This article continues to examine some of the flaws in the conventional wisdom about money management and propose some new ideas for these changing times. Read on for the final three old thinking concepts, as well as the new ideas that should be implemented instead. But first, here are the four ways of thinking that were discussed in part one:
No. 1. If you manage risk through diversification, you'll be rewarded.
No. 2: A diversified portfolio lowers your risk.
No. 3: The longer your time horizon, the more stocks you should own.
No. 4. Borrowing sensibly is a good way to build wealth.
No. 5 -- You can expect your house to appreciate handsomely over the long run.
New idea: Your home won't make you rich, but it can be a helpful savings tool.
If you live in Southern California, like I do, you probably guessed sometime around 2005 or 2006 that home prices couldn't keep rising the way they were. However, the severity of the crash was still a surprise. Even many housing skeptics -- much less the folks at Fannie Mae and the National Association of Realtors -- took it for granted that home prices would keep trending upward, even with a correction. You heard a lot near the top about how the market would have to "cool off," the implication being that slow but steady appreciation was the likely future.
But the long-run data always told a different story. Yale University economist Robert Shiller, who has the distinction of having called the end of both the tech-stock boom and the real estate bubble, looked closely at the history of home prices since 1890 -- having used a database he constructed. What he found was surprising: Except for two spectacular booms -- the first after World War II and the second starting in 1998 -- real estate appreciation has been unimpressive after figuring in inflation. As Shiller wrote in his book "Irrational Exuberance," technology has allowed builders to build more houses faster, ensuring that supply never gets too far behind demand, and often gets ahead of it. Likewise, land has never been in short supply in most of the U.S., and when one town gets too crowded, Americans will gladly move "further out" for a newer, bigger house.
Even when prices rise, gains on real estate aren't as good as they look, especially once you account for expenses. Maintenance costs typically run at about 1 percent of a home's value annually, in addition to insurance and taxes. If you remodel, you shouldn't expect to recoup more than about 80 percent. You have to pay steep fees when you buy (up to 3 percent in closing costs) and sell (up to 6 percent in realtor's fees). Imputed rent may be your only real gain, especially when inflation is taken into account.
So what? This doesn't mean you have to rent, just that you should have modest expectations for your house as a wealth-builder. There can still be financial pluses. First, owning a house gives you a hedge against rising values in your own community so that you don't risk being priced out as rents rise. Moreover, a fixed-rate mortgage payment may eventually cost less than typical apartment rent in your location of choice. Second, a traditional 30-year mortgage acts as what economists call a "commitment device" -- a tool that forces you to save. Instead of writing a check to a landlord, you gradually pay off principal (and get a tax deduction to boot). At the end, you own a house. Finally, there can be great joy in owning and maintaining your own home. The bottom line: Buy wisely and don't stretch too much. A reasonable mortgage payment is roughly 25 percent to 30 percent of your monthly income. It's never a good thing to be "house-broke," especially since there doesn't appear to be any gold at the end of that rainbow anymore.
No. 6 -- Keep enough money in ultra-safe accounts to cover life's emergencies, but no more.
New idea: Relying more on cash can rescue you if an "asset emergency" strikes.
Most experts suggest that you should set aside about three to six months' worth of living expenses in the bank in case of emergency. That money covers the mortgage and puts food on the table in the near-term should you lose your job or be unable to work. The fact that you'll earn almost nothing on that money is beside the point. But what do you do after you build that cushion? Until recently, the usual strategy was to put your savings to work for better return.
But the simultaneous crash in stocks and housing has shown us that we need to redefine "emergency." It's not just something that happens to your income. There are asset emergencies too. If you had been counting on investment proceeds or home equity to pay a college tuition bill soon, for example, you know exactly what that means.
One possible approach is to look ahead at the next one to three years and try to anticipate and total up any big-ticket expenses you see coming, like tuition, a wedding or a down payment on a house. Then aim to hold that much in a cash account or in a safe and liquid savings vehicle as your new emergency fund.
It was never a bad idea to put money for near-term, big-ticket items in a safe place. But, several things conspired against common sense. First, it seemed fussy and old-fashioned to deny yourself current consumption and future growth by saving when your house and portfolio were appreciating -- and appreciating a lot -- especially when money market accounts were yielding so little.
Second, the financial services industry encouraged you to think big. Use leverage. Invest aggressively. Retire young. Retire rich. Seems pretty silly now, doesn't it?
So what? It's not easy to build cash savings and a retirement fund at the same time. If you have to make choices, build up that emergency fund first, then see if you have some flexibility on the big-ticket obligations. Maybe you can plan for a state school rather than a private college or downsize the wedding.
No. 7 -- Retiring early is a prize.
New idea: Retiring early is a problem.
Ever since Uncle Sam set 65 as the age you could retire and collect full Social Security benefits (it's 66 or 67 for baby boomers today), workers have been trying to beat that bogey by retiring early. Retiring before age 60 might have made some sense a generation ago, when average life expectancies were still less than 70 years, but they're closer to 78 years old today. Moreover, a longer life on the beach seemed well within reach earlier in this decade due to a bull market that gave workers confidence that their money could work for them rather than the vice versa. Remember the heady days of the tech bubble when people were retiring to become day-traders?
But, the reality of early retirement, even before the stock market's recent and sickening plunge, was never quite that rosy. More than half of early retirees leave work before they intended, and of those, nine-in-10 depart because they get sick or are downsized. And now the financial prospects for those who had a shot at a secure early retirement have dimmed. Long-tenured workers nearing retirement have seen their 401(k) accounts shrink an average of 30 percent throughout the past 14 months, according to EBRI. There's no way around it. The numbers require you to rethink your plans.
So what? By delaying retirement even one year, you could increase your annual retirement income dramatically. If you can hang on to your current high-paying job, that's great. The reality, of course, is that in an era of harsh cost-cutting, well-paid older workers are more vulnerable. You might not even want to stick it out any longer if the severance is decent. But there's much to be gained from finding another job, even if it's a lower-paid or part-time position. And, despite your fears of having to say something like "you want fries with that?", if you can earn enough to avoid either collecting Social Security benefits early or dipping into your retirement accounts, research shows that you may not feel a hit to your income when you retire. If your new job comes with health benefits, so much the better. The average health care tab for an early retiree before he is eligible for Medicare runs to $8,500 a year, according to an AARP study.
Despite all those benefits, if you are still many years away from the retire-or-work decision, you should think of working longer. As was earlier noted, you won't have complete control over your ability to work. Your health or the job market could make it difficult. That means you can't afford to assume that you'll just work a few more years if things go wrong. You will still have to stick to idea No.'s 1-6. Moreover, you might ask yourself if you really want your retirement to last as long as 30-40 years. Many retirees love the idea of retirement, but when they actually do it, it's not the permanent vacation they'd hoped. They're bored.
Finally, a portfolio loss in the early years of retirement, while taking income from that portfolio, is devastating. At the risk of sounding like a broken record, make sure your cash flow needs are guaranteed. It's the safest way to ensure a good retirement.
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