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This is the fourth in a series of posts made in preparation for a presentation I will be making for physicians in fellowship training. In the last post, I demonstrated how reaching a goal of a $9,000,000 retirement fund is achievable in 35 years if you invest $40,000 per year and get an annual rate of return of 7.5%. On the surface, this sounds so simple, but in reality, many physicians never get this rate of return due to the pitfalls that get in the way. In this post, I’ll outline some of the common pitfalls.
Physicians are in one of the highest paid professions on the planet and so they have a lot of money to invest. But we usually know a lot less about investment than other professionals in business or law. Consequently, there are a lot of people who would like to get paid to steer us toward our retirement goal. Although you are going to need some advice, it is up to you to be sure that you are not being taken advantage of. Here is where we often go wrong:
- Expense ratios. Lower is better. If you are investing in a mutual fund, for example, there will be a certain percentage of the total fund balance that you pay each year to the investment company for them to manage that mutual fund. This is called an expense ratio. These can vary from as little as a tenth of a percent to as much as 2%. Let’s assume that you have $100,000 to invest and you anticipate an 8% annual rate of return and you’re going to leave the money in for 20 years before you use it. Now let’s look at two mutual funds: Fund A has an expense ratio of 0.21% and fund B has an expense ratio of 1.15%. The cost to manage fund A over the next 20 years will be $19,000. The cost to manage fund B over the next 20 years will be $96,000. In other words, when you get ready to take the money out of this account in retirement, you’ll have $77,000 less if you paid the higher expense ratio.
- Mutual fund category. Index funds are better than managed funds. With an index fund, the investment company buys stocks based on the proportion of various companies in some index, for example, the S&P 500. It is all done by computer and the investment company does not have to hire a lot of expensive analysts and stock-pickers to choose the stocks that are in that fund. With a managed fund, there are analysts, managers, and stock pickers that try to outwit other investment companies’ analysts, managers, and stock pickers in order to get a higher annual rate of return. As a general rule, index funds have lower expense ratios than managed mutual funds and so right away, you’ll have more money in your retirement account when you retire if you invest in index funds. On the surface, you might think that the managed funds would perform better than the index funds because they are backed up by all of this human brainpower to choose better stocks to put in the fund. However, as it turns out, humans are pretty fallible in the stock market just like they are in other professions. Although there will always be some winning funds that outperform everyone else, you won’t know for sure now which funds will be winners. Over time, index funds outperform managed funds as a whole..
- Commissions. No load is better than a front load. Some mutual funds will require a “front load fee” which is essentially a commission that you pay when you first put money into that fund. This reduces the amount of your investment and over time, this results in a reduction in your total retirement fund amount. Let’s go back to the example of $100,000 invested for 20 years with an 8% annual return. If a mutual fund has a 1.5% front load fee, the ending value of that investment will be $485, 290. If the mutual fund does not have a front load fee, the ending value will be $492,680. That is a $7,390 difference that you ended up paying over the course of that investment.
- Stocks versus bonds. In the long run, stocks perform better than bonds. In the short run stocks are more volatile than bonds. In the 50 years since 1965, the average annualized rate of return in stocks has been 9.91% whereas the average annualized rate of return of bonds has been 6.58%. In other words, $1 invested in stocks in 1965 was worth $112 by 2014 whereas $1 invested in bonds in 1965 was worth $24 by 2014. The problem is that the value of stocks can vary wildly from year to year whereas the value of bonds varies relatively little from year to year. Therefore, if you have a long investment horizon, stocks are a better investment but if you have a short investment horizon, bonds are safer. But remember, when you retire, you are not going to be taking all of the money out of your retirement fund the day you retire; some of that money is going to need to stay invested until you die 15, 20, or 30 years later. Therefore, it is best to have a mixture of stocks and bonds in your retirement fund with a higher percentage of stocks when you are younger (say 80-90% when you are age 30) and a lower percentage of stocks when you are older (say 50% when you are age 65). An important caveat to this is that if, in addition to your retirement fund, you also have a pension or an annuity and can expect a fixed income from that pension or annuity for the rest of your life in retirement, then you can afford to have a greater percentage of your other retirement portfolio in stocks since that pension or annuity will give you some insulation from the inevitable year-to-year volatility in stock prices.
- Stock turnover. Less is better. If you are purchasing stocks in individual companies for your retirement fund, then every time you buy and sell a stock, you are going to have to pay a stock broker a fee. If you are buying and selling frequently, then those fees add up and you can end up with less money in your retirement fund than if you bought a stock and held it. This has to be tempered with not holding onto loser stocks forever but you have to be judicious. Beware of the financial advisor who periodically sends out sell and buy advisories for the stocks that you own; although it is possible that he (or she) is some kind of stock market oracle with a unique ability to see into the future of stock prices, it is also possible that he needs to make a boat payment on his new yacht.
In the next post, I’ll show how the tax implications of different investment options affect your final net retirement fund value.
August 22, 2016