What to Avoid to Reach Financial Independence (especially low returns)
I’m a big fan of James Clear, author of Atomic Habits. James wrote recently on the idea of inversion-or thinking through how you would not achieve your goals. It’s a powerful tool. If you’re aware of the pitfalls that can derail you, you can avoid them. Financially, there’s a lot of pitfalls you need to avoid. I’ll summarize them in five areas:
Low returns (seems obvious-it’s quite nuanced, though)
Bad advice and/or high fees
Paying too much in taxes
Insurance mistakes (while insurance has a reputation for scuzzy sales, it is the foundational backbone of your financial life before age 55)
Family troubles (touchy subject, so I saved it for last!)
In the niche I work in, most people have a big advantage over the average American. As I wrote in this blog, O&G/petrochemical professionals have a distinct advantage with their savings rate. While it’s true that incomes in this industry are higher than most, that’s not the differentiating factor. There are a lot of ways to make $200,000+ in America. The real advantage is that the average O&G company is matching 14-20% in their employee’s retirement accounts every year (I’m counting 401k and pensions). That is 5-10x more than most white-collar professions.
Think about it this way: if your goal is to retire from your job with $5 Million, the easiest way to do it is to make sure you’re saving $50,000 every year. Simply do that for 30 years and make 7-8% per year, and you’re at $5,000,000.
For most people, it requires a $500,000+ income to save that kind of money in your retirement accounts. This is because most companies have a 401k match of 3-5%. In this industry, you can make $160,000/year at Conoco Phillips, and thanks to the enormous company contributions, you can do that with a relatively normal savings rate.
So, how could you possibly not reach financial independence? There are plenty of options. My list above is a good start. This week, let’s talk about low returns.
Low returns feels too obvious to mention. Still, it can creep into your financial life in several ways if you let it. I’m convinced that if we made a list of simple ideas that everyone understands, but few people truly apply to their lives, compound interest tops the list.
If you believe in compound interest, you would be a hawk with your finances. I’ll dive into this in a minute, but the most immediate application is limiting bond/cash exposure and completely avoiding whole or permanent life insurance.
To start, let’s paint an accurate picture of just how big this topic is for you. I’ll split it into two camps. The first is someone mid-career still in the accumulation phase. The second is someone entering retirement and beginning the distribution phase.
The difference between a 4% annual return and a 7% annual return.
The stock market has historically given a much higher return than both of those numbers. I decided to lower our return comparison to 4% and 7%. Why? A combination of wanting to prove my point with conservative estimates and low interest rates (bonds in your portfolio will likely see a far lower return than their historical average).
ACCUMULATION PHASE: AGE 35
CURRENT 401K BALANCE: $100,000
INVESTING $50,000/YEAR (INCLUDING COMPANY CONTRIBUTIONS)
4% ANNUAL RETURN AT AGE 65: $3,170,000
7% ANNUAL RETURN AT AGE 65: $5,615,000
Now, let’s take a look at a retirement example.
DISTRIBUTION PHASE: AGE 65
CURRENT PORTFOLIO: $3,000,000
TAKING $10,000/MONTH FOR RETIREMENT INCOME
4% ANNUAL RETURN AT AGE 95: $3MIL???*
7% ANNUAL RETURN AT AGE 95: $11,000,000*
*Sequence of returns is critical in this example. If we get a steady 4% every year, that provides the monthly income without touching the principal. But what if the first 10-20 years offer terrible returns, and the final ten years are great. You might average 4% but could run out of money before age 95. NOTE: A guaranteed 4%/year investment does not currently exist.
So what’s the application here?
You likely didn’t need me to tell you that you’ll have a lot more money if you make 7% instead of 4% over a thirty-year period. Even though this is elementary knowledge, a huge chunk of people miss one or both of the following two points:
Limit bond exposure in your portfolio
Bonds. For about 35 years, bonds were a fantastic investment. Drastically less volatile than stocks, they still provided returns north of 5% (well above 5% depending on the bond type). To fully understand bonds, you need to know how bonds provide investors with a return.
Bonds provide a return in two ways.
The interest rate associated with the original bond. This is the bulk of your return. Imagine buying a ten year Coca Cola bond with an 8% interest rate in 1990. We’ll come back to this.
Market fluctuation from interest rate movements. This is secondary, but can still be a force. Imagine the Coca Cola bond above. If you own an 8% bond and current interest rates are at 5%, your 8% bond has a higher market value.
For decades, bonds had both of the above working in their favor. Interest rates were high. So, you could purchase bonds with an attractive yield. But wait! There’s more! Not only did you enjoy your high yield, but interest rates were also decreasing. So, the bonds you purchased five years ago were now trading at a premium.
Both of those now look pretty bleak. Current interest rates are very low. So instead of 8%, maybe you can get 2%. But it gets worse. Your 2% bond today might be worth less if interest rates are higher five years from now.
What does this mean for you? If you’re young, you probably don’t need me to tell you this, but do not own too much in bonds. Virtually no one under 50 should have 40% in bonds (or anything close to 40%).
Where this really gets interesting is if you’re retired or approaching retirement in the next decade. Standard retirement insight for decades has said your age and bond exposure should be directly correlated. As you get older, you need to own less stocks and more bonds. This is fantastic advice for a society where most people retire at 62 and pass away at 70. It can be dangerous today with lifespans reaching well over 90. In fact, there’s overwhelming evidence that increasing your stock exposure throughout retirement decreases your odds of running out of money.
To be clear, bonds still play a critical role in a portfolio. But it needs to be more customized than it used to be. For decades, investment firms have operated by handing clients a risk tolerance survey, shoving their money in a pre-allocated model of stock and bond funds, and checking in once per year. The result was almost all retired clients ended up with a canned 60/40 or 50/50 stock/bond portfolio mix.
Instead, craft a war chest as you approach retirement. Plan out how much money you will need for living expenses and taxes for the next five years. That number should be allocated to high-quality bonds. What if you’re extremely risk-averse? Maybe increase it to seven years. Then, your advisor should be able to allocate and tweak as needed. This dynamic approach is far more sensible for retirement timelines that could last three or four decades.
One other thought: include your pension and Social Security in this plan. I see far too many 60 year-olds with a 50/50 stock/bond 401k allocation. This would be one thing if the 401k were the bulk of their assets. Quite often in O&G, that is not the case. They usually have a pension of equal value and have maximum Social Security benefits. So, they may think they’re 50/50. In reality, they’re closer to 20/80 (20% stocks, 80% fixed or bonds). Or think about in real terms. When they retire and need income, they have their pension. Even if the stock market crashes at a 1929 level and takes years to recover, they can make it through unscathed with proper planning.
With stock exposure making sense for retirees, it’s critical to have enough exposure to large caps, small caps, value stocks, growth stocks, international, and emerging markets. We have no idea where returns are going to come from and what those returns will be. With that being the reality, all we can do is put ourselves in the best possible position to capture higher expected returns.
Avoid expensive permanent insurance
This is critical. I’ll write on insurance in a few weeks. As I alluded to, it really is the foundation of your financial life in the accumulation phase (age 25-50). But, you need to avoid permanent or whole life insurance. Your future wealth is partly determined by your decision to buy permanent life insurance or term life insurance. For the vast majority of you, you should likely choose term.
@WhiteCoatInvestor is a doctor in Utah with one of the most successful financial websites today. Doctors get ripped off from “financial advisors” more than most. This happened to the author. So, he started a blog and now teaches thousands of doctors to avoid his mistakes. He has done such a tremendous job on this topic that I won’t add much. You can see his work here.
I’ll highlight two main reasons you should avoid permanent insurance.
You are likely not going to break even for decades. That’s right. Your cash value is less than your premiums for a long time. White Coat Investor (and myself) have reviewed multiple policies with a break even as bad as 20-25 years.
Your total lifetime return is somewhere in the 3-4% range. Your guaranteed return is about 2%. Your “predicted” return with “dividends” (read: not the same as stock dividends) promises 5-6%. You should expect somewhere in the middle. If I’m investing in something for 50 years, I undoubtedly require a higher return than 3-4%.
I’ll restate something I mentioned at the end of my stock/bond section. We have no guarantee with investing. All we can do is position our assets in the best possible way to capture higher returns. Your future wealth and financial freedom depend on avoiding low returns.