When it comes to my money, I’m a big fan of doing things automatically. Of all of the things I have done to improve my own financial situation, no one thing has had a more positive impact than “set it and forget it.” Generally speaking, I can get behind just about anything that defends me against my own very human nature.
This is one of the reasons I like investments like Target Date funds and asset allocation portfolios. You can choose the best investment mix for you, and someone else does the heavy lifting to see that you maintain it. But some of us don’t like to give up that much control. You can certainly rebalance your investment yourself, but get ready – rebalancing can be hard work. Have an honest conversation with yourself about whether your desire for control will expose you to unnecessary risk.
This is an important point. Sometimes, you have to take a good, hard look in the mirror and decide how far you can trust yourself. Not because you’re inherently untrustworthy, but because, as you may recall me mentioning once or twice, people tend to be unrealistic about their capacity for behaving rationally.
What rebalancing is and why you have to do it
Rebalancing refers to the process of bringing your portfolio back to its original intended asset mix. When you determine your ideal asset mix, you align your investments accordingly. However, your individual investments will grow – or shrink – at rates that are independent of one another. This independent movement will eventually alter your asset mix.
Say you decide the ideal mix for your risk tolerance and time horizon is 70% stocks and 30% bonds. The stocks in the portfolio will tend to be more volatile than the bonds, which means that their value may change at a more rapid pace. That means that, over time, if the stocks do well, they will represent more than 70% of your investment, which is contrary to your original goal. If your stocks perform negatively, the total percentage allocated to stocks will shrink, and your mix will more heavily favor bonds. This is a problem because these shifts can dramatically alter your risk profile, causing you to take on too much or too little volatility.
And here is the crux of the problem. The reason that rebalancing is difficult is because it runs counter to human nature. At this point, you have to steal yourself to make one of two decisions that investors generally hate. Assuming that you don’t have additional capital to invest to bring the portfolio in line, you will either have to purchase more stocks, in the case of a loss, or in the case that stocks have done well, sell off a well-performing asset and use the proceeds to add to your bond allocation.
Seems like logical behavior, right? Any one of us can see that this is a classic “buy low, sell high” scenario. But time and time again, investor behavior proves how unlikely it is that any one of us will actually do it.
So what is an investor to do? I hate to be a broken record here, but the key is to be brutally honest with yourself. Do you have the stomach to hit the brakes on a well-performing mutual fund, or to invest more money into an investment that is down 30% over a year or 18 months? I might be able to do it once, but I wouldn’t trust myself to be consistent. You might be different, and rebalancing your portfolio may not be a problem. But you need to know which camp you’re in.
Make a rule
No matter how rational you believe yourself to be, trusting yourself to make the best decision in the heat of a big gain or demoralizing loss is a fool’s errand. In order to make the best decision possible, you need to make it before it becomes necessary. Basically, you need a rule.
Perhaps you rebalance quarterly, or when your asset mix falls 5% out of line in either direction – there are sound, logic-based reasons for each of these approaches. The most important criterion, from my perspective, is that you actually do it. Which means that you can, if you so choose, save yourself the headache of determining the best method from a performance standpoint. As with many things that are good for us, the very best way to do it is the one that works for you.
Mutual fund investors love to complain about fees. None of us wants to see our returns reduced by expenses, in any market. When our investments are down, it seems like insult to injury. And when they’re up? Our investment has grown, which means that we actually pay more than we would if it hadn’t.
A word of advice: it doesn’t pay to think about it too much. I’m not saying that comparing expense ratios isn’t absolutely necessary for making responsible investment decisions. But I’ll be honest – I have never in my life converted that ratio into actual dollars for any of my mutual fund investments. Why? Because I don’t need to, and because looking at actual dollars going out of my account will probably drive me crazy.
That being said, you won’t find me ranting about fees. My investments are available to me because someone created them and put them on the market – expecting to take advantage of them without paying for it isn’t reasonable or ethical. Just like any other product, however, some operate more efficiently than others, and thus cost less. Index funds tend to be cheaper, for example, in part because the time and effort it takes to run them is less than for an actively managed fund.
I stand by my advice not to dwell on it. But I also find that it helps to know where your money is going. Here is a rundown of the types of fees charged by mutual funds, though not all funds charge all of these fees:
Sales charges, or loads. These can apply at the time of purchase or at redemption, and they are used to pay commission to a broker. No-load funds, as the name implies, don’t have sales charges. But they may have any of the other fees on this list, including a purchase fee.
Purchase and redemption fees. These differ from sales loads only in that the fee is paid to the fund, rather than a broker.
Exchange fee. May apply when a shareholder switches funds within the same fund family.
Account fee. Accounts below a certain amount are purported to cost the fund company more money than they earn in fees, and as such may be subject to an account fee. (I say “are purported” not necessarily because I don’t believe it, but simply because I’ve never seen the math.)
Management fees. These are paid to the fund’s investment advisor for managing the fund.
12b-1 Fees. Also called distribution fees, these relate to sales and marketing activities by the fund, and some shareholder services. Not all funds charge 12b-1s, so you want to pay attention to these.
Other expenses. You knew it was coming – that miscellaneous category of expenses.
Check your prospectus, and a final word of advice.
All of this information is available as a table in a mutual fund’s prospectus. If you have never read a mutual fund prospectus, I recommend you give it more than a passing glance. For starters, prospectuses have a general order to them, so once you get the hang of one, you’ll be able to easily peruse another for the information you deem relevant. Additionally, prospectuses contain information you won’t find in a quick web description or analyst’s report. Be advised, however, that it is an excruciatingly boring read, even for me. If you aren’t the prospectus-reading type, and even if you are, there are a number of calculators available on the web for comparing fees between mutual funds.
As with most things we purchase, cost is an important consideration, but not the only one. Choosing a fund by expense ratio alone makes about as much sense as buying a house based on price and nothing else. You can pat yourself on the back that you paid a low price, but you may not much like where you’re living.
When it comes to life insurance recommendations, I am pretty much in the term camp. There are several reasons for my position, the most important being that life insurance is first and foremost about protection. And since whole or universal life can literally cost over 10 times what term costs for the same coverage, not many of us can actually afford the protection we need in a permanent product.
You may have heard that it’s better to own your coverage than to rent it, and other such nonsense. I’m not buying it. The fact is, most term products provide cheaper coverage at every level – including cost of insurance. And the argument that you’ve thrown your money away if you don’t die (yes, I’ve heard it) is ridiculous. Every insurance product carries cost of insurance, which is not recovered by either the policy-holder or the beneficiary when the policy pays out or is liquidated.
With all that said, I do actually own a permanent insurance product; a VUL, or variable universal life insurance policy. If you Google VUL, you’ll find predominantly two camps: those who sell them and those who hate them. Not a good sign, generally speaking. But I don’t believe that any product is inherently bad, and the policy that I hold works very well for me.
What is a VUL?
First, though, a quick explanation. A VUL combines an insurance product with an investment. Part of the premium paid by the policy holder goes to cost of insurance, and the rest to an investment sub-account. The account can be overfunded, which means paying more than the required premium, with the extra money going into the subaccount. That money can be borrowed down the road for whatever the policy holder wants to spend it on, with any remaining balance on the loan paid off by the death benefit.
A product for a narrow market
There are many features of the VUL that make it different from other investment accounts, but I’d like to highlight two.
Earnings grow tax-deferred. A Variable Universal Life policy is an insurance contract with an investment account attached. Your premium amount will represent your minimum payment every month, but you can and should contribute more in this situation. Overfunding a VUL allows you to invest the amount of the overage and take advantage of tax-deferred earnings. The opportunity is not limitless – there is a point at which you will be penalized for investing too much at once – but there is still a fair amount of wiggle room. The cash value of your policy – or the amount in your investment account – is available for you to borrow without penalty, since any interest is paid back to you.
Benefits are paid out tax-free. Life insurance benefits pass straight to the beneficiary without being taxed or going through probate. If you’re overfunding a VUL, for example, all the assets held in your VUL – the death benefit amount plus the amount held in the investment account – will pass straight to your beneficiaries tax-free. This makes VULs a potentially excellent tool for distributing wealth.
A word of warning
No doubt, there are a few readers who are fuming right about now, given some of the drawbacks of VULs. But as I often repeat, I believe that an informed investor is a more responsible investor. While the niche for this product is rather limited, it definitely deserves consideration in some quarters. If you make too much to qualify for a Roth IRA, for example, and are maxing out your retirement contributions each year, a VUL might be worth a look. Or if you have assets to distribute among heirs, you might consider this option.
The bottom line is that VULs are complicated products that vary greatly between options, so it is imperative to do your homework. They often carry high fees and expensive insurance, so it is important to shop around. Lastly, insurance agents are generally well-compensated for selling them, so it is important to work with someone you know and trust, who is experienced in this area.
It’s been a difficult few years. Many people found themselves in trouble as the effects of the recession reached every corner of society. The days of growth were swept away, and that situation lasted for a few years. There is an argument that the effects still endure in many places today. A large number of US citizens are still finding it difficult to come to terms with their financial position.
It is a common observation that the first thing anyone needs to do if they have a problem is to identify the fact and then look at the situation. They say that recognition is the beginning of the solution. In the case of finance that usually involves writing down income and expenditure, as well as assets and all debts. The aim is to try to prepare a manageable budget. It may involve economies of course. Every case is different.
The budget is arguably only going to be successful if someone with a problem thinks about the reasons why they have got into trouble in the first place. It may be an actual event such as losing a job, but that is far from the complete picture. Many people get into trouble because of their behavior and financial indiscipline. No amount of planning can help if they behave in the future in the same way as they have in the past.
Do you see yourself? If you have financial worries, have you thought about yourself, your strengths and weaknesses? Sometimes you might find it difficult to criticize yourself for being tempted to buy something you cannot afford. If you have a fixed amount of money each month, you will know the limiting factor on what you can safely spend.
If you are ignoring those limits, then you are likely to get into trouble in the coming months if you are not already in trouble. You have to act by first recognizing you have a problem. If your debt is primarily on credit cards, your monthly expenditure will likely be the minimum payments each of the cards require of you. Even if this is manageable, the reality is that the balances you are leaving at the end of each month will barely be diminishing. You need to resolve to not only get rid of these balances but also resist the temptation ever to build up balances again.
You can get personal loans that currently charge far less interest than credit cards. It is likely that you can get loan from excellent service orientated companies to pay off debt that is incurring penal interest. However, it is not a solution that you will be likely to have more than once. If you are unable to resist the temptation of using your credit cards to build up significant balances again you may have no escape route. A personal loan over three years may be able to pay off core credit card debt. It is three years before you can negotiate another loan to repeat the exercise unless your financial circumstances improve. The best budgetary exercise in the world cannot get you out of difficulties unless you, first of all, understand the importance of self-discipline.
The other important element is to understand your spending habits. That understanding brings you closer to the detail that should go into your budget. The exercise involves looking at your weekly food, transport, and leisure spending. Spending less on these things does not necessarily mean sacrifice. You may find that simply walking a little more rather than taking the auto for short journeys results in your enjoying the extra exercise. Eating out is fun but so is cooking. A sandwich taken to work is every bit as good as having lunch from a fast food outlet, arguably better. There are a number of simple everyday habits that will result in your spending falling.
The incentive to return to a financially sound position if your problems have only occurred in the last decade should be a spur to you. Your memory is certain to tell you how carefree your life was in those days. They can return if you sit down and think about things, starting with yourself.
At every family birthday celebration, my mother-in-law buys each family member “Set for Life” scratch off tickets. Part of our traditional birthday fun includes a hunt through purses and pockets for enough coins to discover who among us might receive $5000 every week for the rest of our lives. Cognitively, I am aware of the futility of this game. But I am also a person for whom hope springs eternal, and each birthday celebration brings a millisecond of breathless anticipation of a lifetime of effortless income.
Of course, it is possible, through careful planning, to arrange for automatic income. Retirement planning is based on that premise. But what about those of us who would like to earn passive income before we retire? Advice on the subject is so plentiful as to be ubiquitous, and frankly, most of it is fairly obvious. Here are a few observations of my own.
You may have to expand your concept of “passive”
Rent is a classic example of passive income, and one that illustrates some of the important points on the subject. I have personal experience with this one, and it is not an experience I am anxious to repeat.
Rental property is an asset that must be maintained, and occupied, in order to keep earning money for you. And maintenance and occupancy are hard work, it turns out. Furthermore, if you don’t start with a sound plan (my rental income experience was reactionary to a crashing real estate market), you may find that your returns are less than spectacular, Even less than zero, some months.
That’s not to say that it doesn’t work for lots of folks. Tempermentally speaking, I am spectacularly unsuited to the role of landlord. But those with a well-thought-out plan, solid financials on the property or properties in question (i.e. rents that outpace the costs involved), and room in the budget to outsource caretaking and tenant-seeking functions can and do enjoy great success in this endeavor. So what’s the point of my story? There are a couple.
- Passive income opportunities are not one size fits all. And all are not equally suited to a particular option.
- Unless you are starting out with a great deal of money, many passive income sources do not start out that way. In order to truly make money without lifting a finger, you need to be able to outsource, and make sure that the money you pay to maintain your property/website/vending machine business doesn’t cut into your margins to the point that the investment is no longer worth your time. If these conditions don’t apply, you may have income, but it certainly won’t be passive.
Of course, that doesn’t mean that an option like this isn’t for you. Being in possession of a strong work ethic, I applaud and admire industry. Just make sure that you’re investing your sweat equity wisely, and understand that truly passive income may not come until later.
Investing for income
Of course, you always have the option to put your money to work for you in the market. Most of us are doing that anyway, saving for retirement and other goals. But if you’re looking to use some of your nest egg for current income, here are some considerations.
- Pick a mutual fund or ETF for truly passive income. Researching individual securities is a lot more work.
- Designate a pool of money specifically for income. It seems obvious, but it is important to consider that the money you designate will no longer be growing, which should be factored into your long term planning.
- Be realistic about how much you can earn. A consistent interest rate or dividend of 6%, or less realistically, 10% sounds like a lot until you consider that $200,000 would get you $12,000-$20,000 per year. Living off of your interest requires more money than you might think.
- If you’re withdrawing all of your earnings, be prepared to see your principal lose value. Consider reinvesting enough to keep pace with inflation.
Make it worthwhile
The most sensible advice I’ve ever been given on this subject is to pay attention to what you could earn risk-free. If the 10-year treasury is paying 2%, you probably don’t want to bust your hump or taking on excessive risk for 4%. Your time – and money – may be more profitably spent elsewhere.
My first, briefly-held job out of college had nothing to do with finances. In fact, I was so ignorant on the subject that I somehow failed to realize that one of the job’s very few perks was an automatic, employer-funded 12% annual contribution to a retirement plan. It’s a benefit nearly unheard of these days, and to my knowledge it is still available to employees. (Before anyone gets too excited, I should stipulate that my employer was a nonprofit, and the salary – even factoring in the extra 12% – was ridiculously low.)
Shortly after I had moved on, the retirement plan was liquidating smaller accounts in an effort to cut costs, and I received a check for $786. As a personal finance writer, I would love to tell you that I promptly executed an indirect rollover and that the $786 is worth much more today. Alas, it is not so. I, of course, spent my supposed windfall on something I can no longer recall, and was unpleasantly surprised with a tax bill at the end of the year. Live and learn, I suppose.
The mistake that keeps on taking
I had reason to recall this error in judgment recently, and I began wondering how much it cost me. Turns out, my $786 spending spree has so far cost me $1,388 in lost earnings (assuming a 6% annual return), plus nearly $200 in taxes and penalties in the year that I spent it. I have no idea what I spent it on, but I doubt very much that it needed it badly enough to justify sacrificing $1,588 in the intervening 17 years. And I am quite certain it pales in comparison to the approximately $10,000 it will have cost me by the time I retire.
It’s easy to see how a person could take this line of thinking way too far, so if you’re the obsessive type I recommend you limit this analysis to retirement dollars. But if you’ve ever thought of cashing out all or part of your retirement for anything less than a life or death emergency or qualified purchase (such as a first home), think again.
Consider, for example, a $10,000 distribution from a traditional IRA used to fund the “vacation of a lifetime.” The rationale is that the memories from such an experience will be priceless, so the cost is irrelevant. It would be interesting to find out if the vacationer feels the same way once he or she finds out that those “priceless” memories actually cost over $50,000 in taxes penalties, and lost interest (assuming a 6% annual return over 35 years.)
$50,000. Seriously. If you don’t believe me, do the math yourself. If you put that vacation on a credit card and paid the minimum, your total interest payments would be in the neighborhood of $5,000. One tenth the cost to your retirement nest egg.
The math doesn’t work
The take away is rather obvious here, but I’ll say it anyway. If you are under age 59 1/2 , your retirement is about the last place you should look for extra cash. The sole exception to this would be if you are using a portion of your Roth IRA as an emergency fund, which, as I have written before, is only advisable under certain circumstances. Look for another option.