Some Thoughts Before We Begin
When it comes to “retirement”, the end goal is freedom, not amassing millions of dollars. Sometimes (oftentimes) you may need millions of dollars to live the life you envision, but it is not about piling up money for the sake of seeing how high the pile can grow. It is about having independence and autonomy – living life on your own terms and using money to buy you time – time for your family, your passions, and, most importantly, yourself.
- A high income/salary does not guarantee wealth any more than a modest one guarantees a life of lesser means.
- The majority of your wealth will come from making and saving your money, not your investing prowess; that is, spending less than you earn.
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“The checkbook and the calendar never lie.”
I don’t really care what you say you value. Let me see how you spend your money and your time (and energy and attention), and I’ll tell you what you value.
- Every decision you make with money shortens or lengthens your timeline to reaching financial independence.
- Avoid committing your future funds to spending obligations; instead, commit them to saving obligations.
Know what you control and make that the focus of your time, attention, and efforts.
- For most federal employees, their main sources of income in retirement consist of what is referred to as a three-legged stool: Pension, Social Security, and TSP. Only one of those “legs” is something over which they retain meaningful control – the TSP account – both the contributions made (i.e., amount invested) and when and the amount of time those contributions (and gains/interest) are invested in the stock and bond markets.
“Frontload the sacrifice.”
The best time to start saving and investing has already passed. The next best time is today.
Truths in Investing
- Historically, the stock market has been unrivaled when it comes to growing wealth over the long term.
- Savings are the foundation on which investments are built and grow. Your savings rate matters more than your investment return.
- Prudent investing is not nearly as difficult as it looks.
- While prudent investing may be simple, for the vast majority of us, it isn’t easy.
- Your asset allocation, which will be the main driver of your investment portfolio’s returns, should reflect your unique need, ability, and willingness to take risk in order to achieve your personal goals.
- Absolutely no one has a crystal ball. Time in the market is much more important than timing the market.
- Costs matter. Fees and expenses may seem small, but they compound and can have a tremendous impact on your investment portfolio over time.
- Wise investors focus on net worth accumulation and risk management, not meaningless percentage performance numbers.
General Order of Investing Priorities
- Establish an emergency fund held in cash reserves (conservatively, 6 – 12 months’ worth of living expenses).
- Contribute to your TSP up to your agency match (5%).
- This is free money. An immediate 100% return on your investment.
- Pay off any debts with interest rates greater than ~ 5%.
- Maximize your annual HSA contributions (if enrolled in an HDHP).
- Maximize your annual traditional or Roth IRA contributions.
- Generally, if you are in < 25% tax bracket = Roth IRA
- Generally, in you are in the 25% tax bracket (or above) = traditional IRA
- Maximize your annual TSP contributions (above your agency match up to the IRS limit).
- While it is true that two out of every three times you are going to come out ahead if you invest the contribution early in the year in one lump sum, be sure that you do not invest so much early in the year that you miss the agency match later in the year.
- Pay off any debts with interest rates less than ~ 5% (possibly excluding a low-cost/low interest rate mortgage).
- Invest in a taxable account (in low-cost, broad-based index funds).
The Miracle of Compounding
If you take away only one thing after your time on this site, let it be this – my most significant single piece of investment advice is to start saving and investing early.
Einstein may never have said it (as claimed), but compound interest is a wonder of the world. And anybody can take advantage of it.
“Compounding doesn’t rely on earning big returns. Merely good returns sustained uninterrupted for the longest period of time–especially in times of chaos and havoc–will always win.” – Morgan Housel
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“Compound interest” refers to interest earned from the original principle plus accumulated interest. Not only are you earning interest on your beginning deposit, but you’re also earning interest on the interest.
- Of course, if you are borrowing money, compounding works against you and in favor of your lender instead. You pay interest on the money you’ve borrowed. The following month, if you haven’t paid the amount you owe in full, you will owe interest on the amount you borrowed plus the interest you’ve accrued.
The three elements create the power of compounding – money, time, and return. If we set up our finances correctly, these three ingredients can work together to produce amazing wealth on even a modest income.
“The Benefits of an Early Start”
- Compounding really takes off over long time periods.
- Exponential functions are nonlinear, with every time period building on the previous one.
- In most retirement planning models, money saved between ages 25 and 35 produces more assets in retirement than all savings between ages 35 and 65!
“Contribution vs. Compound Interest”
- Year 1: 100% contribution and 0% compound interest
- Year 10: ~ 70% contribution and ~ 30% compound interest
- Year 20: ~ 45% contribution and ~ 55% compound interest
- Year 30: ~ 30% contribution and ~ 70% compound interest
Define Your Goal
Preparing a written financial plan is the essential first step in achieving your financial goals. Your plan should be focused on your goals, time horizon, and risk tolerance, and it should contain a clear investment strategy that determines your portfolio’s asset allocation. Your investment strategy should be based on what has worked in the past, not on anyone’s predictions about the future.
Broadly speaking, my personal goal – and my goal for you – regarding the TSP is one of sensible investing. Not speculating. Not gambling. To use an analogy, prudent investing is not about speed, it’s about mileage. My goal is for you to save and invest as much as you can in your TSP account, as soon and as prudently as you can, with the goal of achieving financial independence and living life on your own terms for as long as you can.
Figuring out your investment goals as early in life as possible is best; waiting too long introduces complications that may be difficult to overcome. Planning and execution requires a level of education, discipline, and commitment that makes many folks uncomfortable. The TSP Counselor can be your coach and mentor if/when it all seems a little overwhelming.
Make Sense of Investing
“In money terms, we seek a positive return on our investments. But the outcome of our investing will allow us a return on life.” – Unknown
Generally speaking, investing refers to devoting one’s time, effort, and/or money to a particular undertaking with the expectation of a worthwhile result.
Investing – as opposed to saving – is necessary to get a good return on your money. While investing carries risk, not earning a good return on your capital in the longer-term is a much bigger risk than any short-term market fluctuations investors may experience.
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It is understandable that many federal employees find the subject of investing intimidating. Investing fundamentals are not taught at the high school level (as they should be), and even most colleges/universities do not address the fundamentals unless you take an economics course. When it comes to knowing what to do, you’re pretty much on your own.
Investing is the intersection of big numbers, strong emotions, pushy salespeople, and the unknowable future. You may find it helpful to analogize investing to math – while people may try to woo you with complexity, the simple elegant stuff is what is really powerful. Or analogize personal finance to medical treatments – There is no “right” answer. Some will rationally forgo treatment/investments others insist on because people’s goals, priorities, and risk tolerance are different.
How much money will you need for your retirement nest egg? The general guideline suggests you should have saved/invested at least 25 times the amount you plan to withdraw each year. If invested in a ~ 60% stock / 40% fixed income portfolio, this amount has a high probability of lasting 30 years without depleting the original principal.
How will you accumulate that money? This is where investing comes in. To accumulate what you’ll need is going to require higher returns than you can get by simply saving your money in a bank. Investing in the stock market has provided those higher returns. In addition, you want to start as early as possible in order to have the power of compounding those returns work for you.
Six Essentials for Investing Success
Invest you must. No one can predict the future. Stick to simplicity. Keep costs low. Time is your friend. Stay the course. – The sage investing advice of Vanguard founder John “Jack” Bogle
Investments are a tool for executing your financial plan and achieving your financial goals. While it’s easy to get deep into the weeds with investing, here are six of the most important high-level points to keep in mind.
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Understand Risk
- Match your investments with your goals and risk tolerance.
- There is an inherent tradeoff between risk and return. As they say, “there’s no free lunch.”
- “Things that have never happened before happen all the time.” – Morgan Housel
Diversify
- Diversify your investments both across asset classes (e.g., stocks, bonds, and real estate) and within each asset class (using index funds like the five individual funds offered by the TSP) in order to spread/manage risk.
- Rather than investing in a handful of stocks or bonds, it’s often best to own diversified investment funds that own thousands of stocks and bonds across the world. This reduces the chance that one investment will have a big impact on your portfolio. It also tends to produce a smoother ride over time since not all stocks and bonds move in the same direction at the same time, and some of the fluctuations offset each other.
Keep Costs as Low as Possible
- The lower the fees on your investments, the more money you make (and keep) for yourself. Even what appears to be a small recurring fee of 1% will end up reducing the value of your investment portfolio by 64% when compounded over 50 years.
Rebalance
- Rebalance your TSP account periodically. Even though you set an initial investment allocation, over time different investments will perform differently, so your mix of investments will drift from your initial allocation.
- While it may not make an appreciable difference in terms of your returns over the long-term, periodically readjust your allocation percentages back to where you originally set them to maintain your desired exposure to risk.
Formalize Your Investment Plan
- It can be tremendously helpful to document your general investment goals and objectives in an Investment Policy Statement (IPS). Ideally, your IPS would describe the strategies you will use to meet those objectives and will include details on subjects such as asset allocation, risk tolerance, and liquidity requirements. An IPS can serve as a compass to ensure you stay on course during short-term swings in the market.
Understand and Avoid Common Behavioral/Emotional Mistakes
- Perhaps the number one killer of investment returns (unnecessary losses) is emotion. The axiom that fear and greed rule the market is true. Investors should not let fear or greed control their decisions. Instead, they should focus on the bigger picture. Stock market returns may deviate wildly over a shorter time frame, but, over the long term, historical returns for large-cap stocks can average 10%.
Bottom Line – Prudent planning focuses on things as they are today, the most likely scenario for tomorrow, and is flexible enough to accommodate changing circumstances. The best way to do this is to implement strategies and investment principles that have stood the test of time. Keep a long-term focus, minimize expenses and taxes, control your emotions, maximize diversification, and stick with your plan.
Behavioral / Emotional Factors
“Financial success is not a hard science. It is a soft skill, where how you behave is more important than what you know.” – Morgan Housel
Poor saving and investing habits/decisions are not always (or fully) the result of a lack of education and understanding. We all have strongly ingrained biases. While they can serve us well in our day-to-day lives, they can have the opposite effect with investing. Investing behavioral biases encompass both cognitive and emotional biases. While cognitive biases stem from statistical, information processing, or memory errors, emotional biases stem from impulse or intuition and result in actions based on feelings instead of facts. Eight common behavioral biases include:
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Self-Attribution Bias: The tendency to attribute one’s successful outcomes to one’s own actions and bad outcomes to external factors. Investors that exhibit this bias may become overconfident, which can lead to underperformance.
Overconfidence Bias: The tendency to overestimate one’s abilities. Most people tend to overestimate their skills, whether it’s changing an electrical outlet, being a better-than-average driver, or managing their finances.
Loss Aversion: The tendency to strongly prefer decisions that allow us to avoid losses over those that allow us to acquire gains. The human perception of a loss is as much as twice as powerful as that of an equal gain.
Recency Bias: The tendency to weigh the most recent information more heavily than older data. People tend to think in terms of past experiences, arriving at results too quickly and with imprecise information.
Anchoring: The tendency to fixate on / be overinfluenced by the first piece of information presented to us as a basis for future decisions, even if it is not current, logical, or even relevant to the decision.
Confirmation Bias: The tendency to seek out, overweight, or more readily recall information that confirms our preconceived beliefs, while simultaneously undervaluing or ignoring information that conflicts with them.
Herd Mentality: The tendency to be influenced by peers to follow trends; Copying the behavior of others, even in the face of unfavorable outcomes.
Hindsight Bias: The inclination, after an event has occurred, to see the event as having been predictable, even if there had been little to no objective basis for predicting it.
Bottom Line – As Carl Richards likes to say, “Money is not in the math department, it’s in the psychology department.” The dominant predictor of your investment success is not your portfolio. It’s in the mirror. Studies have shown that behavioral biases and emotional reactions can reduce the return on investments that investors actually receive by 10% to 75%! Don’t focus on becoming too smart; instead, focus on avoiding foolish behavior.