Carla Fried: In personal finance, simple is almost always better
Sun., March 7, 2021
The financial industry loves to sell complicated – and expensive – products, but simple is quite often the smart choice.
You know all about the value of diversification. The simplest approach to diversification is to own a mix of stocks and bonds. At the other extreme is a portfolio that owns a dozen or more types of asset classes, such as commodities, alternative investments and real estate, here and abroad.
The triumph of the boring portfolio
A recent analysis by Callan created a simple hypothetical portfolio for a 45-year-old saving for retirement. The portfolio contained only the S&P 500 stock index and the Bloomberg Barclays U.S. Aggregate bond index. Over a 10-year stretch, that boring approach delivered a higher return and less risk than a more complex portfolio holding two-dozen asset classes.
While 10 years is a short time period, and we know that past performance is not a guarantee of future performance, the data suggests that getting basic diversification right (an age-appropriate mix of stocks and bonds) is the big win. Adding all sorts of bells and whistles the sophisticated portfolio isn’t necessarily a big step up. Especially when you consider that the more “sophisticated” an investment, the more expensive it tends to be.
Here’s a short cheat sheet of how to cash in on keeping your financial life simple.
Investing made simple
• TDFs. The average target date fund, or TDF, typically owns four to six asset classes, in a mix tied to the investor’s anticipated retirement age. Not as simple as two, but pretty straightforward.
Moreover, the TDF automatically rebalances from time to time to get back to the “target” allocations for a given asset. And as you age, that target allocation shifts to become slightly more conservative as retirement nears.
Nearly all 401(k)s offer TDFs, and many “default” new employees into one if they don’t choose other funds. Don’t feel like you’re settling. It’s a smart way to get plenty of “sophisticated” elements diversification, rebalancing, an age-appropriate reduction in portfolio risk as you near retirement in a ridiculously simple one-and-done fund.
• Indexing. If a TDF isn’t your cup of tea, the next best approach is to focus on low-cost index funds or exchange traded funds, or ETFs. Aiming to match a benchmark is undeniably the smartest way to invest. Gobs of data, over gobs of time periods, prove that active managers don’t produce better returns.
And active managers typically have a higher fee hurdle to overcome. The annual expense charge is typically a lot more than the annual expense ratio for index mutual funds and ETFs.
Saving made simple
• Automate. Set up an automatic transfer from your checking account to a separate savings account that transfers money every week, two weeks or month. Don’t talk yourself out of this before you give it a try. What typically happens is that once people go this route they find they can live with the transfers, and if necessary can adjust their spending.
Life insurance made simple
• Term over permanent. There are two main types of life insurance: term and permanent policies. Term life insurance is the “simple” approach, in place for a set number of years (the term), and unlike permanent it does not have an investment component. For the vast majority of life insurance needs – protecting kids until they are ready to launch, or providing funds so a partner can keep up with payments on a mortgage that won’t be paid off for a few decades – term insurance is simple and smart. It costs a fraction of permanent insurance. And you are typically better off doing your investing elsewhere.
• Income annuities over … everything else. As retirement nears, a smart strategy is to create a plan for all your fixed essential costs to be covered by guaranteed income, such as Social Security and a pension payment. But if those guaranteed income sources won’t cover your basic expenses, buying an annuity can make up the gap. Unfortunately, there are many types of annuities, some super expensive and insanely complex.
Here, too, simple works great. Check out income annuities. They are a plain vanilla type of annuity where you fork over a chunk of money and then, based on your age and when the payments start – it can be immediate, or you can buy a deferred income annuity where payouts start in a few years – you are guaranteed payments for the rest of your life. No bells and whistles.
Spending made simple
• Pay as you go with a debit card. Avoid overspending and 16% interest on unpaid credit card balances with a debit card tied to your checking account (with no overdraft coverage). If the money’s not there to cover the purchase, the transaction doesn’t go through. Services like PayPal make it easy to link a checking account so you can shop online. (A caveat: Use a credit card a few times a month for small purchases that you can pay in full. That helps build or maintain a solid credit score.)
• Stick with the basics. For instance, the base sticker price for a 2021 Ford F-150 with a regular cab and midsize box starts at $28,949. That gets you a fully functioning new Ford F-150. But if you upgrade the powertrain and opt for an equipment package that adds cruise control and reverse sensors, the cost rises by $4,000, and there are a slew more upgrades and model configurations that can double the cost of the basic model.
The same costly dynamic can be at play buying a home. You need three bedrooms, but you talk yourself into four. Skip the extra bedroom and free up more dollars each month to put toward other goals. Over a 30-year mortgage the savings can add $500,000 to your retirement saving. That’s simply beautiful.
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