A while back I had done a review of the book On My Own Two Feet: A Modern Girl’s Guide to Personal Finance. I enjoyed the book so much that I was able to open the floor to readers where you could ask the authors of the book financial questions. You guys came up with some great questions and Sharon and Manisha came back with some fantastic answers. This question and answer session was also a giveaway and earlier this morning I announced the three winners, so be sure to find out who won.
With the number of questions and the length of responses I will break it up into two parts so the information is easier to digest. There is a ton of great information so I don’t want anyone to miss anything. So, the first batch of questions and answers are as follows:
KMC asked: In your opinion, what is the absolute best hedge against inflation?
Broadly speaking your investment options fall into three main categories: stocks, bonds, and real estate. Historically speaking, over the long-run, stocks have done the best job of fighting inflation amongst these three asset classes. When you think about this, it makes sense as stocks are pieces of ownership in underlying businesses and businesses can raise their prices to keep up with inflation in order to maintain earnings growth. There certainly are more complex strategies to hedge against inflation (using options, derivatives, swaps, etc.). But if history is any guide, investing a portion of your long-term money in stocks is a keep-it-simple way to combat the corrosive effects of inflation.
A reader by email asked: Do you prefer a person to get out of debt first (regardless of how much the debt is) or invest in IRAs, 401K etc. I tend to do both, invest and debt reduction. I wanted to know your advice?
Our personal preference is for people to do both simultaneously. We recognize that from a purely financial standpoint, paying off your debt is clearly the most effective financial move. The reason we recommend doing both, however, is that saving – like flossing your teeth or drinking eight glasses of water a day – is a habit that builds on itself. If you wait until you are 100% debt free, you may never begin to save! As a result, we’d recommend a blend, based on your sleep well at night factor.
Tactically we recommend first making sure that you always pay your minimum monthly payments on all debt outstanding. After that, you can choose what is the right balance between debt pay down and savings for your psychological preference. In other words, for every $1.00 you have available you might put $0.75 towards paying down your debt and $0.25 towards savings. The precise split is up to you, and will be influenced by how high the interest rate is on your debt. Some people can’t sleep with any debt for them the right mix is 100% to debt pay down. However, other people are comfortable gently building up their savings muscles while paying down debt. This is a bit of a chicken & the egg conundrum, and it gets asked a lot which is why we dedicated Chapter 10 of ON MY OWN TWO FEET to talking about this very subject.
TF asked: My younger sister (she�s 25) is desperate to buy a house. However, she�s not started her 401(k) at work, she spends on clothes like they�re going out of style (well, technically I guess they are), and she�ll be borrowing quite a bit from our folks in order to put a decent amount down on the house. In situations like this, is there a good way to talk to people about personal finance, or is it something that you just hope they come into on their own?
You sound like a very caring older sibling, and while your younger sis may not thank you right away giving her some tough love is just what the financial doctor ordered! A house is no laughing matter. Just as with getting a puppy, it may sound all warm and fuzzy but there are serious upkeep requirements to home ownership. On top of this is the fact that house values don’t always go up! So many times when we meet people who are struggling to save money it is because they bought more home (or car) than they can afford. This is not a decision to rush into lightly. Our rough rule of thumb is to follow three rules of thumb for home buying: (a) put down at least 20% of the purchase price, (b) expect to live in your house or apartment for at least five years, and (c) estimate the total cost of home ownership mortgage payment, insurance, property tax, maintenance, and upkeep AND aim to keep this figure to 25% or less of one’s gross income (30% if you live in a major metropolitan area). This subject of housing can be complex, and a one paragraph answer can hardly do it full justice. That’s why we devoted Chapter 11 of ON MY OWN TWO FEET to the subject.
Steve Austin asks: Perhaps a bit of an ornery question: how should one go about identifying whether an advisor or money manager is one of the best in the business (MBA degrees and CFA charters aside)?
Not an ornery question at all in fact, it is very wise of you to ask! So wise, that we’d actually suggest you ask potential advisors that very question. Their reaction will tell you a lot. You want to work with advisors who understand your desire to have a quality professional assist you with your finances. If they bristle at the question, that’s a big warning sign right off the bat. Another qualification for a personal financial advisor that we admire greatly is the CFP designation (certified financial planner). A long track record and the willingness to provide other client references are also a plus. Finally, you want to make sure the advisor is very specific with you about how often and how you will communicate with each other in monitoring your finances. You’ll also want a clear understanding about how the advisor is being paid.
and a second question, less ornery I hope: how did the money management industry come to assess fees on % of assets under management, and what can be done (within the industry) to change that immoderate practice?
Not being financial historians, we cannot give the derivation of this practice. We would direct you to the writings of John Bogle, founder of Vanguard who has much to say on the subject <smile>. We have a sneaking suspicion that you will enjoy reading his work!
Broke Now, Rich Later asked: Something that is rarely covered on personal finance blogs is managing retirment income. How should retirement income be taken out of retirement vehicles? I get 2 paychecks a month right now. Should I take out 2 paychecks a months in retirement? Once a year? Right after any jumps in the market?
You are so right, this is a very important subject that we wish would get more attention in general. Without knowing more about your personal financial situation, we can only give some general rules of thumb. To keep the odds that you will outlive your money in retirement to a reasonable level, it is wise to limit your annual withdrawals to no more than 5% of your assets a year (some advisors have even ratcheted that figure down to 4%). The total dollar amount you withdraw each year as a percent of your nest egg matters MUCH more than whether you take the withdrawals once a month, twice a month, or annually. In terms of how frequently to dip in to your nest egg, there are pros and cons to each approach. One school of thought is that you should set aside an entire year’s living expenses in advance in cash equivalents so that you are more protected from market vagaries. This approach has intellectual appeal to us however it will require the discipline not to spend the money all at once. If you think the temptation will be too great, that is a reason to go towards monthly or twice a month withdrawals. Of course, in this more frequent approach, you will have greater susceptibility to market movements. A good book to read on this subject is Terry Savage’s THE SAVAGE NUMBER, which does a lovely job of discussing the challenges and joys of the draw down stage of retirement.
and also asks: Along the same lines, should any major changes be made in your 401k/ IRAs at the time of retirement (reallocation, etc.)?
The five years right before and right after retirement are the crucial ones. Often they are referred to as the red zone. This is typically the time to begin shifting to a more conservative mix in your portfolio. The specific asset allocation will, of course, be dependent upon your own personal risk tolerance and circumstance. But generally speaking, if you are female you want no more than 120 minus your age in stocks as you roll into retirement (so if you are 60 years old, no more than 60% in stocks) and if you are male no more than 110 minus your age in stocks (because men have shorter life spans, statistically speaking). The pros of having more stocks are that you have a greater chance of keeping up with inflation. The cons are that stocks are notoriously volatile. Alas, there is no magic formula for asset allocation it is an artistic science. The key point for the vast majority of people is that as you near retirement, you want to reduce the risk levels in your portfolio.
Thanks again to those who asked questions and thanks to Sharon and Manisha for taking time out of their busy schedule to answer them. Don’t forget, this is just Part 1 and the remaining questions and answers will be posted tomorrow so make sure to check back.
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.
Regarding the answer to my first question, "long track record" is a little vague, as "long" is subjective. To me, long means more than 30 years. So for me, should I only work with an advisor with that long a track record? Also, just having *a* track record for some long period of time doesn't necessarily mean it is a good record. ;-) So, if I might be so bold as to ask for further clarification, *how* long and *how good* a track record should I demand so that I know I'm working with one of the best in the business?
Regarding the answer to my second question, I haven't read Bogle's book, but I know that Bogle/Vanguard have a reputation for low fees. However, they still use the % on assets under management model (open-end mutual fund expense ratios). So if Bogle rails against that model in his book, he (or at least Vanguard) sure doesn't practice what he preaches.
A big thanks to them for the answers to my questions and others! After being lucky enough to be selected to recieve a copy, I'll be anxious to see the book.