Well The Finance Buff posted this response to my article on his blog and I think he did make some very good points for having a portion of bonds in your portfolio. He also referenced MakingOurWay’s post on the role of bonds in an investment portfolio a simplification of modern portfolio theory. I love writing that makes things simple and his analogy of bonds being a battery and how that you can leverage that battery during times of poor stock performance to rebalance and buy stocks low is a great way to think about things and I think may have me drinking the bonds are ok kool-aid.

Anyway check these articles out and thanks to everyone who commented on my posts and tried to make me see the light.

Simple Summary of discussion
The simple 10,000 foot level summary, that I think most of the commenters agreed with were. Based on historical returns, you are more likely to get the highest returns in the long run (20-30 years) by having a portfolio of 100% stocks, but in order to achieve this you will have wild roller coster type rides of huge runups and huge decreases of your portfolio over shorter periods of times. So if you truly are in it for the long-term and won’t react/panic to huge changes in your portfolios value over the short-term and want to make the most money possible this is the way to go.

Well it’s not that simple, there are other attractive alternatives
Now it was also pointed out that some people think you can remove this volitility by putting a portion of your portfolio in bonds and still get a return that is pretty darn close to the pure stocks portfolio, but without the drastic swings. I certainly agree about the volitility part, but you are still going to be settling for a lower annualized return over the long run, which even 1% can mean huge money when compounded over 30 years. There certainly is no way (in the long run based on historical trends) that you can make more money than a 100% stock portfolio

Reality
I think one thing overlooked by myself and pointed out by some of the commenters is – eventually as you get closer to retirement you will have to switch to a higher percentage of bonds, because then your timeframe is much shorter and a huge swing to the negative could adversly affect my retirement plans (hello Ramen). Now depending upon how the market is doing at this point your life when you need to start switching to bonds could take alot of discipline on your part to sell some stocks to switch to bonds if the market is really tanking or for that matter really rising. I can see here where those lifestyle funds would come in handy because it doesn’t require any interaction on your part.

What I learned
It’s just not that simple and even if I decide to stay with 100% stocks in the short-run I maybe should start considering bonds, high dividend stocks, REIT earlier than I originally thought as the better things go for me, the closer I come to retirement, and the more I need a fixed income contingent in my portfolio for stability. However it still might be hard for me to give up returns just for the extra stability (at least in the next 15 years). I guess worst case scenario I would stay weighted heavy towards stocks and let the market deterimine when I can retire. If it goes into a major slump right before I want to retire, then I will just keep working. I have invested in myself so much (Computer Geek, MBA, etc) that I feel I have pretty good control over the types of jobs that I could hold and that if I had to put off my retirement for another 5 years because of the stock market taking a major dump I could do so and it wouldn’t necessarily be a bad thing. IE I could find a job that I really enjoyed and fit my lifestyle very well while still providing me with suitable income while I wait. However if I didn’t have the education and skills that I have and was working in a mill and stuck with one good job possibility I might be weighted a lot heavier towards bonds (Note: not dissing people that work in mills, I just feel that some career paths have less opportunities than others) Also add in the fact that my wife and I can live very frugally and enjoy doing it, it wouldn’t wreck our lives to have to wait a few years on the stock market before we got all uppity uppity about our retirement (maybe a new Escort )

If stocks are the best performing investment long-term hands down and you can wait out the ups and downs in the market, then why wouldn’t you be entirely invested in stocks to get the most bang for your buck long term. Certainly once you get closer to retirement age you should start moving a portion of your investments to more stable fixed income stocks/bonds, but when you got as much time as I do I just don’t understand why you would put any money in bonds/treasuries/etc.

So here is where someone comes along and educates me. I know stocks are riskier and you have to take into account the risk adjusted rate of return, but if bonds risk adjusted return were higher than stocks (which I’m pretty certain they aren’t) then you should be 100% bonds long-term. I know diversification is good and bonds will help hold up your portfolio in the short-term if the stock market tanks, but it’s the short term….WHO CARES ABOUT THE SHORT TERM. If long-term those stocks are going to bounce back and handidly trounce bonds, then I can handle the fact that for some 5 year span in there I am going to lose my ass (hypothetical paper I spend too much time worrying about my portfolio’s performance in the short term loss).

Now just as a caveat I’m somewhat sure my 100% stock theory here is wrong in some respects I just don’t know why, so I’m asking for someone to school me, because I’m certain that I’ve run across articles that talk about efficient allocation and some mixture is better than 100% stocks, I just am too dense to know why. I figured I can’t be the only one so hopefully once someone smarter than myself shows up with the answer this will be a valuable article for some of readers.

What got me going was that I it was pointed out that I did not consider taxes and inflation in posts like this. While the original post was suppose to be more motivational than scientific it did bring up a good point that I have not talked too much about taxes and inflation on my blog and what do you know I had an article on inflation half done in my drafts folder so here you go.

When it comes to inflation I don’t think many people pay a whole lot of attention to it when doing their retirement planning and I think just how powerful inflation can be is often misunderstood. I think at a high level we all understand inflation, basically the cost of things keep going up. We here our parents or grandparents talking about buying soda and an ice cream for a nickel, or purchasing their first car for a few hundred dollars or maybe purchasing their first house for $10,000-$15,000. To some people this may seem like a fairly land world where everything could be bought on the cheap. The problem is while things didn’t cost that much in comparison to what they cost today, people 40 or 50 years ago didn’t make much money either. The average income in 1960 was $5,600 per year.

Now looking around PF Blog land a common number that I see that for people’s retirement goal is about $2.5 million dollars. That’s a whole lot of money!! A 4% withdrawal rate on $2.5 million is $100,000. So looking at $100,000 a year I sure would think that would be enough money each year for me to retire and live happily on.

Now let’s take a little trip back to the 1960s and find some young lad who happens to be in his 20s just like me. What would his goal for retirement be? Well to figure this out I am going to rely on this website. One thing to note in the table below is that household income has actually outpaced inflation over the last 45 years, which I think means that the average household has more purchasing power today than they did in 1960

So to keep things proportional with today’s $2.5 million goal, that young lad would should have a goal of just under $400,000 written down as a retirement goal in his diary. $400,000 is just as large in 1960 as $2,500,000 is today.

Now jump back to today and that young lad is now right at retirement age and let’s say everything went as planned and he saved up his $400,000 dollars. What kind of retirement can you have on $400,000 today? Not a very good one, or at least not the luxurious one that Mr. 1960 had envisioned. What happened? The answer inflation.

Assuming the same rate of inflation what will be the average salary and average retirement goal 30 years down the road? Believe it or not the average income in 2035 if everything went the same as it did for the last 45 years would be $195,704!! Mr twenty year old 2035 would be coming up with a retirement goal of $10,562,181. Yowsers!!

So what does this mean about your retirement nestegg? Well it means you need to factor in the effect inflation will have on your portfolio or you will be sorely disappointed with your results.

For Part V of this series I plan to talk about what you need to do to factor in inflation into your retirement plan, what rates to use, and how to protect your nestegg against inflation. In other words I need to learn a lot before I right this next post

Ok I will admit that I just finished painting my son’s room so the paint fumes may be affecting my judgement here, but the thing that worries me is that I may in fact become a multi-millionaire by the time I am 50 years old and not be able to touch any of my money. Because all of my current investments are in IRAs and 401Ks I will not be able to take any money out of those accounts without paying taxes and an additional 10% before I reach the age of 59.5, which in turn means I either have to work until age 59.5 or find some other source of income to get me from whatever age I decide to retire at until age 59.5.

Tax-advantaged accounts are very powerful tools, partly because your money grows tax free and depending upon whether its a Traditional or Roth vehicle any money you add to it is either: tax-free when you contribute it (Traditional) or you are able to be withdraw tax-free (Roth). So in most cases and for most people you would just be throwing money away if you did not take full advantage of Tax-Advantaged accounts like 401ks and IRAs before putting any money in a taxable account.

When I look at my situation though I am on a “ok” pace when it comes to building my net worth and if things go as planned I will potentially have enough money in my nest egg to retire earlier than age 59.5, if I so chose. Probelm as I stated earlier is that I just won’t have access to this money. So maybe it makes sense for me in this case if my goal truly is to be able to become financially independent before age 59.5 is to actually start putting a percentage of my “retirement savings” in a normal taxable account.

If I do put money in a taxable account I will have to pay taxes every time I sell a security and also I won’t get any tax breaks when I deposit money into the account or when I withdraw it, so Uncle Sam will definitely be supporting the situation. When I look at the actual taxes I will ahave to pay though, it actually may be fairly insignifigant when it comes to having to pay taxes, at least under the current tax structure. My wife and I are firmly planted in the 15% tax bracket so even if I sell a security that I have held for less than 1 year I only have to pay 15% federal tax (ignoring state right now). When compared to the tax-advantaged accounts still looks like a horrible deal.

However I am a long-term investor and almost all of my investment are held for much longer than 1 year, which then means I pay a long-term capital gains tax on the profit instead of paying taxes at my income tax rate. Long term capital gain tax for my tax bracket is only 5%, which is much better than 15%. Also if I happen to sell one of my securities at a loss, I actually get to use that loss to offset taxes I have to pay on any gains (not something that you want to happen very often, but admit it we all make mistakes….a lot).

So in my situation where I am already in the poor-house I really am not getting an incredibly signifigant advantage of putting my money in tax-advantaged accounts, which means that at least in theory it may be advisable that I at least keep a portion of my retirement nest egg in taxable accounts just for the flexibility stand point. Also seeing as how this money will be used much earlier than the 401k and Roth IRA money, maybe its advisable for me to be more concerned about funding these taxable accounts more so than my tax-advantaged accounts as my tax-advantaged accounts will have roughly an extra 10-15 years to grow before they will be touched.
I guess this article is probably less of a definitive statement and more of a what the heck should I do article. I’m really just posting this blog entry because this question has been bouncing around him head quite a bit lately and honestly I am not sure which is the best path to take. I know there is not cut and dry answer, but I just want to know if I am completley missing something here by actually considering putting some of my money in accounts where it will in the long run create a smaller nest egg for myself. So in short I am looking for advice.

Please help!

Technorati Tags: 401k, IRA, Early Retirement

Now this does kind of put a hitch in my system, because up until this point I had been having $153 deposited into my ING account each week to make sure I had $8000 at the end of the year for the IRA deposits. Was kind of nice because I didn’t have to worry about saving, it just happened each week. Unfortunately I can’t schedule payments to my HELOC, so I will just need to add $666 onto my monthly HELOC payment. My required payment is usually around $100 and I usually pay $200, so I’ve decided $875 a month should get me in the right direction. In fact I believe if I continue with the $875 payments I will actually have temporarily eliminated my HELOC at some point in 2007 until I write the checks for the 2008 IRAs.

Anyway enough boring details, but just an example of how allocating your money a different way can make a difference in your overall performance. It’s always best to reevaluate your current allocation periodically to make sure your system is still the right one for your current situation. ING had served me well for a number of years and that’s probably why it just felt natural to keep making my IRA savings payments to that account, but turns out I was just throwing money out the window each month by not using that money to pay down my HELOC.

Well my main mortgage is locked in at 5.625% for 30 years. We only put 10% down at closing and took out another 10% Home Equity Line of Credit (HELOC). This was originally 5.75% but that was just an intro rate and it jumped up to something like 7% after the first few months. Well the Federal Reserve keeps raising interest rates and I’m now paying 7.75% on my HELOC (I believe that’s prime + .5%). Regardless I was always making the minimum payment on my mortgage and my HELOC, because I was a smart investor and could run the numbers and knew I could get more money in the stock market.

Now just recently I realized I am an idiot. Sure my theory of paying off my mortgage/HELOC as slow as possible and investing the difference works in theory. Only problem is I wasn’t investing the money in the stock market, I was storing up my extra cash in my ING Direct account earning 3.8%. Now it sure feels good to see that monthly statement from ING and see how much money I made in interest, but it didn’t dawn on me until last week that I was shooting myself in the foot.

I think as investors we tend to overlook the negative things and only focus on the positives. We overlook things like annual fees, trading costs, taxes, poor investment choices, etc. Instead we concentrate on our successes, like the stock we blindly picked that went up 75% in the first year, the fact that our mortgage/HELOC is tax deductible, or the hundreds of dollars in interest you were making each year in your ING account. Now granted the huge increase in interest I was earning at ING versus the normal bank surely was something to brag about, but when I finally realized that every dollar that I have in my ING account is another dollar that my bank is charging me for my HELOC it paints a different picture. Maybe I wasn’t as smart as I thought I was.

Well despite all the debating that is done in investing vs. paying off debt, it’s really a very simple common sense math equation to give you a yes or no answer. In this case it’s just as simple as:

Rate of Debt x (1 – Tax Rate) vs. Rate of Interest on investment x (1-TaxRate)
**note: the debt part of the equation is only for tax deductible debt such as HELOC/Mortgage/Student Loans, for normal debt such as credit card debt you would not multiply it by (1-Tax Rate)

So in my Case
Cost of HELOC: 7.75% x (1-.15) = 6.5875% vs. Return at ING: 3.8 x (1-.15) = 3.23%

So every dollar that was in my ING account not being used for anything was actually costing me 3.3575% or over twice the return I am getting in my ING account.

This is a perfect example of why you can’t just listen to the guy who sounds the smartest in a debate on a financial matter. You must look at your specific situation and run the numbers for yourself to find out what truly is best for you.

Just to show you that it’s not always right or wrong to pay off debt or invest, I’ll show you another example with my student loans that will paint a different picture.

Fixed Student Loan Rate: 2.53% x (1-.15) = 2.1505% vs. ING Savings: 3.8 x (1-.15) = 3.23%

In this example every extra dollar that I pay on my student loans costs me roughly 1.08%. Now if it was deciding between paying off student loans vs. investing in the stock market long term it would be an even greater disparity. Essentially I’d be an idiot to pay off my student loans early.

Anyway to my point here – Most financial decisions are relatively straight forward if you sit down and do some simple math, you can’t just rely on anyone else’s advice/opinion.

Going forward I plan on draining my ING account and using every spare penny that I have to pay off my HELOC. I can also write checks from my HELOC so I don’t have to be too concerned about putting too much money into my HELOC and not being able to pay my bills or have money to contribute to my IRAs in 2007. Essentially my HELOC will be my “savings storage” and if I need to withdraw money from the account I will just write out a check from my HELOC (once I get a replacement checkbook to replace the original one I shredded and threw away because I never thought I would use it).