When it comes to investing in stocks, some of us like to be highly active stock pickers. Others among us like to invest passively, even to the point of a “set it and forget it” strategy.

One example of active vs passive can actually be indirect, through mutual funds.  In this example, as many of us know, we aren’t exactly picking the investments in a fund. Rather, the fund manager is picking the investments. Sometimes, these funds can actively trade many stocks. So even though we buy into mutual funds at a price per share (based on the net asset value) similarly to how we do a stock, there can be tons of trades going on with our money even if we ourselves don’t sell anything. The fund manager is behind the scenes making the moves, making this an active strategy of sorts.

On the other hand, if we buy a mutual fund that’s simply index-based, there’s very little activity involved. An S&P 500 index fund, for example, is set up to mirror the performance of the actual index. The brain work is taken out of the process, and there isn’t a fund manager’s acumen influencing the performance of the fund. It’s all based on how the individual stocks in the fund perform.

This of course brings us to the established, oft-discussed topic of index funds vs. actively managed funds. Thinking about it based on what we’ve discussed above, we’re really choosing between:

• Professional fund manager input into our investment; or
• No professional input, just independent stock performance guiding our investment

On the surface, it just seems logical that all things being equal, a professionally managed fund should outperform one that’s not professional managed, right? We’re often told about the virtues of index funds, and passive investing, but shouldn’t there be value to having a professional guide the stock picking within a fund?

Well, maybe there isn’t always value to a a professional actively managing a fund.

An article I saw on Moneywatch further supports the case for index funds over actively managed funds. According to this article, data from Standard & Poors shows that active fund managers have been consistently outperformed by index-based benchmarks. This finding is across cap size and covers the last 3 years.

Here’s the extent of the disparity with these actively managed funds:

• Large-Cap focus: 64% were outperformed by the S&P 500
• Mid-Cap focus: 75.1% were outperformed by the S&P MidCap 400
• Small-Cal focus: 63.1% were outperformed by the S&P SmallCap 600

Thus, for all the extra fees that are being paid, investors are getting nothing back. In fact, one could say that investors are getting punished for going with actively managed funds!

Now, there are some funds that clearly do outperform the market. However, the majority haven’t been doing so.

Personally, I’ve been a fan of index funds, but have a mix of index and actively managed funds.  At this point, it’s hitting home that maybe I should jettison the actively managed funds and replace them by adding additional investment in index funds?

I suspect that many people (including me, apparently), have previously found index fund investing to be “average” or lacking risk taking or a pursuit of wealth.  Who wants to be average, right?

Well, maybe average actually means winning in this case!

My Questions for You:

If you own mutual funds, do you focus on index funds?

What do you think about the notion that the pursuit of average, in terms of market returns, is actually a winning strategy in some ways?

Why do you think people pursue actively manage funds, despite the evidence that index funds outperform them?

Have you ever heard of the Rule of 72?

It’s one of those personal finance calculators that’s been around for a while, and it’s about as basic as it gets. Yet, it’s been used by some people to quickly project results for a given investment over time.

The rule is essentially a quick way to determine how long it will take you to double your money at a current rate of return. It works as follows: start with the number 72, and divide it by the rate of return of an investment over time. The result will be the number of years it will take to double your money.

For example:

Let’s say you have an investment that will earn you a total annual return of 3%.  It would then take you 24 years to double your money (72/3 = 24).  Too long? Well, jack that rate of return up to 6%, and it will then take you just 12 years to double your money.

While I consider myself to be analytical, and comfortable with complex calculations, I do like such tricks such as the rule of 72.  They allow us to quickly, on the fly, do some basic calculations. In this case, we all could have quickly divided 72 by 3 (or 6) in our minds to get the answer in just a matter of seconds.

For whatever reason, this one in particluar has struck me as being nice for those of us who gravitate toward investment growth thoughts.  It”s a quick way to think about what money could become in the future.

As with any shortcut, however, there are pitfalls.  There are three that I see with the Rule of 72:

1. Taxes.   If you’re paying taxes on earnings, this needs to be considered in any calculation. So, if you’re earning 6%, but will pay some tax on that, your after tax rate may actually be somewhere in the neighborhood of 4% or so.  This needs to be factored in, or the Rule of 72 will give you erroneous results.
2. Inflation.  Let’s say you’re earning 3% after taxes for example. If inflation is 3%, you’re not really getting ahead. The $1,000 you have invested will turn into $1030 a year later, but will still buy the same amount of goods as $1000 did the year before. So, inflation needs to be taken into account.
3. Accuracy. This rule is meant to be a shortcut, so it’s not 100% accurate down to the decimal point. For example, if you wanted to see how long it would take to grow a $1000 investment into $2000, with a 3% rate of return, the Rule of 72 would tell you 24 years. If you calculate it manually, it actually comes out to almost 23 1/2 years. Close enough for an quick estimate, but important to note that it is in fact an estimate.

Personally, I find that many quick financial projections, particularly those that are intended to show the power of compounding over time, tend to ignore both taxes and inflation.  To the latter point, always keep in mind the time value of money.

In any event, as long as we’re aware of it’s limitations, the Rule of 72 can be a useful tool for quick projections of how long it will take us to double our money.

My Questions For You:

Have you ever used the Rule of 72?

Do you ever stop to question assumptions in such financial projections, such as I did with taxes and interest?

When making everyday purchasing decisions, we have variety of ways that we determine whether or not something is a deal.  Maybe it’s at a low price compared to the price we’ve seen it elsewhere. Perhaps, it’s priced well compared to substitutes. For some of us, we consider how a purchase fits into our budget.

What about thinking about how a purchase impacts our long-term financial situation?

On the surface, this makes sense. The more we spend now, the less we might have in savings later.

For example, let’s say you’re deciding between 2 vacations for the summer:

1. An inexpensive, 4-day vacation that’s within a few hours from home, with fun activities and solid if unspectacular lodging. Cost: $1,000
2. A pricier, 7-day vacation that requires booking a flight across the country, also with fun activities, but more upscale lodging. Cost: $3,000.

If these are your two alternatives, you have a decision that involves an incremental $2,000 at play. So, by choosing option #2, it can be said that you’re taking $2,000 away from your future retirement. That is, assuming of course that you would saved it instead of splurging on something else. That’s an assumption to be sure, but let’s go with for now.

Down the line, you’ll have to earn an extra $2,000 to make up for that amount, right?

I think that might be true, but in reality it could potentially be a lot more than that. As I postulated in a post last year (when Squirrelers was fairly new), what you spend today could mean something very different in the future. Your opportunity cost is not just what you spend today, but what that money might become in the future.

Let’s take that $2,000 from the example above.  What would that be worth in the future?

Well, let’s assume it’s invested and grows at 5% per year. Let’s say this is after taking inflation into account.  That $2,000 will be worth the following amounts, at different points in time:

Clearly, that $2,000 which was spent turned out to be just like spending a lot more future dollars. Factoring in growth, that vacation actually cost $8,644!

Crank up that growth rate to 8%, and this $2,000 becomes something much more:

$20,125 after 30 years. That sure was an expensive choice, to upgrade to a deluxe vacation!

Now, the purpose of this exercise is obviously not to focus about different expected rates of return, or the merits of spending on vacations. Rather, the takeaway is that when we spend money today, we’re really spending a sum of money that might be worth a lot more in the future.

From big purchases all the way down to the smallest purchases, I think this concept holds.

My Question for You: 

Do you think about how a sum of money today can be worth a lot more in the future, and connect it to spending decisions made today?

“Every little bit counts!”

This approach is often taken by those of us that try hard to save our money. This popularly applies to saving money by methods such as:

1. Cutting coupons
2. Price comparison shopping
3. Not spending money

In other words, focusing on the expense side of the equation.

The other side, as I allude to here on occasion, is growing your income. Whether through one’s career or entrepreneurial ventures, increasing the top line is very important. After all, you can only save so much. Maximizing income while minimizing expenses is a good thing, as it results in savings.

Great! Mission accomplished, right?

Well, it’s a really good start.  But what you do with your savings matters too. In other words, that savings has to be managed properly.

1. Don’t lose money. Check out Warren Buffet’s Rule #1 as a primer to this concept. Mathematically, it’s more important than might meet the eye.
2. Have your money work for you. Your money is like an teammate of yours, in a way; you can go far on your own by saving, but letting your money do some work to can take you even further.

With this second principle, I’m talking about the percentage return that you earn on your investments. A big driver of this is asset allocation, which is a broader topic unto itself. However, when you look at rates of return, it’s really interesting just how important each percentage point is. Once again:

“Every little bit counts!”

I decided to go egghead today, and run some numbers to illustrate why rate of return is important. Now, I realized this before, but revisiting it reminds me of how important it is to grow/protect your rate of return.

For example:

Let’s assume that you take a lump sum of $10,000, and hold it for 20 years. The result: you’ll have $10,000 after 20 years. Now, of course, I’m not counting carrying costs or the time value of money. Just trying to keep it simple for illustrative purposes. Bottom line: if you earn nothing, you’ll have no growth.

Now, let’s look at how much you would have in 20 years if you invested $10,000 at different rates of return, compounded annually:

Clearly, there is a big difference between earning a paltry 1% and a robust 10% annually. When this is extrapolated to higher initial investment levels, it’s clear how the rate of return one earns can be a game changer.

There are many ways to apply this. Two examples that come to mind are:

1. Properly Allocating Assets Among Classes.If assets are held in low-yield, minimal growth vehicles, the downside might be limited in some cases. However, the risk aversion can be costly in terms of growth potential. It’s important to look at historical and expected rates of return on different asset classes, so as not to shortchange oneself from an overall portfolio perspective.
2. Smart Choices Within Asset Classes. Let’s say you’re paying a management fee on a mutual fund, instead of using an index fund. Or, let’s say you’re earning a lower rate of interest on a CD than you could at another institution. Even a 1% difference can add up over time. The difference between 3% compounded annually vs. 2% compounded annually is $3,202, in the above example. All attainable through smart, informed choices up front.

Every percentage point counts, and can make a big difference over the long run when compounded annually.

Many of us realize this concept, but get caught up in the income and expense side – the latter being an obsession for many - and lose sight of how important this is for managing the money that we do actually save.

What about you?

How much time an effort do you spend on managing your savings to optimize your rate of return – as opposed to spending time figuring out ways to get the savings in the first place?

When I have looked at asset allocation, I have considered a variety of factors to keep my investments balanced. One of these is large/medium/small cap categories of equities. Historically, I have weighted my U.S. stocks heavier in large and medium-cap funds, while maintaining a small percentage for small cap.

This interesting article in Kiplinger’s provides some interesting information on small cap stocks. According to the article, long-term historical data of U.S. stocks from 1926 to 2009 shows that there is a clear difference in returns, anchored by the following groups:

• Top 10% by size (largest of the large cap companies) returned 9.1% annualized
• Bottom 10% by size (smallest of the small cap companies) returned 13.1% annualized

Ok, so the small cap stocks returned more. What I found particularly interesting is that when the companies are broken out into deciles based on market capitalization, that returns increase steadily by decile as market caps get smaller. For example:

• Stocks in the 3rd decile (within the large cap group) returned 10.7% annualized
• Stocks in the 8th decile (within the small cap group) returned 11.4% annualized.

Clearly, when you take the 4 deciles listed above, it’s evident that average return increases as company size decreases.

That said, on the flipside, these smaller stocks are clearly volatile compared to larger cap stocks.  The range of returns for the top decile vs smallest decile have been as follows:

• Top Decile: between -10% and +29%
• Bottom Decile: between -32% and +58%

The small stock volatility gap is quite broad, and a buy-and-hold strategy with such funds would likely be a wild roller coaster ride, to be sure. Nevertheless,  based on the data, it might to be a good move over the long run to allocate at least some percentage of your total portfolio to small company stocks – particularly if you have many more years to retirement. For large investing decisions, you can consult with a professional such as Fisher Investments Private Client Group.

What do you think? Do you have the stomach to invest in the smallest of the small-cap stocks, knowing that the nice returns come with extraordinary volatility?

This post was included in the Carnival of Personal Finance at Provident Planning

There are many ways that we measure wealth, and many ways that we can fund our retirement through our wealth.

One way to measure to determine where we are in terms of our savings is to look at months of covered expenses. For example, if a couple had $600,000 in net worth (assets minus liabilities), and $4,000 in monthly expenses, then they are 150 months wealthy in terms of savings.

Covered expenses is a simple, practical way for many of us to assess where we are financially. I’m a big fan of this personal finance diagnostic tool. It tells us how long we can live on what we have saved. Most of us are not multi-millionaires who can live off interest income and not touch our principal. Some folks reading this might be in that position, but if the rest of us stopped working, we would have to use our savings. This approach tells us how long our savings will last.

Stretching our minds and looking at things differently, perhaps we can save money with the intent of accumulating year in, year out, and never spending your savings. Keep on saving it, even when your months of covered expenses exceed your estimated remaining lifespan.

Why? Well, not touching savings is not just letting money sit there. Rather, it’s repurposing the money to be used as a source of more money.

This is where portfolio income comes into play. Instead of consuming your savings, you preserve your savings and let your money work for you. It becomes your faithful source of your own personal social security check.

Lets say the couple with $600,000 wants to live off an income stream without touching the principal. One could look at the required rate of return to see how how hard this money needs to work in order to satisfy their expense needs.

Taking a conservative view of returns, however, one could try to backsolve for the required nest egg size they would need to accumulate in order to live on their income stream.

For example, if the couple wanted to live on $4,000 monthly – $48,000 annually – they would have to amass quite a nest egg. If you took $48,000 and assumed a 3% rate of return to match inflation, it would take a next egg of $1.6 million for them to live on that $4,000. If they reduced their expense needs to $3,000 per month, it would take a nest egg of $1.2 million for them to accomplish the same goal.

This specific example doesn’t factor in the idea that your principal will reduce in purchasing power every year due to inflation. Remember that a dollar today is worth more than a dollar tomorrow. That said, portfolio income is cash flow that you can rely on without directly touching the principal. The good thing is, if you need that, you can eventually tap that as well. It’s another layer of conservatism is making sure you have enough to live on.

Ultimately, my take is that by working toward portfolio income, while trying to leave the principal intact as much as possible, you’re taking a big step toward financial freedom.

You will have worked hard to save and grow your money. Allow it to reciprocate and work hard for you in return!

Any thoughts? Do you look at retirement savings in terms of income streams, or in terms of a lump sum to tap into?

One note: I am personally a long, long way from retirement. Not going to stop me from dreaming big though:)

This article was included in Carnival of Personal Finance #264 at My Journey to Millions

Have you saved enough for retirement, and your future financial needs?

As much as I would like to say that I have done so, I’m a long way from that point. In fact, I’m not even remotely close. I’m actively working on it though, day by day, focusing on growing the income minus expense gap. I’m guessing that if you’re reading this, then you’re probably somewhere on that same journey as well. 

Since we know that we aren’t there yet, just how close are we to actually being able to retire? What is health of our portfolio, and how do we measure that? 

One could take the traditional approach, and focus on net worth, calculated as assets minus liabilities. I have advocated taking this a step further by calculating months of covered expenses, to determine just how long you can survive based on your current net worth and expense needs. 

I often look for different ways to answer such questions, with the hopes that some additional insights could be gained by viewing a situation through a different lens. In this case, determining where we are with respect to being able to retire, I suggest that we also consider our current required rate of return.

So, what is the current required rate of return? 

In essence, it is the rate of return that we will need to earn, in order to survive with our current nest egg. 

Let’s assume a couple with the following financial profile: 

Assets: $800,000

Liabilities: $200,000

Monthly Expenses: $4,000 

Further, let’s assume the following additional information:

Tax Rate: 25%

Rate of inflation: 3% 

To calculate their required rate of return, let’s first subtract liabilities from assets to obtain net worth: 

Net Worth = $800,000 – $200,000 = $600,000 

Then, let’s annualize their expenses: 

Annualized Expenses = $4,000 x 12 = $48,000 

Next, calculate percentage return on net worth:

$48,000 / $600,000 = 8.0% 

So, this means that the couple needs to earn 8.0% on their nest egg to meet their expenses. Or so it seems. 

The 8.0% figure is an interim step. There are two more factors that need to incorporated:

1)      Inflation

2)      Taxes

 To account for these factors, let’s take these steps: 

1)      Rate of return adjusted for inflation = 8.0% + 3.0% = 11.0%

2)      Adjusted rate of return, pre-tax = 11.0% / (1-.25) = 14.67%. 

Thus, on a pre-tax basis, the couple’s portfolio must return 14.67% annually in order to meet their annual expenses. 

Here’s the formula:

1)      Return on net worth = annual expenses / net worth

2)      Required return = (return on net worth + inflation) / (1 – Tax Rate)

What insights can we get from this calculation? 

1)      The ability of the nest egg to meet income needs. In this case, when you see a required rate of return at 14.67%, it tells you that you likely don’t have enough saved!

2)      Direction on reallocating our investment mix. In this case, with this type of required return, one might want to consider a mix of assets that is more likely to obtain a higher return. With higher potential return comes higher risk. And closer to retirement age, that might not be such a good thing. But it’s something to consider.

3)      Information on how we can improve our balance sheet and cash flows. Taking this formula, we can make changes to net worth and expenses to see how increasing/decreasing these measures can help us meet our goals. For example, in this case, reducing expenses to $3,000 per month and boosting assets by $200,000 changes the required rate of return to 10.00%.

It’s interesting to view the health of our portfolio using different calculations. What I like about this one is that it incorporates taxes and inflation, which many more basic views don’t.

Any thoughts? Do you have any other measures for assessing the ability of a portfolio to meet future cash flow needs?

This article was included in Carnival of Personal Finance #260 at Rainy Day Saver.