Have a question:

What reasonable standards should investors use to measure how well or poorly that they are doing?

I’m sure that an answer would include “it depends” but if so, depends on what?

We are about 10% under our 12.31.07 balances and we are pleased but how pleased should we be? There is always someone who well fare better or worse but I’m at a loss as to which reasonable “standards” that I should use to know how I’m doing?

That’s a very good question.

Unfortunately, the appropriate answer is: it depends.

From a general standpoint, your portfolio’s performance should be judged against the appropriate benchmark or benchmarks.

For instance, if you have a portfolio of 50% large-cap stocks and 50% bonds, you would not base your performance on solely on the S&P 500 Index. Rather, you’d base it on a 50/50 split between the S&P 500 Index and the appropriate bond index.

If your portfolio is comprised of large-cap, mid-cap, small-cap, bonds, and real-estate investment trusts, then you need to base the performance on benchmarks for all of those asset classes.

The reason for this is that it’s easy to say, “Wow! We did awesome last year. Our portfolio was up 8%!” The reality could be that a benchmark portfolio might have been up 12%, making your 8% return not so stellar.

Of course, another way to judge your performance is to do what BG suggested in the comments of that post and that is to base your performance on whether or not you’re meeting your future goals. It doesn’t matter how your portfolio is doing if it’s not helping you meet your future goals.

For example…

Let’s say you have a retirement goal of $1,000,000 (purely hypothetical, ignoring inflation). Your retirement is 20 years away and you have $100,000 saved up so far. You are contributing $500 per month into an S&P 500-based fund. You don’t expect your contribution amount to change (again, hypothetical).

Using the RATE function in Excel, I figured that the required rate of return to meet that goal is .78% per month (9.79% annualized). Given that the monthly geometric average total return on the S&P going all the way back to 1926 is .77% (9.64% annualized), you most likely will fall short of your goal by around $25,000.

This leaves you a few choices:

1. You can accept the lower amount at retirement.

2. You can take on more risk by moving into small cap stocks, which have a higher expected return but also are a lot more volatile (more on that in a future post).

3. You can increase your contributions. Based on my numbers, increasing the contribution amount to $540 per month, put’s the expected account value at a little over $1 million.

I realize that we are talking about math based on linear growth, which never happens in the real world. But, it can still be beneficial to have some sort of basis in reality. If your goal is $1 million and you’re investing a certain amount per month, it would be wise to know if you have a shot at meeting your goal.

Thoughts?

Hi!

I’ve been subscribing to AFM for quite some time now and I really appreciate almost all of your blog posts. My room mate just bought a car yesterday and because he has little to no credit (and may have been an easy target) got a 24.99% 6 year loan (his payments are around $380/month making the $13,000 car actually cost close to $30k!). He says he’s going to refinance in a year and hopefully will get a better interest rate after establishing more credit. The salesman said that he could pay extra towards the loan to pay it off early, etc. Let’s say he could afford to pay $480/month, would it be better to pay the extra $100 every month on this higher interest rate, or pay an extra $1200 once he gets on the lower interest rate? I hope my question makes sense! You always do a great job explaining things with your spreadsheets!

Thanks,

R

Your room mate made a really bad decision for a couple of reasons:

1. Running the numbers, I come up with a principal and interest payment of around $350 per month. R says his room mate is paying around $380 per month. This means that the sales guy either talked the room mate into buying insurance or he slipped it in under the radar. Regardless, it’s some expensive insurance that will cost him over $2,100 over the life of the loan. Your friend would be wise to go back into the dealership and DEMAND that they take the insurance off. UPDATE: It was a warranty.

2. He most likely will NOT be able to refinance his loan because the car will depreciate in value very quickly. It’s hard to refinance a loan on an asset that is worth less than what is owed on the loan. Due to the high interest rate on the loan, your friend will be upside down on this loan unless he pays substantially more towards the loan than his payment. That said, given how crappy the financing is, I wouldn’t be surprised to find that this loan has some sort of prepayment penalty.

Your friend would have been smart to have done some homework BEFORE he made such a commitment. It sounds like he made a decision with his heart and ignored his head.

Now, concerning your question:

Let’s say he could afford to pay $480/month, would it be better to pay the extra $100 every month on this higher interest rate, or pay an extra $1200 once he gets on the lower interest rate?

Here is a look at your friend’s car loan amortization summary:

Assuming there’s no prepayment penalty, your friend would be wise to pay as much extra towards this loan as possible. I’m skeptical that he will be allowed to refinance this loan. I ran some numbers and found that if he paid an extra $100 per month towards the principal, he could pay the car off in less than 4 years, saving himself over $5,200 in interest.

I just hope that his decision hasn’t started him down the path of one bad decision after another. Usually people who get upside down on a car, stay that way for A LOOOOOONG time.

Here’s the list along with my thoughts on each point. You can read the original article here:

1. Pay off your nonmortgage debt.

I totally, 100% agree with this. You should have no debt except for a mortgage and possibly a (reasonable) car note.

2. Kick the debt cycle altogether.

I like what the article’s author said here so I’ll just repost it: What good is it to pay off your loans only to take out another one and rack up more debt? An easy way to save for big-ticket items –and avoid going back into debt — is to put money you would have used for monthly debt payments and interest charges into a savings account. For instance, after you make that final $300-a-month student-loan payment, keep making an equal payment to yourself. After one year, you’ll have $3,600 saved. (See “Your 5-minute guide to budgeting” for help allocating your money.)

This is something my wife and I have started doing. We had a 401(k) loan out once and when it paid off, I upped our contribution to close what the loan payment was. The cool thing is that I was actually able to increase our contribution by MORE than the loan payment because 401(k) contributions are payed before tax while 401(k) loan repayments are not. I only wish we would have done this when we payed off our Rendezvous nearly two years ago. We would have nearly $12,000 in a car fund by now had I saved our car note after the car was paid off.

I also use our high-yield savings account (well, it “used” to be high-yield…it’s not so much right now) and pay our property tax into that account so that we have the money available when the tax comes due.

3. Get serious about retirement.

The 30s is when we saw amazing growth in our 401(k) balance. Unfortunately, the market has taken back much of those gains but over the long-run things should be better.

4. Diversify your investments.

We are diversified amoung equities. We don’t have any bonds in our portfolio yet.

5. Continue to learn.

This is one area where I have been lax. I have considered going back to get an accounting degree and becoming a CPA. That’s the degree I probably should have gotten in the first place.

I do at least continue to read books so I’m not completely forsaking educational endeavors.

6. Protect your assets.

As our budget has allowed, I have upped our insurance coverages where I thought it was important. I also upped our deductibles—something that can be done if you have an emergency fund—in order to keep the costs down.

7. Live simply.

I’m thankful that my wife and I live simply. I was looking at our budget the other day and noticed that our mortgage payment, property taxes, and homeowner’s insurance added together are less than 17% of our net income. Yes, we live in an affordable area and make decent money, which makes a huge difference. Lots of people don’t have that advantage. That said, we still made the decision to buy a house that we could afford. It WAS NOT our dreamhouse and it took us EIGHT YEARS before we did any major renovations to the house. And, we STILL don’t have our master suite the way we would like it. Bottom line: unless you make lots of money, you can’t have everything all at once. There’s nothing wrong with waiting until you can afford something.

8. Make your will known.

This is an area my wife and I are going to work on this year. We haven’t done enough in this area.

9. Get a life . . . insurance policy.

Check with your employer to see if they offer life insurance. BE AWARE that if you leave your employer (or are fired), you will most likely lose your life insurance. That’s why it is good to also have an insurance policy that’s not connected to a job. I’d suggest a nice long-term term policy.

10. Be charitable.

My wife and I tithe but could also do better in giving. We do little things like give to the United Way and a couple of religious charities that we agree with but that’s about it. I also am too stingy with my time.

I thought this was a good list. I feel a little better at what my wife and I accomplished in our 30s.

I’m 27 and I can tell you really simply why we are not investing.

1. Since the day we graduated we’ve seen nothing but bad news. Huge tech crash, current crash. We’re not even back to where we were almost 10 years ago.

2. We have huge student loans to pay back.

3. Finally got out of college in 2004, saved as much as possible and am currently underwater…may as well have spent that extra money.

4. There are no solid investment vehicles that are even matching inflation right now.

5. We want to start families soon and need short-term funds, not long-term retirement funds.

6. We don’t really have much trust in our country. Frankly, I don’t think the US is really #1 anymore and our economy will only decline in the long run unless we are willing to tackle education’s inadequacies, stop giving money for oil to countries that hate us, and truly address the issue of consumerism.

We don’t see the market as a stable investment for the near future and would rather sit on cash and then get in either in the US once we balance out or elsewhere if my dollars are still worth anything.

I know firsthand how hard it is to get on your feet after you graduate from college and are just starting out in life. It is tough to think about retirement planning when you’re barely making ends meet. That said, most of those reasons are really nothing but excuses. Let’s look at each one:

1. Since the day we graduated we’ve seen nothing but bad news. Huge tech crash, current crash. We’re not even back to where we were almost 10 years ago.

Tell me one generation that didn’t experience bad news. Bad news is part of life. We go through tough times all the time. It’s nothing new. Use those tough times as buying opportunities since asset prices are typically lower during the bad times than they are during the good times.

2. We have huge student loans to pay back.

Figure out how much you owe and map out a plan to pay them back.

3. Finally got out of college in 2004, saved as much as possible and am currently underwater…may as well have spent that extra money.

Please don’t think this way. Instead, think about it this way: spending that extra money would have only put you further into the hole. It took my wife and I several years to get above water.

4. There are no solid investment vehicles that are even matching inflation right now.

Investments fall in and out of favor. Stocks are suffering right now. However, over the long run, stocks are superior inflation-beaters. Don’t base your long-term projections on short-term performance.

5. We want to start families soon and need short-term funds, not long-term retirement funds.

With proper planning you can have both. It’s extremely important to take advantage of the one thing you have on your side: TIME! Start out by putting a 3-6% of your salary into your 401(k). Once you get used to it, you won’t miss the money.

Saving for retirement when you’re trying to start a family will require some sacrifice. But, it is well worth it. The absolute BEST thing my wife and I did was to start putting money into her 401(k).

6. We don’t really have much trust in our country.

What? The greatest country in the world? Sure, we have problems but this is still a great place to live. Even if you don’t trust our country, what else are you going to do? Go live somewhere else?

Bottom line: it takes patience and sacrifice to get ahead.

I appreciate this reader’s honesty even if I don’t necessarily agree with them.

Lauren Willis, for instance, an associate professor at Loyola Law School in Los Angeles says that financial education for the masses is not only a waste of time and resources, but it may be dangerous.

At first I was shocked at such a statement. How can education ever be a bad thing? A few ways, apparently:

• Sellers of financial products would (and do) spend billions drowning out well-meaning messages to consumers from nonprofits or government agencies.
• Also, financial products and regulations are always changing making it hard for educators to keep up.
• Teaching the basics is a waste of money. Studies show that sending people to either high school personal-finance classes or adult retirement seminars does not result in better financial behavior.
• Financial literacy classes give people the illusion that they can successfully manage their finances. So rather than seek help, they end up making worse decisions.

This is very thought-provoking to me. I can understand the argument that financial companies would just try to sell consumers under the guise of a financial education seminar; financial planners and insurance salesmen and stockbrokers do it all the time – and that’s when dealing with relatively savvy and educated consumers.

Also, I can see how it might be a waste of resources in certain circumstances, especially when dealing with older people who already have bad habits ingrained. And then there are some who just can’t or won’t make responsible financial decisions no matter how many times you tell them about how great compound interest is or how important it is to pay your bills on time. Also, many people who need the most help and make the worst decisions are so under-educated and/or have so few resources that financial literacy classes are way over their heads or flat out inapplicable.

For instance, I volunteer for a non-profit and regularly lead personal finance seminars for women who are trying to enter/re-enter the workforce. Last week one middle-aged woman interrupted my speech on how to track spending to ask what she should do since she gets the numbers mixed up. She keeps getting called by the bank because someone is trying to cash a $75,000 check when she meant to write a $750 one, for instance. I was speechless, unprepared to deal with such a basic comprehension problem. If she can’t even keep her digits straight, all this other information is totally and completely useless!

Another lady wanted me to go into my “how to make a budget” example in more detail. She’d just gotten a job in fast food making $6.15 an hour and she works 30 hours a week and she wanted to know how much that meant she’d be making per month; and she wanted to know how to save up the $500 she needed to get off the Salvation Army program. I hardly knew where to start (though I did use her numbers as an example, and it turns out she can afford to save at least $100 a month, if not more).

In any event, sometimes the best financial advice you can give someone is to GET HELP – not to try to turn them into a financial planner. Lauren Willis’ advice is to try to get everyone to understand that the people selling you financial products often don’t have your best interests at heart. “What’s more, politicians need to regulate financial products and make them into things that will benefit consumers, rather than expect education to be the cure-all it is not. Sellers could be required to offer you a default product that is safe. Whenever you applied for a mortgage, for example, you would have to be offered a 30-year fixed amortizing loan.”

In general I’m an advocate of people being responsible for their own decisions rather than turning the government into a giant babysitter. But at the same time I do agree that we can’t expect everybody to be as knowledgeable and diligent about personal finance as those of us reading this blog right now.

More from Meg at The World of Wealth

But if you’re young enough, with some concerted effort you can save for only ONE year, never save another dime, and still retire with a million dollars. This Motely Fool article explains.

It all comes down to the power of compounding. Let’s say you’re 26 years old, you start with $0, and somehow you manage to invest $20,500 that year (not so coincidentally the same amount it takes to max an IRA and a 401k in 2008). If you never save another dime after that, you can retire at 67 with over $1M if you can achieve annual returns of 10%.

As daunting as it sounds, coming up with $20,500 in one year is not impossible for many 26 year olds. Maybe you live at home after graduation and save most of your salary; maybe you receive a small inheritance; maybe you even have a high paying job and decide to just save half your salary and continue living like a student. The beauty of it is, it’s a one year committment – you don’t have to do it year in and year out forever.

And the longer you wait, the harder the one year challenge would be. If you wait until you’re 30, you’ll have to come up with $30,000 in one year.

Of course you don’t have to do it all in one year (though it’s kind of an exciting concept, isn’t it?). If you can manage to have invested $30,000 by the time you are 30 years old, you can quit saving for retirement and hit 67 a millionaire. That means if you start saving at age 20 you only need put away $2,000 a year for 10 years (earning 10% a year) – and then you’re done. You’ll have $37,000 at age 30 which will grow into $1.3MM in 37 years.

I must point out that $1MM several decades from now will not buy nearly as much as it does today. Still, it’s a nice round number to shoot for. And once you’re in the habit of saving that much I doubt anyone would really be able to stop. If that 20 yr old kept investing $2,000 a year rather than stopping at age 30, she would have $2MM at 67. And if she increased her contributions with inflation (putting in $2,060 in year two, 2,121 in year three, etc) then she’d end up with almost $3MM.

[Note: invest in index funds to minimize fees and within retirement accounts to minimize taxes, and you'll be even farther ahead!]

More from Meg at The World of Wealth

We Savers (if you’re reading this you likely fall into that category) spend much of our free time reading and perhaps even writing about finance. We track our spending, set annual goals, and excitedly check our 401k balances periodically to see how much they’ve increased. Generally Savers would rather have a cushy emergency fund than the latest designer shoes or electronic gadgets.

Non-Savers like to compete with the Jones’, blow their bonuses and tax refunds on luxury vacations, and are comfortable taking on debt if it means having the latest cars, clothes, or toys. They’re much too busy enjoying life to worry about boring things like credit scores and debt-to-income ratios. Generally Non-Savers would rather splurge than put their cash in the bank.

The difference between these two types is not based on personality, education level, job satisfaction, or the ability to understand compound interest. It’s this: Savers value freedom of choice more than toys. This sentence struck me when reading a particularly interesting article on Yahoo! Finance this morning.

Savers often harshly judge their counterparts, righteously classifying them as lazy, indulgent, ignorant, even immoral. But that usually isn’t the case when you meet individuals who lack the motivation to save. I have friends who are hardworking, energetic, good people – who also don’t think twice about passing up a 401k match or financing new clothes – long term! – on a credit card. I, on the other hand, get antsy when my emergency fund drops below $5,000.

This doesn’t make me better, but it does draw a line in the sand with regard to priorities and values. Non-Savers are comfortable living for the moment and having to rely on others if push comes to shove. Savers strongly value financial independence and having options – and they know those things don’t come without some serious financial assets. Savers don’t want their standard of living to be determined by spouses, parents, or the government. They don’t want to resign themselves to jobs just to pay the bills. I for one want to go to sleep every night knowing that if I really want to, I can wake up and start traveling the world.

These are generalizations of course. Many people don’t save because they can’t afford to; others save only because they make far more money than they could possibly spend. But I’m talking about attitude and values, not actual bank balances. Of course then it gets even more dicey – to what extent can we choose our values? Some people go through specific experiences that deeply ingrain values, along with saving or non-saving tendencies – such as living through the Great Depression, or being born with a $20M trust fund.

For the rest of us it may be difficult to pinpoint the origin of the values that shape our savings habits. Whether you choose to be a Saver is likely the result of of a multitude of experiences and beliefs that shape your outlook. It’s interesting to analyze about yourself and an important thing to understand about others.

In any case, it’s important to seek a balance between the two mentalities. It’s no better to live on a shoestring and die with millions in the bank than it is to never save a dime. I’ll be the first Saver to admit to and justify periodic splurges, though my desire for financial freedom usually outweighs my (very real) desire for the latest fashions, to eat out every other night, and to become a regular down at the spa.

I know I might save and save and never actually achieve total financial freedom; and non-savers may be rewarded with good luck and/or handouts. But I sleep better knowing that I’m on my way, that my choices are growing along with my savings, and that no one else has to worry about paying my share.

More from Meg at The World of Wealth

I got my renewal in the mail this week. It looks like I’m going to have to give back some of that savings.

The renewal premium is $731, which is $84 more than my policy from 6 months ago. It doesn’t seem like that much of an increase but if they do this to me every six months, I ain’t gonna be happy! If I annualize the new premium, it makes premium $1,462 per year, which is still a lot cheaper than the old policy.

I asked the agent about this and she said that Travelers raised their rates and that my renewal reflected that. Now I know why the insurance company went with a 6-month policy! Every six months they have an opportunity to raise rates.

However, I have to totally disagree with PaineWebber’s stance. I think it is very important for clients to know how much they are being charged and HOW they are being charged, especially if commissions are involved. Why? Because there can be a huge conflict-of-interest involved when a broker recommends one product over another. Kirk, a fee-only financial planner and blogger, illustrates this point as it regards to the subprime mess.

It’s unfortunate that people can’t simply trust that their advisor is going to do what’s best for them. But, that’s the way it is.

Here’s a few questions I would ask as it pertains to hiring a financial advisor (there are more, I’m sure. These are the few I could think of off the top of my head):

1. How will you get paid for your advice?

2. How MUCH will you get paid for your advice?

3. Are there cheaper viable alternatives to the products you are recommending?

4. What share class are you suggesting I invest in? – Although I think it is somewhat rare these days, some brokers will claim that B and C share mutual funds are no-load. That’s a lie.

5. What are the ongoing fees associated with this product? How much will it cost me per year?

6. How can I be sure that you won’t forget about me after you have made the sale and have collected your commissions?

7. Is there a surrender period for this product? If so, how long is it, and how much is it?

If you are talking to a mortgage broker, you might want to ask:

1. What was my credit score? – I think you should know this information BEFORE you go and talk to a banker or mortgage broker. If they give you a number that is significantly below the number you obtained, call them on it.

2. Is this the best product for my needs? What alternatives do I have?

3. Is this considered a subprime loan? – if the rate is significantly higher or lower than 30-year fixed rates, let it be a warning sign. If it is lower, it’s probably a teaser rate, which will go up in the future.

4. How much are you getting paid for this loan?

5. Does your commission depend on the type of loan you sell me?

6. Who is the lender behind this loan?

Like I said earlier in the post, these are a few questions I could think of off the top of my head. Here’s a more extensive list from the SEC.

Many dreams never become reality because they aren’t true desires. I might dream of winning the lottery on occassion, but that’s not a serious objective in my life. There’s nothing wrong with having dreams, but if your true desires never make the transition from dreams to goals then they can become frustrating regrets.

2. MAKE YOUR GOALS SMART
Goals are more Specific than dreams. To qualify as a SMART goal, your dream should also be measurable, attainable, realistic, and timely. Setting goals with all of these characteristics almost ensures you’ll reach them if you put your plan in action and stick to it.

Specific & Measurable: “I want to have $1,000,000 by the time I retire” and “I want to lose 20 pounds” are closer to goals than dreams because they are specific and measurable objectives.

Attainable & Timely: To really make them goals you have to outline specific steps that will enable you to attain them, and you should have a deadline. Our examples would become “I will accumulate $1,000,000 by the time I turn 65 by saving $1000 each month” and “I will lose 20 pounds in six months by jogging for 30 minutes 4 days a week.”

Realistic: Of course, if your goals aren’t realistic (because, say, you’re 63 with nothing saved and you earn $50,000 a year), then they aren’t really goals at all.

3. THE REAL KEY
It’s easy to turn your dreams into goals on paper. But the real key to acheiving those goals–and being satisfied when you do–is setting goals that reflect your true values. That may sound cheesy, but it’s especially true when it comes to financial goals.

If you pick some arbitrary net worth target or aim to accumulate expensive homes and cars based on someone else’s expectations, not only might you find it difficult to muster the motivation and discipline to get there, but you’re very unlikely to feel fulfilled when you arrive. Linking your financial goals to your values (education, family, independence, etc.) gives you the energy, encouragement, and motivation you need to work towards your goals. And you might even end up happy when you reach them.

More from Meg at The World of Wealth