skyrocketing.   Investments in the stock market can provide you with long term growth and a hedge against inflation.  Historically, the stock market has trended upward and over long periods of time has outperformed other investment categories.  However, in the short term the stock market can be very unpredictable and volatile and should only be used for long term needs – money that isn’t needed for five to ten years.  Keep your short term money in interest earning investments.

Real estate serves a dual purpose for most investors, it gives us a place to live and it provides us with an asset that usually appreciates over time.   In addition to your home, as your portfolio grows, you may want to consider additional real estate investments in mutual funds or rental property.  Like the stock market, real estate should be treated as a long term investment.  The real estate market can experience extreme downturns and commonly lacks the liquidity needed to cover short term needs.

These three categories of investments have their advantages and disadvantages.  Focus on the role the asset plays in your financial plan and avoid becoming overly comfortable and confident with a single category – it’s all about balance.  The appropriate amount in each category will vary over time and is dependent on your age, your financial goals, your cash flow needs and your risk tolerance.

Mutual Funds Best Option for Most Investors

Jane Young, CFP, EA

Jane Young, CFP, EA

There are three primary ways to invest in the stock market; mutual funds, exchange traded funds (ETFs) and individual stocks.   With mutual funds and ETFs your money is pooled together with money from other investors and is professionally managed in accordance with a predefined objective.   Some major benefits of investing in mutual funds and ETFs include diversification, professional management and time savings.  Some disadvantages of mutual funds may include management fees and less control on when gains become taxable.

An essential factor in effectively managing your portfolio is diversification and it’s difficult to maintain a diversified portfolio without investing a significant amount of money.  A diversified portfolio should be comprised of a combination of fixed income investments and stock market based investments.  The stock based investments should be comprised of small, medium and large companies in a variety of different industries in both the United States and abroad.    Investing in a wide variety of companies and industries can spread out your risk.  Mutual funds allow you to easily diversify your portfolio by pooling your funds with those of other investors.  Instead of buying 10 individual stocks you can by 5 to 10 mutual funds in different areas of the market, each of which may contain hundreds of companies.

Although managing your finances should be a priority, most investors lead busy lives and don’t have the time to research and monitor individual stocks.   Mutual funds can be a good alternative to doing your own research.   Most mutual fund companies have entire teams of highly skilled analysts who visit companies, analyze data, assess the competition and monitor industry trends.  It would be difficult to attain this level of knowledge and understanding on your own.  Additionally, professional management provides the methodology and discipline to keep emotions out of investment decisions.  When investing in individual stock, investors can become emotionally attached to a company whose stock has performed well.  This can result in dangerously high concentrations in a few individual companies.

Mutual funds and ETFs use a broad approach that generally tracks more closely to the entire stock market or a specific index.  Individual stocks, on the other hand, can provide the opportunity to break away from market performance to make a significant profit, if you select a winner.  However, you many also experience a significant loss if the stock is a loser.

Some potential disadvantages of mutual funds in comparison to individual stocks include management fees and less control over when you pay capital gains tax, within non-retirement accounts. With individual stocks and ETFs you don’t pay capital gains until you sell your shares.  However, when a mutual fund manager sells stock within a fund, gains earned on the stock are passed through to the shareholder as a taxable gain.  This gain is added to the investor’s basis in the mutual fund to avoid double taxation when the fund is eventually sold.

Financial Mistakes to Avoid as You Approach Retirement

Jane Young, CFP, EA

Jane Young, CFP, EA

As you enter your 50s it becomes increasingly important to incorporate retirement planning into the management of your finances.  Your 50s and 60s will probably be your highest earning years at a time when expenses associated with raising children and home ownership may be tapering off.  It’s crucial to take advantage of the opportunities during this time to shore up your retirement nest egg.

One significant retirement mistake is the failure to assess your current financial situation and understand how much is needed to meet your retirement goals.  Many underestimate the amount of money required to cover retirement expenses which may result in delaying retirement.   Consider hiring an advisor to do some retirement planning and help you understand your options, how much money is needed, and what trade-offs may be required to meet your goals.

Another common mistake is to move all of your retirement funds into extremely conservative options, as you approach retirement.  With the potential of spending 30 to 40 years in retirement, it’s advisable to keep a long term perspective.  Consider keeping your short term money in more conservative options and investing your long term money in a well-diversified portfolio that can continue to grow and stay ahead of inflation.  As you approach retirement, it’s also important to avoid making emotional decisions in response to short term swings in the stock market.   Emotional reactions frequently result in selling low and buying high which can be harmful to your portfolio.

Many in their 50s and 60s have more disposable income than at any other stage of life.  Avoid temptation and be very intentional about your spending.   Avoid increasing your cost of living with fancy cars and toys or an expensive new house as you approach retirement.  Instead, consider using your disposable income to pay down your mortgage or pay off consumer debt to reduce your retirement expenses.

Another common pitfall is spending too much on adult children including your child’s college education.  The desire to help your children is natural and admirable but you need to understand what you can afford and how it will impact your long term financial situation.  Place a cap on how much you are willing to contribute for college and encourage your kids to consider less expensive options like attending a community college or living at home during their first few years of college.   They have a lifetime to pay-off reasonable student loans but you have limited time to replenish your retirement funds.

Finally, a failure to care for your health can be financially devastating.  If you are healthy you will probably be more productive and energetic.   This can result in improved job performance with more opportunities and higher income.  If you are in poor health, you may be forced to retire early, before you are financially ready.   You also may face significant medical expenses that could erode your retirement funds.

Defending Yourself Against a Market Correction

Jane Young, CFP, EA

Jane Young, CFP, EA

The recent increase in the stock market is making a lot of investors nervous about the possibility of a significant correction.  I am frequently asked what the market will do over the next few months.  In reality, no one can predict market performance, especially in the short term. Your best defense against a volatile stock market is to create a financial plan and an asset allocation that is appropriate for your financial situation and time horizon.

If your current asset allocation is in line with your financial goals, there’s probably no need to make major adjustments to your current portfolio.  Your asset allocation defines the percentage of different types of investments such as U.S. stock mutual funds, international funds, bond funds and CDs that are held in your portfolio.  You should establish an asset allocation that corresponds with the timeframe of when your money will be needed.   Investments in the stock market should be limited to money that isn’t needed for at least 5 to 10 years.  Keep money that may be needed for emergencies and short term expenses in safe, fixed income investments like bank accounts, CDs or short term bond funds.

The stock market is inherently volatile and there will be years with negative returns.  However, over long periods of time the market has trended upward with average annual returns on the S&P 500 exceeding 9% (approximately 7% when adjusted for inflation).  It’s important to consider your emotional risk tolerance in establishing your asset allocation.   You may have the time horizon to have a significant portion of your portfolio in stocks but you may not have the emotional tolerance.  Your asset allocation may be too risky if you are tempted to sell whenever the market goes down or you are continually worried about your investments in the stock market.

Establishing an asset allocation that meets your situation can help your ride out fluctuations in the stock market more effectively than trying to anticipate movements in the market.  It’s impossible to time the market and a short term increase is just as likely to occur as a drop in the market.   Although you want to avoid timing the market, you should rebalance your portfolio on an annual basis to maintain your target asset allocation.  Additionally, you will want to adjust your target allocation over time as your financial situation changes and you move through different phases of life.

Keeping other areas of your financial life in order can also help you through a major market adjustment.   It’s essential to maintain an emergency fund of at least 3 to 6 months of expenses,  make a habit of spending less than you earn, and  save at least 10 -15% of your income.

Rather than focusing on where the market is headed and what the financial pundits are predicting, maintain an appropriate asset allocation and keep your financial affairs in order.

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