If you have money left over after paying your bills, you fall into the category of “investor.” You could invest your surplus money in having a good time in Vegas, a mattress, a bank savings account, or any manner of financial instruments. Some investments have a financial return; others only a psychic return if you are lucky.
Most people invest for a simple reason: to provide income when they are no longer able to work. Some people might actually want to retire, so they invest to provide income for the time after they voluntarily choose to stop working. To get from “investor” status to actual retirement status, a few difficult things have to happen correctly.
1. You actually need to save money. And you have to save a lot. In today’s America, this means becoming a cultural outlaw and foregoing some current consumption. Welcome to the radical underground.
2. You need to save the money in assets that produce income or capital gains. (Income-producing assets are nice, but capital gains can be spent just as effectively.) These assets are often volatile, leveraged like real estate, or intangible like stocks and bonds. Scary stuff, in other words. Investing your surplus funds in Budweiser, while it may confer certain social benefits, will not provide a retirement income.
3. You need to manage not to muck up your returns. The DALBAR numbers don’t lie. To earn decent real returns, you need to select quality money managers and/or funds and then leave them to do their work.
4. You need to be able to do realistic math. For example, most people think their home is a great investment—but they never subtract from the returns all of the property taxes and maintenance that are required, or remove the effects of leverage. Every study that does shows that homes are not a good financial investment. In addition, in order to make a projection of how much money you will require to retire, you need to be able to make a reasonable estimate of your real net-net-net returns (after inflation, taxes, and expenses) over your compounding period. Investors, imbued with overconfidence, almost always make assumptions that are far too bullish.
Jason Zweig has an excellent article in the Wall Street Journal discussing realistic assumptions for net-net-net rates of return.
Since 1926, according to Ibbotson Associates, U.S. stocks have earned an annual average of 9.8%. Their long-term, net-net-net return is under 4%.
All other major assets earned even less. If, like most people, you mix in some bonds and cash, your net-net-net is likely to be more like 2%.
Mr. Zweig points out that many investors, even some institutional investors, are assuming net-net-net returns of 7% or more. When he asked truly sophisticated investors what return they thought was reasonable, he got very different answers.
I asked several investing experts what guaranteed net-net-net return they would accept to swap out their own assets. William Bernstein of Efficient Frontier Advisors would take 4%. Laurence Siegel, a consultant and former head of investment research at the Ford Foundation: 3%. John C. Bogle, founder of the Vanguard Group of mutual funds: 2.5%. Elroy Dimson of London Business School, an expert on the history of market returns: 0.5%.
The reality is pretty shocking, isn’t it? This is why the investor has an uphill battle. And the consequences of messing any of the four steps up along the way can be pretty steep. In Mr. Zweig’s eloquent words,
The faith in fancifully high returns isn’t just a harmless fairy tale. It leads many people to save too little, in hopes that the markets will bail them out. It leaves others to chase hot performance that cannot last. The end result of fairy-tale expectations, whether you invest for yourself or with the help of a financial adviser, will be a huge shortfall in wealth late in life, and more years working rather than putting your feet up in retirement.
Saving too little can become a big problem. I would add that ruining your returns by thrashing about impulsively will only add to the amount you will need to save. Almost everyone has a number in mind for the amount of assets they will need in retirement. Try redoing the math with realistic numbers and see if you are really saving enough.
—-this article originally appeared 1/19/2010. Americans are still under-saving to an alarming extent. Given that we are currently in a very low yield environment, a high savings level is more important than ever.