Average Joe on the Path to Retirement

According to Census Bureau data, the real median income of a household 10 years ago was $65,000.  This is where we 'll start our average Joe. Today, Joe's household income, adjusted for inflation, again from median Census Bureau data, is approximately $67,141.

The following simple exercise shows how Joe has done on the path to retirement if he followed some basic guidelines.

Tables from the book Your Money Ratios by Charles Farrell show that a 40-year-old on track to achieve an 80% income replacement at age 65 should have a nest egg of 2.4 times his income.  In average Joe's case, this amounted to 2.4 * $65,000 = $156,000.  This is what his nest egg should have been 10 years ago.

Farrell's tables also show that Joe should have been saving roughly 12% of income or $7,800/year (.12 * $65,000).  In case you're interested, Farrell also says that Joe's mortgage should have been 1.8 * $65,000  = $117,000 and his household education debt should have been zero.  Given these stipulations, at 40 years old, Joe would have been on a path for a successful retirement.

But how is Joe doing today at 50 years old given market performance over the past 10 years?  Most studies show that the average investor underperforms the market by a significant amount.  This is because the average investor jumps in aggressively when prices are high and panics when prices are low.  For our purpose, we'll assume that average Joe isn't like the average investor.  Instead we'll assume Joe invests in low-cost, well-diversified index funds.

For our performance data, we will use the chart produced by BlackRock.  The chart shows annual performance for a diversified portfolio comprised basically of 65% stocks and 35% bonds.  This is the portfolio whose performance we update each quarter.

For the purpose of the analysis, I used $7,800 as the amount Joe saved each year.  This amount would ratchet up according to plan because Joe's salary increased but also because Farrell suggests the saving rate be ramped up to 15% at age 45. I  kept it simplistic at $7,800/year.

Joe's goal, as given by Farrell's tables, is to have 5.2 * $67,141 = $349,133 to be on plan at age 50.  The following table shows the year-by-year results:

Start of Year	Amount  in Nest  Egg	Diversified Portfolio Performance	Annual Saving
1/1/2005	$156,000	+5.4%	$7,800
1/1/2006	$172,425	+13.0	$7,800
1/1/2007	$203,117	+6.0%	$7,800
1/1/2008	$223,327	-23.0% *	$7,800
1/1/2009	$177,967	+20% *	$7,800
1/1/2010	$222,087	+13.0%	$7,800
1/1/2011	$259,236	+1.8%	$7,800
1/1/2012	$271,770	+12.2%	$7,800
1/1/2013	$313,174	+20.0%	$7,800
1/1/2014	$384,335	+8.1%	$7,800
1/1/2015	$423,566

The results in the table were obtained using a bankrate calculator.  I used the calculator to calculate year-by-year returns assuming Joe contributed $300/week to a qualified, 401(k) type plan.  The calculator doesn't handle negative investment performance or returns exceeding 20%.  For those years, I used rough estimates to calculate by hand.  The performance numbers came from the aforementioned BlackRock chart obtainable from the link above.

The diversified portfolio is weighted as follows:  35% Barclay's Aggregate bond index, 10% MSCI EAFE index, 10% Russell 2000 index, 22.5% Russell 1000 growth index, 22.5% Russell 1000 value index.

The bottom line is that Joe is not doing badly, with a portfolio above target by approximately $73,000. In fact, Joe would have probably done better because most 40-year-olds would be more aggressively invested than with a 65% stocks/35% bonds portfolio.

Disclaimer:  info here is for educational purposes only.  Individuals should consult a professional and do their own research before making financial decisions.

Are You With Buffett or With the Hedge Funds?

If you like high stakes poker, you'll like this.

Back in 2008 (great timing!), Buffett made a $1 million performance bet with Protégé Partners LLC, a fund of hedge funds.  Buffett took the Vanguard S&P 500 Index fund and Protégé chose 5 funds comprised of hedge funds to see which would have the best performance over 10 years.  At the half-way point, Buffett is up +8.69%, Protégé's picks are up + 0.13%.

Worth emphasizing and keeping in mind:

• the difference (not unexpectedly) seems to be in the costs.  As most observers know, hedge funds have notoriously high fees, typically north of 2%, along with a percentage of profits.  This contest is turning out to be a real-life demonstration that even brilliant strategists have difficulty overcoming those kinds of costs over the long run. 
• Secondly, although I can't say I am familiar with Protégé, I believe I can safely assert that they are considerably better positioned to pick fund managers than, say, the typical advisory firm for individuals purporting to be able to select superior active mutual fund managers. 
• Thirdly, an investor building a nest egg would face a difficult decision at this point even though the experiment is only half way over - can he or she take another 5 years of similar results? 
• Finally, if Buffett had a portion invested in a bond index fund over this difficult period, his returns would be considerably higher than +8.69%.  In fact, the zero coupon bond each participant put the payout funds in increased in value so much that they already have the $1 million to be paid out!  The charity receiving the loser's funds will likely get considerably more than $1 million.  This speaks to the value of sticking with an allocation.

What is the bottom line?  Low-cost index funds are not easy to beat.  Maybe the market isn't efficient, but it sure acts like it is!

CNBC SCARE MONGERING

On another topic, I have to say that I've immensely enjoyed watching CNBC over the past few months. On a daily basis, they have tried their hardest to convince viewers that apocalypse was around the corner whether it was an apoplectic Simon Hobbs or a ranting Rick Santelli.  They paraded on  politicians who exhibited their talents for playing up the fiscal cliff and avoiding specifically answering questions.

Viewers were poised for a huge air pocket over the last weeks of 2012.

Obviously it didn't happen.  The question is why?  I have to offer one theory I haven't seen bandied about.  Markets emphasize recent experience and put great weight on mistakes.  Indeed, 2008 is a recent example that has kept many would-be investors on the sidelines.  Even more recently, however, many investors sold out in 2011 in the midst of the hoopla surrounding the debt ceiling talks and missed the strong rally at the end of that year.  This time around they made up their minds they wouldn't be spooked.  The widely-anticipated down draft failed to materialize.  Investors held on to a greater degree as the fiscal cliff approached at the beginning of 2013.  As this happens, it seems a sort of immunity builds up.  Keep saying there is a boogey man behind the bush and eventually it loses its scare factor - especially when believing it costs money and performance rankings.

Bogle Answers Five Questions

Jack Bogle answers 5 questions in this interview by Ben Steverman of Bloomberg.  Bogle offers the best advice he ever received, his views on the current market, and mentions the biggest problem facing the industry today.

He says "The fund industry has turned into a marketing business, and the important thing is getting a lot of assets under management. It’s run for the benefit of financial conglomerates that own most of the large mutual fund management companies."

Most of you know Bogle's story.  He founded Vanguard and established an S&P 500 Index fund.  The Street referred to it as "Bogle's Folly."  That is until it became one of the largest funds in the world. Today, of course, every major fund provider has a similar fund - which should tell you something.  Still, it is not something pushed by the fund providers - they would rather naive investors go into their money-making (for the fund providers, not the customers) active funds.

Gen-Yers Uncomfortable With Market

Source: Richard Scarry

The September 12 - September 18, 2011 issue of Bloomberg Businessweek reports ("Armageddon" "We're Dealing With a Culture of Hypochondria" by Robert Farzad) that, according to an MFS Investment Mangement survey, 40 % of Gen-Yers (ages 18-30) agree with the statement, "I will never feel comfortable investing in the stock market."

The article goes on to say that this is "understandable"  because funds are underperforming today.  JPMorgan Chase found that 47% of 2,808 funds they track trailed their benchmark by more than 2.5% this year.

This underperformance is not news to the readers of this blog.  I, along with many other bloggers, constantly preach the folly of investing in actively managed funds and constantly report on their underperformance, after all fees and costs, over the long run.  Depending on the time period studied, 75% to 90% of actively managed funds underperform over the long run.  Furthermore, it is impossible to pick the superior performers.

Source: Bloomberg Businessweek 9/12 - 9/18, p, 47

Some specific year-to-date fund returns reported by Farzad are shown in the table.  Over the same period, through September 5 the S&P 500 was down 6%.

The American Funds fund is the largest fund in the country.  The Fairholme Fund is managed by Bruce Berkowitz, who was named "domestic stock fund manager of the decade" in January 2010 by Morningstar.  By contrast to these stalwart funds, the index is the equivalent of "the lowly worm" in the picture books by Richard Scarry my kids enjoyed as infants.

The full picture can be seen in the graphic:

Source: Bloomberg Businessweek 9/12 - 9/18, p, 47

 CLICK IMAGE TO ENLARGE  The negative view of markets by so many young people is disheartening on 2 counts.  First, one of the main tenets of attaining a decent retirement is to start investing early.  In the "haven't we seen this movie before" category, you can bet if the Dow rose 2,000 points over the next 12 months the very same Gen-Yers would be jumping in.

Secondly, in the view of many long time observers of the market, young people shouldn't even be considering high-priced active funds.  Minimize cost and index the market.  Hold on for the long term.  Embrace falling prices.  You are interested in where prices will be 30 years from now!

Long Term Market Outlook

Gen-Yers face the same hurdle as most investors:  they have a hard time seeing ahead.  Like many, they look in the rear view mirror.  Like many, they focus on the problems.  Suffice it to say that, over the past 30 years, there have just about always been very good reasons not to invest, including the S&L crisis, corporate governance problems, the East Asian crisis, the need to bail out the largest hedge fund in the country, the dot.com crash, 9/11, etc., etc.

But go back to 8/6/1991.  This was when Tim Berners-Lee created the first web site.  First cell phone?  In 1994, the first cell phone weighed 2 pounds and cost almost $4,000.  My first calculator was a Bowmar Brain that cost $110 and was equivalent to what you can get today for $12.  And so it goes with flat screen tvs, medical technologies, online courses in education, online banking, and on and on.  These are the things that make the world completely different from 30 years ago and are made by companies who prosper.

These were the changes we couldn't see.  These were the changes that drove stock prices sharply higher.