The simple answer to this question is “as soon as you have money.” Ideally, you should start investing whenever you have money to invest. Time is on your side and those who start young will be very richly rewarded. That said, life sometimes happens. Not everybody is in a position to invest for retirement, perhaps because they have other more immediate obligations (medical emergency, family issue, high-interest debt, etc) or maybe they just plain don’t make enough money at the moment to save money after buying the necessities.

At the risk of wading uncomfortably deep into Dave Ramsey territory I’m going to lay out a few basic guidelines for when you should definitely start investing for long-term goals.

You’re Ready To Start Investing When…

You’re consumer-debt free

While there are some exceptions (you should definitely invest at least enough to get the full 401k employer match regardless of your other obligations, for example) you will get more bang for your buck from concentrating on paying down high-interest consumer debt than investing in the stock market. Over the long term, stocks have averaged in the 8-10% per year range. Credit card interest rates, on the other hand, are usually in the 13%+ range. It would take an incredible amount of skill to earn more in the stock market (or even with real estate) than your credit card charges. Warren Buffett can probably get away with taking out a cash advance on his credit card in order to invest in stocks, but you and I sure as hell can’t.

You don’t have to cut corners on your health to come up with money

I am a very firm believer that your health is your most important asset. While I’m not saying you have to be able to afford organic everything and belong to a fancy gym before you start to invest, you definitely shouldn’t be cutting corners on your health. If the only way you can come up with extra cash to invest is to skimp on your health insurance coverage, skip doctor visits, or eat processed junk rather than fresh vegetables, you should seriously reconsider opening that Roth IRA. That’s right: I’m telling you not to start a Roth IRA if you can’t afford to eat well. First things first.

You have an emergency fund

Some people argue a credit card or home equity line of credit (HELOC) can function as an emergency fund and while that’s probably true for people with substantial assets, there’s really no substitute for having a cash emergency fund, in my opinion. Some gurus recommend you have 3 months worth of expenses in an emergency fund, others 6 months – I’m personally more comfortable with 12 months – but however much you decide is sufficient for your situation, build up your emergency fund in full before you start investing for retirement. I find myself having to use my emergency fund far more often than I would have thought possible when I first started one. This goes doubly for homeowners. Sh!t is always breaking.

You have realistic expectations about investing

It’s quite sad how many people I come across on the interwebs with insanely unrealistic expectations about investing. In fact, it appears this describes a sizable minority of the general public. Why else would the “earn 20% per month investing in xyz” scams be so prevalent? Somebody must be buying into that crap. If it sounds too good to be true, it probably is. You aren’t going to earn more than 8-10% per year with a properly diversified portfolio. You’re just not. If you’re expecting more than that, you probably shouldn’t be investing because odds are good you’ll fall victim to a scam and lose all your money eventually. You are Madoff’s wet dream.

You understand the basics

I don’t care if you aren’t interested in investing. You probably aren’t all that  interested in brushing your teeth or flossing either, but you do it. Why? Because it’s good for you. It’s just something you have to do. It’s the same with learning about personal finance. Not being interested isn’t an excuse. Man (or woman) up and learn the basics. There are a billion good personal finance blogs on the internet, tons of good books on the subject, and some great internet forums like Bogleheads.org to help you along the way. You aren’t alone. The information is out there and investing isn’t difficult. Just do it. No excuses.

Warren Buffett once said the key to successful investing is to avoid making major mistakes. Kinda. He actually said “don’t lose money,” but I think my paraphrase is more useful. You don’t need any big wins as long as you avoid the big, fatal losses. Which is good, since very few people have the skill to score big wins consistently.

Luckily, avoiding fatal losses isn’t overly complicated. In fact, I can think of just 5 fatal mistakes. Avoid those and you’ve got an excellent chance of funding a comfortable retirement.

5 Fatal Investing Mistakes You Must Avoid

1. ) Not saving enough

This is mistake numero uno. If you aren’t saving enough for retirement it almost doesn’t matter what else you do. Chances are if you’re under the age of 40, you won’t have a pension. And while I think claims that Social Security won’t be around in 30 years are mostly BS, there’s a real chance it might be somewhat less generous than it is now.

The old rule-of-thumb is that you should save 10% of your income for retirement. That made sense when pensions were more mainstream, but today’s young worker probably needs to save more like 15% of her income to really guarantee a good shot at a comfortable retirement.

2.) Not taking personal responsibility for your finances

For many, the temptation is strong to throw up their hands and proclaim “I just don’t get this stuff. I’ll let a professional handle it.” There’s nothing wrong with seeking professional help, but blindly trusting somebody else to handle your money is a recipe for disaster. Nobody cares about your finances as much as you do.

The world is full of people who handed off responsibility for their money to some “highly qualified professional” and lost it all. Plenty of celebrities, professional athletes, and lottery winners who made more than enough money to provide for themselves and their children for a hundred years have ended up bankrupt. Why? Because they weren’t paying attention. And when the fit finally hit the shan, what was their excuse? That they trusted somebody else to handle their money and they were betrayed. Screw that. Even if you trust somebody else with your money, it’s still up to you to monitor their actions. Do you think those people who were betrayed by others kept tabs on their advisors? Nope. That’s the opposite of taking personal responsibility for your money. Don’t be that person.

3.) Investing without a plan

Investing without a plan all too often leads to emotional decision-making. If you have a well thought-out plan, you’re more likely to stay the course when the market hits a rough patch. My advice: come up with a reasonable asset allocation according to your willingness and ability to take risk and write it down along with your reasoning for choosing that particular allocation. Whenever you feel panicky, read back to yourself what you wrote. Often, that will be enough to convince you to stay the course.

4.) Neglecting to educate yourself about  money

This is an absolute necessity. Even if you decide to invest with a competent financial advisor, you need to know the basics of investing. How would you ever be able to figure out which advisors were competent and which weren’t if you didn’t?

5.) Getting too cocky

Everybody thinks they’re a genius in a bull market. How many ordinary, everyday people turned day traders thought they were stockmarket geniuses during the late 90′s when tech stocks were setting new records daily? Tons. How many still thought they were geniuses a few years later after the crash? Almost none. Don’t buy into your own hype. Everybody looks good in a bull market.

It’s difficult to get into an “active vs passive investing” discussion on the internet without somebody throwing out the “yeah, but if everybody indexed it would stop working” argument. Yeah, that’s true. But that’s also true of just about everything, everywhere.  If everybody invested in real estate, there’d be no renters. If everybody was an electrician, there’d be no plumbing, etc. You’re not everybody and shouldn’t invest as though you are. Is there currently an advantage to preferring index funds to actively managed funds? Yes, there is. Might this advantage disappear in the future? Possibly. But until it does…

Here’s Why “Everybody” Will Never Index

The aforementioned objection is stupid for a lot of reason, but let’s take a moment to think about why it will never be an issue in the real world.

1. The market is inherently efficient – The public stock and bond markets are extraordinarily efficient, which is what makes indexing such a smart strategy to begin with. But what if everybody suddenly started indexing tomorrow. What would happen? Huge pricing errors would quickly arise. Eventually, these pricing errors would grow so large that even investors of modest skill would be able to profit from active management without much effort. Once that happened the pendulum would swing in the opposite direction and everybody would become an active investor because it would be, by far, the most profitable thing to do.
2. People are greedy – Unless you believe people will knowingly avoid acting on what they believe to be easy profit opportunities for long periods of time, you’ll never have to worry about the pricing errors mentioned in item #1 above going unexploited for long. If I see $100 on the ground in front of me, I’m going to pick it up. Likewise, if some mutual fund manager sees an obvious mis-pricing, she’s going to act on it. It’s what she’s paid to do, after all.
3. Prices are set at the margin – Market prices are set at the margin, which means the market only requires a relatively small percentage of investors to be actively trading in order to remain efficient. The market doesn’t need 95% of market participants to be active in order to set prices accurately. It can get by on much less. What’s the real number? I have no idea, but I’m going to wildly speculate that it’s probably around 50%. I very much doubt indexing will ever comprise anywhere near 50% of the market. Fama and French actually wrote a paper on the topic. Their conclusion? It depends on who goes passive. Not very helpful, I’m afraid.
4. Stock picking is fun – Passive investing is horribly boring. I would know: I have to find a way to write about it on a weekly basis.
5. Passive indexers are poor owners – There is a class of investor out there, called activist investors, whose raison d’être is to unlock shareholder value by provoking management to take actions they otherwise wouldn’t be apt to take. In other words, they attempt to stir the pot for their own benefit. You can’t do that via an index fund. Corporate governance fanatics, likewise, find index investing to be untenable. Unless those types of investors disappear, indexing will never take over completely.
6. Most people don’t care and would rather just have somebody else do it – The vast majority of people just don’t care enough to learn about investing in general and indexing in particular. Those people will continue employing active managers because intuitively, active managers should be able to add value. That they don’t will go unnoticed. I don’t see this ever changing.

Ed: First of all, it should be noted this title is only half sarcastic. Have you seen some of the stuff rich people feed their pets? We should be so lucky.

Regular readers of this blog already know the truth: investing isn’t particularly difficult or complicated. Why, then, do so many intelligent and seemingly rational individuals regularly make such idiotic mistakes with their money (I’m looking at you, doctors and lawyers!)? Why do we read headlines like “Paycheck to Paycheck on $300k per Year?” on a semi-regular basis? Other than the obvious answer that it’s just really, really awesome to make fun of rich people, I believe its a combination of over-confidence and the fact that skills necessary to climb the corporate ladder just don’t translate well to money management. In most aspects of life, style over substance works out okay. Not so with investing!

Awesome photo by: DonkeyHotey

Want to be one of those people who blows through her lottery winnings in 3 years or the NBA superstar who declares bankruptcy before the age of 40? Well pull up a chair! I’ve got a few tips for you.

How To Eat Cat Food In Retirement (In 8 Easy Steps)

1.) Blindly trust somebody else with your money

Got money? Who better to manage it than your cousin’s best friend’s sister who went through a weekend course in financial planning down at the local community college?!? You’ll be cruising down easy street in your new yacht in no time with all those huge financial gains that are sure to come your way as a result of giving somebody else responsibility for your money. You have better things to do than rebalancing your portfolio once a year and monitoring your financial progress, after all. Like bocce. Bocce is fun. What could possibly go wrong? It’s not like there are greedy people out there looking to line their own pockets at your expense or anything.

2.) Invest in a business you know nothing about

Have you ever worked in a restaurant before? Managed a clothing boutique? No? What better way to learn the business than invest vast sums of your own money to start your own?!? Nine out of 10 restaurants go on to make their owners quadrillionaires, so there’s very little risk involved. Who do you know who lost money starting their own business? Okay, besides Jim, who do you know? Okay, but Karla doesn’t really count, though. Who ELSE do you know? Didn’t think so.

3.) Buy the best-performing funds

Everybody knows past performance is the best and only predictor of future results. All you have to do, then, is buy the funds with the best returns last year and you should be able to afford that island in French Polynesia by 35. 40, max.

4.) Ignore costs, because it’s returns that matter

This one is a no-brainer after the point above. Why would you care what your investments cost so long as they are the highest-performing investments? Costs aren’t good predictors of future performance, after all. Past returns are. Everybody on Wall Street who wants your money knows and will tell you that.

5.) Watch CNBC religiously

Nobody knows what’s going to happen in the markets better than a guy in a suit wearing makeup who doesn’t even actually trade stocks for a living. It’s very important that you only take financial advice from guys wearing makeup on TV, because they know best. Sorry Morgan Stanley.

6.) Always drive a nicer car than Bob

Did Bob just bring  home a new Porsche? Better man up and get a Ferrari, even if you can’t quite afford it. Your portfolio knows what car you drive and will punish you by going down if it’s not nicer than Bob’s. Seriously.

7.) Borrow money to buy your Ferrari

That’ll show Bob! He’s such a pissant. (Why don’t more people use the word “pissant?” It’s such a cool word.)

8.) Develop an insanely expensive habit and pretend it makes you sophisticated

Sure, you could go the traditional route and collect original Matisse paintings, but I urge you to be creative here. Did a random drunk hipster once tell you original-pressing vinyl records played on rare 19th century phonographs have better sound quality than CDs? Collect those! Your friends will be amazed how sophisticated you are and your net worth will, almost as if by magic, go up as a result.

Current conventional wisdom holds that interest rates are at unsustainably low levels and have nowhere to go but up. Neverminding the fact that people have been saying this for several years now, they have a point: interest rates are very low and they probably will rise in the next few years, although that’s by no means guaranteed (for instance, if the economy slips into recession again, rates will probably remain low). But so what if they do?

Assume Interest Rates Rise: Then What?

Let’s assume for a moment that interest rates must rise. Then what? Since bond prices covary inversely with changes in interest rates, bond prices will fall if rates rise. It’s unavoidable. But is that really a big deal? Well, that depends on what kinds of bonds you own!

The Worst-Case Scenario For Bonds Isn’t That Bad

The arithmetic of bonds works out this way: for every 1% change in interest rates, a bond fund’s nav will move by the amount of its effective duration in the opposite direction. For example, a bond fund with an effective duration of 5 years will drop 5% in value for every 1% increase in interest rates. So if interest rates are currently 1%, a bond fund with a 5 year effective duration would drop by 15% were interest rates to increase from 1% to a more historically-normal 4%.

Sound bad? It’s really not. For starters, the moment rates start going up your fund will begin reinvesting the proceeds from maturing issues at higher rates. Instead of paying just 1%, the fund’s yield will rapidly increase, given you a yield cushion of an extra 3% per year. Thus, over a 3 or 4 year period, you’re looking at maximum losses in the 5-6% range. Hardly ideal, but it’s not going to cause you to start eating dog food in retirement, either.

Of course, that’s just the worst-case scenario for the total bond market (which happens to have an average duration of right around 5 years). Investors in long-term bond funds, with durations ranging anywhere from 8 years up to 20+ years, could be in for a much rougher ride. On the longer side of the maturity spectrum, investors in long-term bonds could be in for losses of 15-20% or more over a 3 or 4 year period if rates rise dramatically. Investors who have shifted their bond allocation to ever longer-maturing bonds in search of extra income could get hurt, which is one of the reasons I advise people to never reach for yield: the extra risk just isn’t worth it, in many cases.

What Are The Alternatives, Anyway?

Now that we know what the worst-case scenario for most bond investors is, and that it’s not that bad, I pose the following question to the bond-bubble rabble rousers: if not bonds, then what? After all, you’ve got to invest in something unless you think putting your money under the mattress is an acceptable investment. Let’s look at how the alternatives might fare in a rising interest rate environment.

Stocks

Rising interest rates usually  mean one of two thing:

1. Rising inflation
2. A booming economy

Clearly, stocks are a great place to be when the economy is booming. If you think the economy is about to take off, it might be rational to dump bonds in favor of stocks (but only if you know something the market doesn’t!). If runaway inflation is the reason rates are heading up, though, moving into stocks will likely be disastrous because, while stocks act as decent hedges against inflation over the long run, they don’t do very well at all when inflation spikes in the short term.

So as you contemplate moving out of bonds, think about which scenario seems more likely: inflation or an economic boom. I think even the most optimistic prognosticator would have a hard time predicting an economic boom. In light of our economy’s lingering systemic issues, I think the most likely scenario is a decade of moderate, not great, economic growth with perhaps a few major bumps along the way. The bond bull market may be over, but equities aren’t exactly primed for a monster bull run. Yet.

Real Estate

The real estate recovery seems to have finally begun in earnest. I don’t see a return to pre-bubble appreciation rates, but I think it’s realistic to expect real estate prices will at least keep up with inflation (or perhaps beat it slightly) in most markets going forward. Unfortunately, there’s a very direct inverse relationship between interest rates and home prices. If interest rates go up, expect real estate values to drag. Thus, real estate isn’t a good substitute for bonds if you’re afraid of a bond bubble.

Commodities

Commodities could be your best bet in the event of sudden inflation. They could also wind up being decent investments in the event of an economic boom, as demand for raw inputs tends to increase when times are good. But here’s the problem: commodities are extremely volatile – every bit as volatile as stocks, in fact. It doesn’t doesn’t make sense to sell a mostly-safe asset (bonds) because of the possibility of a small price drop in order to buy an asset with a proven history of volatility. Commodities could go up, or they could go down. The point is, if they do go down, they will probably go down far more than bonds will even in the worst-case scenario.

Stay The Course, And Shorten Your Duration If You Must

In light of the facts, it just doesn’t make sense to get out of bonds at this juncture. You’d be trading a likely small loss over the short term for a possible large loss over the intermediate term. That’s not a smart bet to make. I do think there’s an argument to be made for shortening up your bond exposure, though. If you hold long-term bonds, I wouldn’t argue against moving to short or intermediate-term bonds. If you hold intermediate-term bonds, I wouldn’t give you any flak if you chose to move into short-term bonds. But sell out completely? That’s probably the worst thing you could do!

What do you think? Are you staying the course with bonds or have you gotten out?

***
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Last week’s post about the quality of Dave Ramsey’s investment advice got a lot of attention. Today, I’d like to focus one just one of the claims Ramsey made in the March 11, 2013 episode of his podcast (free on itunes). In it, he states that individual investors who invest with the help of a qualified financial advisor earn approximately 3% more per year on average compared to investors who don’t invest with the help of financial advisor. Here’s the exact quote at around 27:20:

“On average several different studies show that the investor using an investment professional to assist them in their purchase makes an average of 3% more on their money. They choose better funds, they stay in when the market turns down, and the big factor is they stay in when the market turns down.“

Do Advisors Boost Returns?

Is there any truth to Ramsey’s claim? I was immediately skeptical. While I obviously can’t keep on top of everything, I do a lot of reading on this subject and found it odd I’d never heard of any such studies. Usually when somebody mentions a study, I’m at least familiar with its existence, even if I’ve never actually read it. Not so, this time. And Ramsey, unfortunately, didn’t cite any sources.

After some digging, I couldn’t turn up any conclusive evidence such a study exists. That’s not to say it doesn’t exist, just that a fair amount of digging didn’t turn anything up. I did find one study, often mentioned, titled “The Impact of Financial Advisors on the Stock Portfolios of Retail Investors” by Marc Kramer and Robert Lensink (open as pdf) which found that, on average, individual investors in individual stocks who invested with the help of a financial advisor did earn returns about 3% in excess of investors who didn’t engage the services of an advisor.

The problem with the above study is obvious: it only applies to retail investors in individual stocks and not to mutual fund investors of the kind Ramsey (and I, and practically all experts) is talking to/about when he gives out financial advice. I have no proof, but I suspect what happened is that Ramsey read the abstract of this (or a similar) study and misinterpreted the results as supporting his position when, in reality, it says nothing about the ability of advisors to influence the returns of mutual fund investors, either positively or negatively. Barring good evidence to the contrary, this seems the simplest and most likely explanation of Ramsey’s statement. Is anybody out there aware of the exact study/studies Ramsey was referencing when he made that statement? If so, I’ll buy you a beer.

There’s Some Evidence They Don’t

While there is plenty of evidence good advisors can add value by acting as “ledge insurance,” as Ramsey puts it, and keeping investors from shooting themselves in the foot when the market get choppy, I’ve seen no evidence that advisors, on average, are actually better investors than the average DIYer. They don’t have a magical ability to pick mutual funds that beat the market and they don’t have the ability to time the market. While advisors do tend to put their clients in slightly better mutual funds than they would otherwise invest in, they fee they charge tends to be even larger than any resulting gain.

Consider the following overview of a 2009 study by Hacketal, Haliasso, and Jappelli: the uninterpreted results were that “investors who delegate portfolio management to a financial advisor achieve on average greater returns, lower risk, lower probabilities of losses and of substantial losses, and greater diversification through investments in mutual funds.” Sounds like a slam-dunk in favor of advisors, right? Not so fast!

The authors found that advisor-investor pairing is not random and cannot be treated as such (which would be required if you’re to believe Ramsey’s claim). Advisors tended to be matched with richer, older investors rather than younger, poorer ones. Once controlling for those factors, the authors found advisor actually, as a group, subtracted value by hurting returns and increasing risk. Does this mean advisors don’t know what they’re talking about? No! It means that even if they add value to the account, they tend to over-charge for their services, leading to a net loss in value.

Not That Financial Advisors Can’t Provide Value

The above findings represent the average case. On average and in a perfect world, most people would be better off educating themselves and investing on their own in low-cost index funds. Unfortunately, hardly anybody is an “average” investor and we don’t live in a perfect world. There is a sizeable population of investors who are truly better off investing with the help of a competent financial professional. After all, the fact that “on average” advisors extract value isn’t particularly meaningful if you’re one of the investors who, for whatever reason, just aren’t very good at managing your own money.

Maybe you need somebody to talk you off the ledge, teach you the basics (“with the heart of a teacher” as Ramsey is so fond of saying), make you stay the course, and prevent you from trading too much. This is an area where a good advisor could really make a positive contribution to your financial well-being. The problem, of course, is that there’s no guarantee this type of investor tends to attract the good advisors. It stands to reason that somebody who doesn’t know enough about markets to invest on their own probably also doesn’t know enough to be able to sort the good advisors from the bad and just might end up being taken advantage of. What’s the solution to this dilemma? I don’t know. But I doubt Dave Ramsey’s ELP program does much to remedy the situation.

You’ve no doubt heard of Dave Ramsey, the popular get-out-of-debt guru. Those of you who pay attention to such things have probably heard the following about him: his advice for getting out of debt and living within one’s means is great but his investing advice leaves something to be desired, at best (and is downright dangerous, at worst). The criticism has obviously gotten to him, because he recently devoted an entire podcast (it was the March 11th, 2013 episode) to defending his investing advice. While he may sound incredibly defensive in the podcast, in my experience he’s just extremely cranky-sounding in general, so I wouldn’t read too much into it.

So, objectively, how does Dave Ramsey’s investing advice stack up? Is he an enlightened guru? Or is he just going to end up costing his followers their retirement savings? My opinion is that as with most things, the truth lies somewhere in the middle. His advice isn’t great by any stretch of the imagination, but it’s not as bad as many of his critics would have you believe.

In A Nutshell: Dave Ramsey On Investing

Dave’s investment advice is pretty simple, in keeping with his overall message. First, he doesn’t advise anyone to invest for retirement until they’ve saved up $1,000 in an emergency fund and paid off all non-mortgage debt. While I don’t necessarily think this approach is ideal, there’s nothing particularly controversial about it (I know a few experts who would vehemently disagree).

After paying off all non-mortgage debt, Ramsey recommends you invest 15% of your income (as reasonable a number as any) for retirement. This is where things begin to get a little crazy. Ramsey actually makes several highly-controversial recommendations at this point:

1. Diversify over 4 different asset classes - Nothing controversial on the face of it. Dave recommends investing 25% of your retirement portfolio in each of the following for asset classes: growth stocks, growth and income stocks, aggressive growth stocks, and international stocks. Notice anything missing? Yep, it’s…
2. No bonds – Dave doesn’t like bonds. For anybody. Ever. He does make an attempt to explain himself, but makes several fundamental errors while doing so. More on this later. Suffice it to say I very, very, very, very strongly disagree. It is my opinion that all investors, even very young investors, should probably keep a token bond allocation. This advice is quite bad and Dave’s defense of it strikes me as extremely weak.
3. Don’t go it alone – Dave discourages his followers from trying to invest on their own. Instead, he recommends you invest through his Endorsed Local Provider program. Basically, it’s a list of local (to you) providers who recommends. There have been accusations Dave earns a revenue stream off his ELP program, making for obvious conflicts of interest. I don’t have any special information, so I won’t comment on the subject.
4. He hates most kinds of annuities – Dave is down on variable annuities on account of their complexity, which makes sense. But he also dislikes fixed annuities, which doesn’t make any sense. He simply advises us to “stay away from fixed annuities” without offering any explanation as to why (that I can find, at least).

The Good, The Bad, And The Ugly

So how does his advice and defenses of it stack up? I’ve broken things down.

The Good

Dave advocates buy-and-hold
He rightly states that timing the market is a loser’s game. Instead, he preaches the virtues of buying a diversified basket of securities and holding on for the long haul in spite of market conditions or short-term trends. This does tend to lead to superior results over time.

Stay away from individual stocks
Dave recommends investors stay away from individual stocks. I agree: most people have no business investing in individual securities.

Dave makes the psychology of investing front and center
Dave knows the biggest impediment to a successful investment program is psychology, not picking investments. The biggest mistake an investor can make is to panic and sell out at the wrong time. This is an area I think he receives far too little credit in. His solution to this problem leaves a lot to be desired, but he deserves credit for drawing attention to it.

He makes it easy to get help with your investments
Say what you want about his ELP program, but he makes it so easy to get over one of the most significant humps in setting a long-term investment program: hiring financial help. Sure, his ELPs don’t exactly set the bar high, on average, but what’s the alternative? Not investing at all or putting your money in penny stocks? For a lot of the less-sophisticated Dave followers, those are both realistic outcomes.

The Bad

Dave doesn’t care about expenses
Dave does a grave disservice to his followers by stating how he doesn’t really like index or no-load funds. Why? As he puts it, if you bought a no-load or index fund, you probably did it without the help of a competent financial advisor. That’s blatantly untrue. Plenty of financial advisors use no-load index funds, including the majority of the best ones. Investment expenses matter, even more-so when investing through an advisor. While it’s true investment advice isn’t free, going Dave’s route is among the most expensive and least-efficient imaginable. You could easily get better advice for less money than what Dave suggests.

There are seemingly few requirements to get into his ELP program
Dave’s ELP program is great in theory, but there don’t seem to be particularly stringent requirements to gain entry. From what I’ve seen, almost any advisor, regardless of skill, could get accepted just by paying a fee. I hope this isn’t true, but I’ve seen no evidence that it isn’t and plenty that it is.

His methodology for selecting mutual funds is provably incorrect
Dave recommends you buy “good growth stock mutual funds earning at least 12% per year.” How does one do that, you may ask? It’s easy! Just sign up for an account on a site like Morningstar (I do highly recommend Morningstar’s free, not paid, account). Of course, past performance is no guarantee of future results. Surely Dave knows how many dozens and dozens of studies there have been conducted proving this approach doesn’t work, right?

The Ugly

Dave still stands by his claim that you can get 12% returns
First of all, the long-term market average is not 12%! Anybody who tells you otherwise is lying. The data is shaky before 1920, but according to Ibbotson (not free, sorry) the annual compounded growth rate of US stocks going back to 1825 is only 8.5%, nowhere near 12%. 12% is crazy. But even if 12% were the correct number, are you likely to earn it on your portfolio? You may, but probably not. While the market may return 12% over the very long term, the chances of you investing through one of the boom periods isn’t all that high because there are many periods with much lower returns. Take the 40-year period from 1968-2008, for example. According to Larry Swedroe, stocks generated only a 4.2% real return over that period, a period, by the way, that included one of the greatest and longest bull markets in stock market history. That’s no more than long-term government bonds returned over that same period. That’s a loooooong time for all that risk you’re taking with equities not to pay off, which brings me to my next point.

Dave recommends 100% stocks
This is horrible advice. Expected returns doesn’t necessarily translate to actual returns. If the risk of owning stocks were guaranteed to pay off over long periods of time, they wouldn’t be risky and there would thus be no risk premium for owning them. Stocks are considered risky because there are no guarantees. Stocks will probably return more than bonds over the next 30 years, but they might not. Can you afford the consequences if they don’t? If not, you had better own bonds. Dave doesn’t seem to take this risk seriously even though history has shown its not unheard of (in fact, it happened quite recently). While I don’t think this advice is going to bankrupt anybody, it’s definitely going to make for a lot of either extremely happy or extremely bitter retirees in 30 years. Hopefully it’s the former but you shouldn’t underestimate the probability it’s the latter. That’s why I own bonds.

Dave recommends an absurdly high withdrawal rate
Last I heard, Dave was saying you could withdraw 8% of your portfolio per year in retirement. That’s absurd. Under certain very specific conditions and in a bull market this might be reasonable, but it’s absurd to think an 8% withdrawal rate would hold up under more normal conditions or, gasp, a secular bear market. Anybody who retired and tried to withdraw 8% circa 2000 is almost certainly back at work today.

The Verdict

If I had to rate Ramsey’s get-out-of-debt advice, I would probably give it a 9 out of 10. It’s excellent. His investment advice, on the other hand, would probably warrant more like a 3 out of 10. His advice is poor even by guru standards. Unfortunately, it doesn’t matter. If stocks do well, Ramsey will look like a genius. If they don’t, well, he’s already a multi-millionaire. He might lose credibility, but not his fortune. His followers, on the other hand, could be wiped out. Dave can afford a 50% drop in the value of his portfolio; his followers can’t.

Overall, Dave seems to be unaware of the findings of a huge variety of academic research from the psychology of markets to behavioral finance to asset allocation. Consequently, I would not recommend following Dave’s investing advice. Instead, I recommend you pay a visit to the Bogleheads forum and check out some of the better investment books out there, among which The Bogleheads Guide To Investing by Taylor Larimore et al, Unconventional Success by David Swensen, All About Asset Allocation by Rick Ferri, and especially The Intelligent Asset Allocator by William Bernstein (from which the inspiration for the name for this website was drawn) are a few of my favorites.

I’m going to start off this post with what seems to me an obvious given: the retirement system in this country is broken. Social security is all well and good, but the do-it-yourself retirement savings experiment has been an abysmal failure. 401k plans have been co-opted by the financial services industry for their own benefit and Americans as a group don’t save nearly enough in them as they need to, anyway. Frankly, at this point we’d be better off without them.

How To Solve This Problem?

I don’t see a return to the pension era. Pensions are expensive and let’s face it, most companies just can’t afford them in the era of globalization (despite what many union bosses would claim). Back when the US dominated global industry and American companies had ample pricing power, profits were high enough to support generous employee retirement benefits. No more. Workers are going to have to shoulder the burden of providing for themselves in retirement whether they like it or not.

Unfortunately, workers just aren’t equipped to do so. They consistently under-save. Almost as bad, the tend to mis-allocate what they do save. While a Social Security-style defined benefit system has its place, it isn’t really a scalable solution. That is, we couldn’t afford to simply expand social security to cover more of the average consumer’s retirement income needs because it can’t be invested in marketable securities other than treasury bonds. That means slow growth and unfortunately, allowing the Social Security system to invest in the securities of publicly traded companies would be too big a conflict of interest.

We Should Force People To Save

The obvious solution? Force people to save. It’s not as controversial as you might think at first. We already do it, after all. What else is Social Security but forced savings? Several nations have enforced such policies at some point in their existence to varying levels of success. Singapore still does to this day. While I think a 36% forced savings rate is more than a little obsessive and wouldn’t scale in the US,  something like a 5-6% forced savings rate would. Invested moderately in something like the TSP target retirement funds (which would be expanded to allow all citizens access and is relatively immune to Wall Street profiteering), this would go along way towards bridging the retirement income gap in conjunction with Social Security in its current form.

There are plenty of issues to work out, but the solution is workable. There would probably need to be some moderate system of tax credits for very low-income taxpayers to compensate them for the corresponding reduction in take-home pay, but practically everybody would benefit from this program. The rich would love it because it would allow them to defer even more income than they otherwise would be able to. The poor will love it because it’s a painless way (after tax adjustments) for them to save for their future.

3 Reasons Saving For Retirement Should Be Legally Mandated

There are three primary reasons this is a vastly better solution than our current system.

1. It’s automatic, tax-efficient, and frictionless – One of the main knocks against 401k plans is that they’re too complicated. When faced with too many competing options for their retirement cash, some people just give up and don’t do anything. Automatic-enrollment has mitigated this somewhat, but plenty of plans don’t have automatic enrollment and if they do, the default investment is often a stable value fund. Besides, even if you are automatically-enrolled in one 401k, you won’t necessarily be auto-enrolled which you switch jobs. And you’ve got an orphan 401k just sitting there, to boot. No wonder so many people cash out their 401k when they change jobs. It’s just easier.
2. It’s cheaper – Wall Street makes a fortune ripping off 401k investors. If I can invest as little as $1,000 with Vanguard and gain access to excellent funds with rock-bottom fees, why can’t I do the same in a 401k plan with millions of dollars in assets? It doesn’t make any sense. Expanding the TSP program to all Americans and mandating employees invest 5% of their income in it would lead to incredible economies of scale. The average American would be able to invest in quality, well-diversified mutual funds with expense ratios only huge institutions with tens of millions of dollars to invest currently have access to. That’s a win-win for everybody: except Wall Street.
3. Financial literacy has failed – People don’t need to be told they should save for retirement. They know that. Telling them not saving will make them poor isn’t going to make them more likely to save in the same way telling an overweight person eating double cheeseburgers at every meal will make them fat won’t cause them to stop eating double cheeseburgers: they already know it’s bad for them, but they do it anyway. We need to influence people to change their behavior: merely educating them isn’t enough. And what better way to influence somebody to change their behavior than to legally mandate them to do what they should have the will-power to do on their own (but obviously don’t)? It seems authoritarian and “anti-American,” but honestly, I think we’re running out of choices.

Target Date Funds catch a lot of flak these days. They were originally designed as an easy, one-stop solution for people who didn’t have any interest in managing their own money (or hiring somebody to do it for them). When the concept was first hatched a decade ago, they were widely hailed as the solution to America’s retirement problem. Finally, a simple way for the layman to invest for retirement without getting taken to the cleaners by greedy Wall Street types! Alas, it was not to be.

A Good Idea Gone Bad

Target funds were a good idea. Problem is, no good idea goes uncorrupted for long on Wall Street. These funds quickly caught on with the investing public and as a result, practically everybody got in on the action. All kinds of target date funds were launched: some good, but most full of high-cost, poorly-performing active funds. Then came the market timing. Despite how ridiculous judging something as inherently long-term as a retirement fund based on short-term results is, like everything else in Wall Street, target funds are unfortunately judged by recent returns. During the pre-bubble years when equities were booming, there was a trend of target date funds increasing their exposure to equities in order to keep up with competitors. Disturbingly, even Vanguard got in on the act (although you could make a reasonable argument that the changes were necessary).

A Laundry List Of Valid Criticisms

Target funds are seriously flawed investment vehicles. They:

• Attempt to time the market – While not overt, that several large firms are guilty of increasing/decreasing equity allocations after long runs of over/under performance is extremely suspicious. Market timing? Maybe not. But if it looks like a duck, walks like a duck, and quacks like a duck…
• Conform to no real best-practice glide path standard – A 2020 fund from one fund family may be nothing like the 2020 fund of another fund family. Just how much should an investor retiring in 7 years have in equities? 50%? 75%? 35%? There is no consensus. This had led to the popular argument that since you can’t really tell whether or not a given target date fund is appropriate for an investor of a certain age by looking at the date, they are useless as tools for unsophisticated investors. I do not share this view.
• Are expensive – With the exception of Vanguard and a few other low-cost providers, the majority of target date funds are relatively expensive. T Rowe Price and Fidelity both have reasonably-priced target date funds for actively managed shops, but even the 0.61% T Rowe currently charges can add up to one heck of a performance drag over time. Of course, this isn’t a feature just of target date funds.
• Are too risky – Some of them are too equity-oriented for many investors, I agree.
• They aren’t the best option - Target date funds are almost never the best option.

Why I Still Recommend Them Anyway

All of the reasons above are perfectly valid. An investor could legitimately choose to avoid target date funds for any one of them. And even the good target funds from the low-cost fund families such as Vanguard aren’t the absolute best options. Vanguard’s target funds are cheap, but they are still more fund than holding the same portfolio separately using admiral shares or ETFs.

So when do I still recommend them to people who neither have knowledge of  basic investing nor the willingness to learn (a far larger subset of the population than the financial literacy advocates would have you believe, by the way)? Simple: because target date funds are the best option under these less-than-ideal conditions. A pension would be better for these investors. A low-cost three fund portfolio would be better for these investors. Picking up a book and learning investing fundamentals would be better for these people. There are a ton of things that would be better for these people than owning an expensive target date fund.

Well, guess what? None of that is going to happen. A generous pension isn’t going to magically materialize. Social security payments isn’t going to double overnight. Somebody barely making ends meet who hates money isn’t going to pick up a book and learn about investing. It would be awesome if they did, but it’s just not going to happen most of them time. In this situation, an expensive 1% ER target date fund is the best they’re going to get. Yes, they’re going to give up a significant portion of their returns to the fund company. Yes, they’re probably going to end up with less in retirement than they deserve because they’ll be invested in subpar active funds. But you know what they won’t do? They won’t panic and sell out at the bottom, because their investments are on auto-pilot. That’s a good thing.  They won’t try to time the market, because their investments are already being “handled by experts.” That’s a good thing. They won’t chase penny stocks or be so quick to fall victim to some get-rich-quick-with-real-estate guru because hey, their portfolio is already diversified.

Do target date funds sell the highest returns? No. Could they be much better? Yes. Would it be better for naive investors to go with the low-cost Vanguard option over the high-priced boutique option? Yes. Will these investors end up taking either too much or too little risk to meet their goals, in aggregate? Probably. But they’ll move on with their lives and do the absolute best thing a person with little financial knowledge could possibly do to their portfolio: ignore it. Target date funds aren’t great, but you could do a lot worse than buy one and ignore it. If this sounds defeatist, it is. I believe many people are capable of investing their own money competently. But some people, a significant chunk of the population actually, just aren’t capable of doing it themselves. For those people, target date funds are the best option barring a return to the pension system. I’m not excusing the crappy state of our retirement system in this country, but it is what it is. Until it changes for the better, this is what we’re stuck with.

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All mutual fund data in this article is accessible using a free Morningstar account. If you don’t already have one, I highly recommend you sign up for one now.

It happens every time the Dow comes close to a new all-time high (why people pay attention to the Dow instead of a more suitable index, I’ll never know): nervous investors flood internet forums with questions like “I have $10,000 to invest but it feels like I’ve already missed the party. I don’t want to invest it all now only to lose it in a market crash. Should I wait?” As if there’s something magical about the Dow hitting a new high. I’ve got news for you: the stock market grows over time. Hence, the Dow will always be hitting new highs eventually. It doesn’t mean stocks are due for a decline.

For the record, I don’t think stocks are in a bubble. Here are three reasons why stocks aren’t in a bubble.

3 Reasons Stocks Aren’t In A Bubble

 1.) Valuations are reasonable

Of all the stock valuation ratios perhaps the most hallowed is the price-to-earnings ratio (P/E Ratio), which is a measure of how much investors are willing to pay for a dollar of earnings. Back in the late 90′s, the P/E ratio peaked around 34, meaning investors were willing to pay $34 on average for every $1 of corporate earnings. Today, the P/E ratio over the trailing 12 months stands just under 17, or almost exactly half what it was before the tech bubble burst.

Since the late 1800′s, the P/E ratio has fluctuated wildly but has averaged around 15 times earnings. So while stocks may be slightly more expensive than the long-term historical average, they’re still only half as expensive as they were before the last big stock bubble burst. The Schiller P/E 10 ratio shows similar relative valuations. While nobody can say for certain stocks won’t undergo a major drop in the near future, it won’t be because stock valuations are outrageously high.

2.) Individual investors still haven’t piled on

Usually in a stock bubble, individual investors pile on near the top. Market timing just doesn’t work, and individual investors have absolutely horrendous timing. While there’s been an uptick in individual investors buying the last month or two, up to that point individual investors had been net sellers every month since 2009. Overall, individuals still own far fewer equities directly than they did at the market bottom. It’s the institutions (read, smart money) that has been doing the heavy buying the last few years. When individuals begin piling on and P/E gets above 20, then it’s probably time to worry. But as it stands, I don’t see any signs of “irrational exuberance.”

As an aside, check out this article I wrote about market timing right as the market was within a few months of hitting a bottom towards the end of 2008. The article is indicative of the panic prevalent in those days. The market would go on a monster bull run over the next few years and those who sold out at the bottom missed those gains.

3.) High school kids aren’t daytrading

When I was a senior in high school (I graduated in May 2000), a classmate of mine was heavily into daytrading  and even tried to convince me to try it. It was my first real exposure to the world of investing. Sure, I knew what mutual funds were and I was generally aware of the concepts of diversification, but the whole daytrading thing sounded pretty exciting. I briefly considered opening up a daytrading account with a few hundred dollars and giving it a try but luckily, my laziness saved me from losing all my money.

In retrospect, the fact that 17 and 18 year olds were even discussing daytrading stocks was a major red flag that things were getting out of control. I’m not in high school anymore, but I just don’t see that level of obsession with stocks (or the level of obsession with real estate a few years ago) right now. Well, there is that recent article I saw about a 16 year old actress daytrader who has her own website giving out financial advice, but that seems like an isolated occurrence. Tellingly, her advice on active trading seems to be geared towards taking control of your own financial destiny rather than making a quick fortune. Her advice is wrong, but at least it’s not blatantly based on greed.

Could I Be Wrong?

Of course, I could be wrong but I just don’t see it. I’m not saying stocks won’t drop significantly in the near future, just that if they do, I don’t think it’s because stocks are in a bubble. An economic crash could do the trick, for example. What do you think? Do you have any convincing arguments that stocks may be in a bubble? Leave them in the comments below!