If your investment strategy was a dancer

1/11/2019:  I thought this would be a great time to re-post this, since many people are starting to dance with their investments!  There has been some ups and downs in the stock market the last month or so, and it’s making people do weird things.  

I’ve heard many people say that they are stopping their retirement account contributions or moving some of their stock positions into bonds or money market accounts.  Don’t do these stupid dance moves! 

Making investment decisions for retirement money based on a few weeks activity is almost guaranteeing that you will retire with less money.  Just keep contributing and rebalance as you have been, and you will come out on the other side smelling like a rose.

Investing is a patient man’s game.  This applies to almost any type of investing including real estate and stocks.  In general, if you’re investing for the long term (more than 10 years), the best strategy is to have a great plan and stick to it.

Unfortunately, many impatient men (and women) are investors.  This means many plans never make it past the first big market drop.  That’s usually when panic sets in and investors do something short sighted.

A 2015 study proves exactly this.  The study shows that we are our own worst enemy when it comes to investing.  And no other reason even comes close.

Let me set the stage by showing you the study results and what we can learn from them.

People are Not Good at Investing

I recently wrote why many investors are their own worst enemy when it comes to their investment performance.  While the subject of this post is similar, after reading the results of the aforementioned study I felt a separate post was needed.

The study was conducted in 2015, and at the time the S&P 500 Index had a 30-year annualized gain of 10.53%.  That means that every year for the last 30 years, the S&P gained an average of 10.53% per year.  Some years were way more and some years were way less (think 2008).  But on average, a nice 10% return every year.

What this means is that an investor who simply held an S&P 500 index fund for the last 30 years should have returned 10.53% minus fees.  Let us say this investor had some crazy fees which brought the return down to 8%.  Paying high fees is annoying, but 8% is still not a bad overall return.

According to the study, the average investor didn’t do this well.  In fact, they did a lot worse.  The study found that the average investor returned 1.65%!

1.65%!!!???  They might as well have put all that money into an online savings account and saved themselves the stress of investing.

This means that the average investor is probably not using index funds.  And if they are, they are using the wrong ones or are just going in and out of investments way too much.  I think the latter is the culprit for most investors.

Dancing In and Out of Investments

“Since the basic game is so favorable, Charlie and I believe it’s a terrible mistake to try to dance in and out of it based upon the turn of tarot cards, the predictions of “experts,” or the ebb and flow of business activity. The risks of being out of the game are huge compared to the risks of being in it.” -Warren Buffet in his 2012 letter to Berkshire Hathaway shareholders

(The basic game is investing and Charlie refers to Charlie Munger, Buffet’s partner at BH.)

As Mr Buffett explains in this quote, “dancing” in and out of investments is very risky.  I firmly believe this is why the average investor does not even come close to the returns of the S&P 500.

But why does going in and out of investments produce such poor returns?  Shouldn’t we always be looking to get out of our investments when things get bad and find some better places to put our money?

The answer is yes, we should be looking for better places to invest.  But the best place to invest is usually in an index fund that follows the overall market.  And it’s almost impossible to find another group of investments that does better than the overall market on a consistent basis.

And by dancing in and out of investments, most people are actually buying high and selling low.  We should always try to buy low and sell high!  People usually panic and sell investments when things get bad (sell low), and then they try to buy into investments that everybody is saying is “safe” (buy high).

A great example is the recent Brexit vote that will lead to the UK withdrawing from the European Union.  It was expected that the stock market would fall after the vote was yes, and it did just that.  The day after the vote was final, the S&P 500 dropped 66 points, which was about a 3% loss.  Not a huge drop, but pretty decent.

But if you turned on any form of financial news, you would think the Four Horsemen were arriving.  Predictions that the international markets will be in turmoil for years was the theme of the day.  The S&P actually did fall about 1% more the next day, which lead to more doom and gloom.

But about 10 days after the Brexit vote, the S&P 500 was right back to where it was before.  And as of now, 2 months after the vote, the S&P 500 is about 3% higher than it was pre-Brexit!

The Big Takeaway

What this all means is that if you were one of those investors who panicked and sold some stocks after Brexit and then bought more stocks when the market rebounded, you were dancing in and out of the market which means you were selling high and buying low.

And this is why the average investor averages returns a little over 1%.  As the study showed, just owning an S&P 500 index fund for the last 30 years and not doing anything with it would get you a 10% return.

The best course of action for investors who don’t want to make stock picking their full time job is to formulate an index fund strategy that is appropriate to your investing timeline.  Pick the funds.  Rebalance the funds every year so they don’t get too out of wack.  And then leave it alone.

You will be a better investor than the majority of America.

The humble Individual Retirement Arrangement, known in most sane circles as the IRA, is getting a level up in 2019.  IRA’s should be a big part of everyone’s retirement plan, whether you’re self employed or working for another company.

People who make too much money according to the IRS can’t take advantage of some of the tax savings that IRA’s offer.  Let’s forget about those people for now and let them swim in their vault of gold coins.  (But there is even a change there so read on Scrooge McDucks).

For the rest of America, IRA’s are a great place to save for retirement because they can reduce your tax bill. They also provide flexibility to choose your own investments which may not be available in a company 401(k) plan. 

Let’s see what’s in store for IRA’s in 2019:

Raise the Limits!

IRA’s have limits on how much you can contribute each year.  This is a bummer for us but makes sense from the government’s point of view.  If there were no contribution limits, people would be putting their entire salary into an IRA and not paying taxes on it for decades.  Those potholes would never get fixed and bombs would never get made!

So while there are limits in place to ensure the federal and state government’s get their piece of the pie, the limits are increased from time to time.

And 2019 is one of those times.  

For tax year 2019, individuals can contribute up to $6,000 into their IRA, up $500 from 2018.  This applies for Traditional and Roth, or a combination of the two.  The total contribution between all the accounts has to be $6,000 though.  The catch-up contribution limit will be the same, $1,000 extra allowed contribution for those 50 years and older.

There are a number of rules governing the tax deductible status of IRA contributions.  If you and your spouse don’t have a retirement plan at work or are self employed, then each of you can contribute $6,000.  Giving you a potential joint contribution of $12,000 for the year.  Not bad at all!

It’s also worth mentioning that 401(k) plan contribution limits have increased as well.  The new contribution limit is $19,000, up $500 from 2018.

There are many people who may not be able to contribute the maximum amount to an IRA.  Don’t let that deter you from contributing at all.  Set a monthly contribution for what you can afford to contribute.  Try to find ways to increase your income or decrease expenses to raise that contribution amount over time.

Phase in.  Phase out.

Just as there are rules governing HOW MUCH you can contribute to an IRA, there are also rules governing WHO can get the tax benefits of an IRA.  And these limits have changed for the better as well.

These “phase out” limits are different for Traditional and Roth IRA’s.  In general, contributions to a Traditional IRA are tax deductible in the year you contribute.  But you will owe taxes when you take the money out in the future.

Roth IRA contributions are not tax deductible in the contribution year but you will avoid paying taxes on future withdrawals.  So it’s a decision between getting a tax break now with a Traditional IRA or a tax break later with a Roth IRA.

If your income is too high on your tax return, you won’t be eligible for these tax benefits.  People with high incomes are taxed at higher rates, so this is another way for the government to make sure wealthy people don’t hide too much of their money and avoid paying taxes.

The good news is these phase out limits have slightly increased from last year, so more people will be eligible to contribute to IRA’s.  For the sake of simplicity, I’m only going to refer to the limits for those who are married filing jointly.  To see the info for all other tax statuses, click here.

For Traditional IRA contributions, the income limits differ if you or your spouse have access to a retirement plan through an employer.

If you DO have access to a retirement plan, the income limit to get a full deduction is $103,000 or less.  If you DO NOT have access to a retirement plan but your spouse does, the income limit is $193,000.  When neither spouse has access to a retirement plan, there is no income limit.

Roth IRA income limits are more straightforward.  If your income is $193,000 or less, then you can get the full tax deduction.  This is up $4,000 from 2018. 

So if you happen to fall within these new income limits, rejoice!  You get to save some taxes.

 It’s important to know about these IRA upgrades, but it’s even more important to take action.  If you were already maxing out your IRA contribution for 2018, all you have to do is add $41.67 to your contribution per month to max it out in 2019.

If you’re not quite at the point of being able to max out your IRA, just try to increase your contribution as time goes on and your income increases.