A year when savings trumps investing
A plummeting stock market makes conservative investments a wise move for the short term.
As investors peer into today's highly uncertain market, many are hesitant to put their deeply depleted portfolios at risk, despite the pressure to recover from losses sustained in 2008. Many Americans who have sold their stock holdings are choosing to remain in what is perceived as safer investments: bank CDs, municipal bonds, Treasuries, and perhaps index funds.Skip to next paragraph
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This dramatic shift has translated into a "cash is queen" mentality. It is only one step away from attitudes held during the Great Depression, known as "going to the mattresses" to hide cash. A "savings trumps investing" approach to managing retirement accounts is credible – but only for the short term.
Before explaining the rationale of a "savings is investing" approach, consider what John Bogle, founder and former CEO of Vanguard Group, said before the House Education and Labor committee last week: "Today we realize much of the value and wealth we saw reflected on our quarterly 401(k) statements was indeed 'phantom wealth' that could not be sustained."
Mr. Bogle emphasized that the 12 percent annual returns of the 1975-1999 market period were abnormalities, citing the 6 percent return on equities achieved in the 1926-1974 period and the negative 7 percent returns generated from 2000-2008 as equally representative of risk/return relationships. He argues that the current employer-sponsored 401(k) retirement system should be replaced with mandatory participation in broad market index funds that spread risk and, more important, charge minimum fees.
As lawmakers, economic think tanks, and Obama administration officials debate options to restructure retirement investment, market regulation, and financial transparency, individual investors might benefit by adopting an interim financial posture. Among points to consider:
•Traditional asset allocation models did not deliver protection in the wild market downturn of 2008 and probably will not be effective this year.
•Investment risk and longevity risk should be equal pillars guiding investment decisions. Translation: A low-risk investment strategy that generates safe but limited returns – while a comfortable and reasonable near-term investment approach – will not be sufficient to fully fund retirement years that could last several decades.
•Risk/return relationships have become dysfunctional, as recent governmental actions have created quasi-public financial institutions that operate with public capital and assumed guarantees. Such hybrid banks and financial products make risk pricing difficult and values highly dependent on daily fluctuations of market transactions. Beware of unusually attractive rates that may be simply a market aberration – and demand an independent, third-party review of the financial product and advisers before committing. Don't be Madoffed!
Given this sea change in market dynamics and the wisely skeptical reaction of consumers, you might choose to sit out the market for an intermediate period. If so, consider these strategies:
•Use 2008 as a base year. Create a stripped-down family budget – at least 10 percent lower than 2008 and avoid major purchases. Establish realistic targets for savings, maintaining or increasing your 401(k) and IRA contributions, regardless of whether your employer decides to reduce, freeze, or end their contributions. Financial advisers urge a 10-15 percent savings target.
• Preserve your remaining capital by simply placing your portfolio in multiple FDIC-insured CDs. Identify all investment expenses, including up-front, annual, and transaction fees, and deduct from potential yields.
"If the money is needed in the next five years, a market-based investment is not appropriate," advises Karen Schaeffer, a certified financial planner in Rockville, Md. "A laddered CD approach extending through 2011 may net higher returns at no risk than a market-based portfolio."
•Before committing cash to any investment, consult an accountant or financial adviser to understand potential tax consequences.
•Protect your primary asset – your home. If you're a homeowner with a jumbo mortgage, consider buying it down – a move that would increase equity and qualify you for a lower interest rate when refinancing. Lower monthly mortgage costs are a way to hit your slimmed down 2008 budget targets.