Financial illiteracy is common among Americans. While you may not be a financial expert, avoiding these financial planning errors can help ensure your future success.
Financial literacy in America is about as common a trait as fluency in Flemish. The simple fact is most Americans—whether it's due to lack of interest, believing Wall Street mythology and sales spin, or internal bias—could probably stand to understand personal finance concepts more deeply.
At Fisher Investments, we believe this lack of literacy causes many to approach retirement planning with fear. As a result, many investors wind up making fairly simple, yet tremendously damaging mistakes that could easily have been avoided.
Yet take heart: You can learn from others' errors to avoid repeating them.
Below is a tutorial displaying three of the most common errors we've seen in over two decades of working with high net worth individuals. Simply avoiding or correcting these basic mistakes can help put you on stronger footing to retirement.
1. Underestimating Your Time Horizon
Traditionally, the brokerage world has taught investors to think of time horizon as "the time until you retire," which gives someone who is approaching the twilight of their career or is already retired a very short time horizon. This typically leads many to slash the share of stocks in their portfolio as retirement draws near.
Perhaps you do have a short time horizon, but retirement timing alone probably won't indicate that. In our view, it's much more pertinent to assess what your retirement planning goal is: Funding the years you aren't working.
According to the Centers for Disease Control and Prevention (CDC), the average American 60-year old retiring today should expect to live another 23.5 years—longer for women! And that presumes you live to the average. According to the latest CDC data, a 60-year old American woman had a 31.9 percent probability of reaching age 90.i
That means a soon-to-be or recent retiree (and his or her spouse) likely has decades of retirement to fund. Slashing equity exposure too soon could introduce more inflation risk and diminished returns as your retirement investments would not sufficiently outpace the rising cost of living, eroding its purchasing power. Of course, your family history and health will have a big influence on your time horizon, but a conservative planner would aim for longer to ensure he or she doesn't run out of money too soon.
Many target-date retirement funds make this mistake for you, dialing down equity exposure as the targeted date draws near. For example, if you buy a "Retirement 2020" fund because you plan on retiring around then, you could be making a big mistake by overlooking the years on the other side of working.
2. Thinking Your Need for Cash Flow Requires Income-Generating Investments
When retired, many investors lean on their investments for cash flow—withdrawals taken to supplement their household income. To some, this means they must seek investments that generate income such as bonds that pay interest, dividend-paying stocks, preferred stocks, real estate investment trusts, Master Limited Partnerships and more. But you don't need income to meet a cash flow need. And many times, you'd be better off not focusing on income first.
Beware of Income Generating Investments
Cash Flow is any money withdrawn from your account, regardless of the source. It is what you need to meet expenses. Income-generating investments can kick that off, but they aren't the only way.
- Bonds: Increasing an allocation to bonds increases inflation risk, and it can be difficult to find the yield you need if rates are low. (Take our word for it; you don’t want to dive into Greek bonds just because the yield matches your needs.)
- Dividends: Many other “income-generating” investments are just misunderstood. Dividends, for example, are not a free lunch. Every time a firm pays a dividend to you, its share price is reduced by the amount of the dividend. It’s hard to see because markets move fast, but it’s true! Cash is valuable.
And those dividends aren't permanent. Firms can, have, and do slash payouts. Many will recall U.S. megabank Citigroup slashing its dividend in 2008. Oil firm BP plc did the same following 2010's Gulf of Mexico oil spill. Utilities firms have also historically cut dividends, including California's PG&E, which suspended payment in the early 2000s.
An income focus can lead to inadvertent sector concentration. Less diversification on a sector, country and style basis increases risk. Consider: Prior to 2008's financial crisis, high-yielding securities were commonly real estate investment trusts, banks and automakers. All were smashed in the downturn. In 2014, Master Limited Partnerships — predominantly publicly traded Energy pipeline companies — were all the rage for their high yield, but the downturn in oil prices hit their investors hard. Preferred stocks are effectively the most junior class of banks' and, to a lesser extent, utilities' debt. The entire security class is dominated by only 2 of 10 sectors.
There is a better way to include cash flow in your retirement planning, in our view. If you need cash flow, you shouldn't forget that you can invest in stocks and sell slices periodically to build cash. Some say this is inefficient, but it can carry both additional flexibility and tax benefits. And it allows you to diversify freely, without being anchored to yield.
3. Allowing Emotion to Steer Your Investment Decisions
Reaching your long-term retirement planning goals requires sticking with a long-term strategy likely to meet them—staying disciplined and shunning emotion and biases. Many investors struggle with this. Fear and greed are powerful, driving many investors to make ill-timed moves in and out of the market.
Studies have consistently shown emotion is one of the biggest roadblocks between investors and their long-term goals. When volatility rises, fear rises along with it and many want to "stop the bleeding" or get off the "roller coaster." The problem is this allows past performance to steer future actions, and markets are not serially correlated — results from yesterday, last month, last quarter or last year have no bearing on tomorrow's.
If you have a reasonably long time horizon, rest assured: There will be points of negativity, even sharp negativity, in markets. How you deal with the emotions this can stir is crucial to your long-term success. Reacting to negativity by getting out of investments like stocks is a recipe for selling low. This is the error many investors made on or around March 9, 2009, the bottom of the Financial Crisis-driven bear. Fear made people extrapolate the market's direction, and many exited stocks thinking the bottom was nowhere near. A bull is typically born at a bear's deepest, darkest, most-depressed point. Those who sold and stayed out even weeks missed the huge spike that started the ensuing bull.
Equally as powerful: Fear of missing out on big gains. In 2000, the peak of the dot-com bubble, euphoric investors bought high-flying Technology stocks with no profits or prospects of profits at sky-high valuations. Folks commonly shunned anything but Technology and internet stocks. No one could get enough IPO shares, so long as ".com" was in the firm's name. While the market fell, still-elated investors doubled down — seeing it as a buying opportunity. Meanwhile, stocks were only beginning their slide down a slope of investor hope. The ensuing bear market ravaged investors.
For many investors, the biggest risk isn't anything stocks will throw at you. It's the person in the mirror.
Fisher Investments can help you through the muddy waters of retirement planning and investing.