Enough with the fluffy stuff, how about some firm numbers. Imagine that a young college grad actually has the forethought to even think about what they need for retirement. They check out an online retirement calculator, and see their needed amount is… 5.7 bajillion dollars!¹ Shocked, they shake their head, walk away, and promise themselves to revisit it again in a few years… hopefully.

A more attainable goal: You should aim to accumulate double your salary by age 40. Doesn’t that sound more reasonable? This is the solution proposed by this Wall Street Journal article A $1 Million Retirement Fund: How to Get There From Here. (Thanks Don for the tip.) Why double?

Let’s say your salary has hit that $80,000, you have amassed $160,000 in savings, you are socking away 12% of your pretax income each month and your investments earn 6% a year. Over the next 12 months, your $160,000 portfolio would balloon to $179,518, or $19,518 more. Your monthly savings would account for $9,600 of that growth. But the other $9,918 would come from investment gains.

In other words, you’ve got to the crossover point, where the biggest driver of your portfolio’s growth is now investment earnings, not the actual dollars you’re socking away.

My only beef is that the math in the article is a bit vague. First, the article means double your expected salary at age 40, by age 40. Now, is the 6% assumed return supposed to be real or nominal? Are we assuming this is all in a 401(k)? How much inflation-adjusted money will this give you at age 65?

However, the main points remain. Money saved now will be worth a lot more than money saved later. Once you generate a “critical mass” in your retirement funds, they really do seem to gain a life of their own.

The graph on the right shows three investors, each of whom invests just $1,000 a year until age 65. However, one begins at age 25, investing a total of $40,000; one at age 35, investing a total of $30,000;
and one at age 45, investing a total of $20,000. Each earns 7 percent per year and, for purposes of this illustration, the effects of taxes and inflation are ignored.

The result? The early bird ends up with more than double the one who waits until age 35 and more than four times the one who waits until age 45.²

I’ve certainly experienced this. As our own retirement balances have grown, the recent stock gains alone are often thousands of dollars each month. So what are you waiting for? Get started with just $50 per month!

¹ Actually if you plugged in 21 years old and $40,000, the goal would be $2,591,000. Still big!
² Source: Investment Company Institute

Vanguard has just announced some changes to their fee schedule, which includes some great news for us smaller investors who like Vanguard but kept getting dinged by their low-balance fees.

Before, you had to dodge the following $10 fees:

• The maintenance fee on index fund accounts with a balance of less than $10,000.
• The custodial fee on traditional IRAs, Roth IRAs, and SEP?IRAs with a balance of less than $5,000.
• The low-balance fee on all nonretirement accounts with a balance of less than $2,500.

These have all been replaced with a single account service fee of $20 annually for each Vanguard fund with a balance under $10,000. Okay, that’s not too special. The good news is that if you agree to get electronic versions of statements and other documents, all the fees are waived!

The waiver is available immediately, so switch now 🙂 If you have $100,000 in total balances, you’re also fee-free. I already have everything set to deliver electronic format, so I’m all set. (Also you save lots of trees! Those prospectuses are thick.) In addition, you can still choose the “E-delivery and mail year-end-statement” option and get the fee waiver. That’s perfect for me.

I’ve always felt the $10 fees were justifiable, as if you were paying for things a la carte, because otherwise at 0.20% of say $5,000, that’s just $10 a year for IRS filings, paper, printing, postage, great customer service, and so on. Still, they were annoying. Even though my wife and I together have over $60,000 invested with Vanguard, we were still being hit with fees.

Now I’m less likely to switch to Vanguard’s ETF offerings, as I was considering for the future when I start putting money into taxable accounts. I prefer the simplicity of mutual funds.

It’s time for another bi-monthly update on my investment portfolio.

Thoughts
Not much going on, I have been contributing a $500 a month to my Solo 401k while trying to build up my cash hoard for a house downpayment. I still plan on tweaking my asset allocation, but I’ve just been distracted by other things and kind of want to wait a full year before making any changes.

All of our Vanguard funds are held at Vanguard.com, where there are no commissions for trading their mutual funds. Currently, everything there is in Roth IRAs, one each for my wife and I. Even though Roth IRAs rock, we haven’t contributed to one this year yet because we might be over the income limits for 2007.

The Fidelity fund is also held in-house at Fidelity, where I have my Self-Employed 401k. Funds are also no transaction fee (NTF) there. It’s a bit annoying that both their Spartan Total US and International funds have high $10,000 minimums, but the 0.10% expense ratio is nice. I could also trade ETFs, but at $20 a trade it’s a bit expensive.

You can see some older posts on how this portfolio came to be here, as well as my previous portfolio snapshots here.

Ben Stein has an good read on Yahoo Finance about what he terms the Six Key Principles of Saving for Retirement. Although I agree with all six main ideas, I question some of the specific numbers. Here are some excerpts and my comments:

1. How much you save.
Simply put, if you’re a typical American (who happens to save close to zero right now), you have to save more. When you’re young, 10 percent of your income will get you there. If you don’t start saving until middle age, aim closer to 15 or 20 percent. If you don’t start until later than middle age, save every penny you can.

Interesting. Is 10% really enough? If so, maybe I really am saving too much for retirement. 🙂 To what degree of certainty is that true?

2. How long you give your savings to compound.
A thousand dollars socked away when you’re 20 and growing at 10 percent per year will be almost $73,000 when you’re 65. The same sum saved when you’re 50 will grow to $4,200 at age 65. That’s a stunning truth that should compel any young person to start saving early — and the rest of us to start right now.

As for timing your retirement, Ray advises that if you can push it back by even five years you’ll allow your money to grow and have fewer years to need it.

Compound interest is truly powerful. A dollar saved now is worth more than a dollar saved later.

Although it hasn’t been helping me control my spending as much as I’d like either, I did make the horribly unpopular true cost of frivolous shopping calculator. 😉

3. How you allocate your assets.
Typically, for those who start early, stocks are the answer. Over long periods, a diversified basket of common stocks wildly outperforms bonds, cash, and real estate. The differences are breathtaking.

But, as we’ve seen lately, there’s also a lot of volatility in stocks. As you age, you’ll want more of your money in bonds and money market accounts. These have lower returns than stocks, but they also have far lower volatility.

Phil DeMuth recommends that, as a basic portfolio, you have half of your savings in the broadest possible common stock index such as the Vanguard Total Stock Market Index (VTSMX) and half in the Vanguard Total Bond Market Index (VBMFX)… To me, that’s a bit conservative if you’re young. I would have more in stocks and also a good chunk in international markets.

Here is a compilation of various model asset allocations from other respected sources. Pretty pie charts included!

4. How much your investment returns annually.

Now, this is largely unknown from year to year. But over long periods, stocks return close to 6.5 percent after inflation, and about 10 percent before inflation.

Can we expect 6.5% real returns in the future? Lots of conflicting opinions out there on this, but I really want to look into this more.

5. How low you keep your fees and costs.

This principle is largely about using index funds and no-load mutual funds, which makes perfect sense.

Costs matter, whether you go actively or passively managed. I’ve seen some really expensive index funds. Always look up the expense ratios and any commissions you have to pay either when you buy or when you sell for all the investments you own.

6. How closely you keep an eye on taxes.
Finally, Ray advises maxing out your tax-protected accounts like IRAs and 401(k)s; keeping high-dividend stocks in accounts that are tax-deferred; and, when retiring, carefully considering what bracket you’ll be in and drawing out your funds to remain in the lowest possible one.

Ah, taxes. Here is a discussion on where you should place investments for maximum tax-efficiency.

J.D. of Get Rich Slowly also shared his thoughts on these six points, and believes the most important factor in retirement savings is psychological.

I’ve been trying recently to try and make some minor adjustments to the target asset allocations of my portfolio. I want to create something that I won’t be tempted to change again for many years. While attempting this, I keep noticing how hard it is for a beginning investor to try and figure out where to put their hard-earned money. So many websites, books, magazines, television shows… and the amount of information being thrown at you just seems to multiply daily. Everybody has an opinion, including me. Am I right?

Who knows? I don’t. I’m simply doing the best anyone can do – read a steady stream of books, academic studies, participate in discussions, and then making a decision based on that information. I try look at the bigger picture and draw conclusions based on historical studies going back from the 1920s and not five-year historical returns. But none of us can predict the future.

What is accepted as common knowledge often changes with time. My own views shift as I read more. I also see a lot information out there that I disagree with. Therefore, I encourage everyone to do their own due diligence, keep their minds open, question things, and try to separate the wheat from the chaff for themselves. All I can do is to promise that I will try to keep doing the same.

(This will be added to my compilation of posts about managing money called My Rough Guide To Investing.)

After looking at how other people and mutual fund companies choose their asset allocation, I’m a little conflicted. Both the Vanguard and T. Rowe Price mutual funds recommend holding nearly 80% in stocks at age 50. That’s pretty aggressive in my book. To see why, let’s look at some historical numbers.

Coincidentally, a commenter left me a link to a recent FundAdvice article about fine-tuning your asset allocation. I’m actually going to ignore the specific components of his portfolio and focus on the general trends instead. Let’s just say it’s well-diversified.

The article provides historical numbers (1970-2006) that compares risk versus return for portfolios ranging from 0% stocks to 100% stocks. Risk is represented by standard deviation, a measure of volatility.

Risk vs. Return For Varying Stock Percentages

This is pretty consistent with a lot of other similar charts I’ve seen. You’ll notice that the slope of the curve decreases as you move towards holding more stocks. Accordingly, if you compare the differences between successive dots, there risk gap grows larger and the return jump decreases. In other words, you are generally getting less return for each unit of risk as you keep adding more stocks.

Here is another risk-reward chart for increasingly aggressive portfolios.

Still, this chart really doesn’t help too much either. Why not just go for the 100%? Instead of averages, let’s focus on how bad it can get over the same time period (returns not annualized):

This second chart is more important than the first one, because you won’t get any of the returns listed above unless you can “stay the course” through periods such as these.

It’s really easy to say “Oh, 30% drop, no problem”, but that’s not the whole picture. Not only will stocks be dropping, but bonds may be skyrocketing. Imagine if bonds are returning 15% a year at the same time stocks are going down 15%. You will have what appears to be a way out! Personal finance magazines will be shouting “Bonds are back!” Cutting down on your stock exposure will become the “prudent” decision.

Going back to the 80% stocks at 50 years old… Can you imagine losing 35% of your portfolio in one year at 50 years old? I would freak out. This is why age matters, it’s so much easier to shrug off losses when you know you won’t need the money for another 30+ years.