Taking Stock of Your Financial Future, Part 1

Though it takes time to become an experienced investor, it’s never been easier to become a successful investor. Thanks to falling transaction costs and an explosion in the number of sites devoted to helping ordinary people make informed investment choices, the playing field between do-it-yourself bark-a-lounger capitalists and Wall Street’s storied Big-Whigs has never been more level. Technological progress and financial innovation has spurred economic opportunity for those hoping to achieve greater upward mobility. Computers with blinking lights, once the stuff of campy science-fiction movies, now rank right up there alongside the telephone and the microwave as indispensable and commonly owned household appliances. In this brave new era, knowledge is perhaps the most valuable form of currency and the widespread availability of financial data (on demand and at little-to-no cost) is a real game-changer.

Contrast current economic reality with the financial dark ages of the early 1990s, or—worse yet—late 1980s. Just a few decades ago, obtaining actionable investment information was neither simple nor easy. Moreover, putting it to work required knowing the right people, paying exorbitant up-front fees, and waiting hours—sometimes even days—for stock market transactions to be executed. Remarkably, a generation ago, the spring-loaded gears and cogs that kept the machinery of the stock market churning forward were manually cranked by an invisible behind the scenes army of brokers, floor traders and other specialists. Nowadays, stocks and the companies they represent can be bought and sold on-the-fly in mere seconds with the aid of an Internet enabled mobile phone. Though the old financial gaurd certainly had a good run, its convoluted architecture prevented all but the most affluent Americans from participating in the world’s capital markets. Fortunately, times have changed; the old financial gaurd has been gruffly tossed out on its ear and has long since been replaced with a newer, far more inclusive, financial order; one that's sensative to the needs of a much larger and presumably far more demanding constituency: The general public.

Nowadays, when it comes to making informed investment choices, the analytical tools that were once available to a small minority of financial elites are now broadly accessible to anyone with a personal computer, an understanding of the investment basics, and an Internet connection. But how did this unlikely turn of events come to pass? Why did the old financial guard, which profited so handsomely and for so long from its indispensable role intermediating stock market transactions, cede market share and content itself with a dwindling slice of a growing economic pie? To be sure, this unlikely surrender of influence didn’t happen voluntarily or overnight. Deregulated financial markets and steadily intensifying competition gradually weeded out inefficent and less competitive firms. This Darwinian market phenomenon has fundamentally changed how capital markets function. As a result, ordinary people are newly empowered to research and select their own investments. Suddenly, the taxpaying public is less reliant on the formely indispensible assistance of "industry professionals" when it comes to managing their brokerage and retirement accounts. The Internet, which makes accurate and timely investment information widely available, has been a significant driver of this trend. Tom Friedman, New York Times columnist and the Pulitzer Prize winning author of The Lexus and the Olive Tree, calls this revolutionary trend the democratization of finance.

Web sites like Yahoo! Finance, MSN Money, and Morningstar offer a sign of the times, and a tantalizing glimpse of the financial future. The user traffic that they draw is a tribute to consumers’ appetite for all manner of financial information. Want to know how a particular stock is doing? Simply key in its corresponding ticker symbol, and, viola, you can view late-breaking business headlines, see what financial analysts have to say about it, scrutinize every aspect of its financial performance, and examine its stock price over any specified interval of time. No-doubt, having all of this information at your fingertips is tremendously empowering. Through the medium of technology and the lens of financial supermarkets, consumers can put their money to work for them in unprecedented ways. For many Americans, the level of enthusiasm that was once reserved exclusively for the sports section of their local newspaper has gradually spilled over to the business section. Nowadays, since more and more people are directly or indirectly participating in the stock market through participation in employer sponsored pensions, 401K plans, brokerage accounts, IRAs, 529 college savings plans and medical expense savings accounts, they’re as likely to be found cheering the performance of their investment accounts as they are to root for their favorite sports home team(s). As financial assets like stocks, bonds, commodities and real estate (Yes, even real-estate. To understand why real-estate is as easily acquired with a brokerage account as it is with the costly assistance of appraisers, real-estate agents and bankers, read What’s in a REIT? & REITs and Investment Property.) become easier to acquire, people on all rungs of the socio-economic ladder can afford to accumulate them.

To help novice investors make sense of this alien investment landscape, companies like Vanguard, Fidelity and Morningstar offer a wealth of educational content as well as an assortment of interactive tools and a wide variety of low-cost investment products for beginning investors to choose from. Mutual funds, exchange traded funds and life-cycle funds are fantastic options for those who want to participate in the stock market's gains but avoid the tedium of having to research, select and manage their own investments. Nowadays, novice investors armed with basic knowledge about how to construct a well diversified portfolio can quickly and easily do just that; something which, twenty years ago, couldn't have been achieved. Moreover, with mutual funds, investors can hitch the financial performance of their portfolios to the best and brightest minds on Wall Street. Add to this the gale-force economic tailwind of tax-deferred, or, better yet, tax-free growth (which can be had by opening and funding a 401K or Roth IRA) and the long-term benefits of investing becomes downright attractive.

Capitalizing on the opportunities that these favorable circumstances present, however, is another matter entirely. For starters, cashing in on capitalism via the stock market requires knowing a thing or two about stocks, which, incidentally, over any multi-decade period, have handily beat alternative asset classes like bonds, real estate, cash and commodities. Stocks are widely followed and breathlessly discussed because they allow investors to pick-and-choose from a dizzying array of proven and, in some cases, obscenely profitable companies to own. And this is because stockholders are legally entitled to share in a company’s current and future profits; which are usually well supported by an organization's stability and strength of cash flows and the ingenuity of its managers and employees. Moreover, through voting rights, stockholders can influence how a company is managed. And because publicly traded companies' stock prices (particularly those of the small and mid-sized variety) tend to change over time to reflect the underlying fundamentals of businesses, they tend to respond favorably to an organization's thoughtful strategic planning, soaring sales, and steadily improving operational efficiencies--all are things which, luckily, profit seeking entities vigorously pursue. Consequently, the value of a company's shares are likely to rise over time to reflect this.

Luckily, when it comes to cherry-picking good investments, newbie investors needn't agonize over cherry-picking winners and shunning losers. With well diversified blunt force investment instruments like mutual and exchange traded funds, it's possible to purchase hundreds or even thousands of investments in a single transaction. To be sure, the old adage about not putting all of your investment eggs in one basket is sage advice, and certainly well-worth heeding. Sprinkling one’s savings over a wide range of asset classes (namely, commodities, real estate, stocks, cash equivalents, and bonds) is an effective way to lower financial risk and optimize long-term returns. Imagine how foolish you’d have felt if, back in the good-ole' days, you staked the entirety of your life savings on a single holding, like, say, AIG, Enron, GM, GE or WorldCom. No-load and low-fee mutual funds, though certainly attractive, aren’t necessarily your best investment option either. Nobel laureate William Sharpe calls indexing (that is, buying lower cost exchange traded funds) “a dull, boring way to become a better investor than many of your friends.” Index investing offers broad diversification and cost-efficient exposure to a variety of investment themes. ETF’s allow investors to own companies of a certain size or even those that operate in specific sectors of our economy—i.e., health-care, technology, the energy complex, consumer staples, or banking. And since money and the desire to make it is an increasingly global phenomenon, investors can lace up their walking shoes and dispatch their hard-earned capital to the furthest regions of the earth in search of high returns. Exciting stuff—no?

This is all well and good, of course, but the likelihood of future appreciation in the value of one’s stock holdings is only part of the reason why stocks are worth holding for one or more decades. Dividends, which are cash disbursements that select companies pay their shareholders, are another way to profit from owning stocks. Though, at first glance, dividends might seem puny, as the years tick by, they add up to big money over time. According to Standard and Poor's Howard Silverblatt, from 1926 through March 2009, reinvested dividends accounted for 44% of the S&P 500's 9.5% annualized gains. Of course, not all stocks pay a dividend, but many do. And once a company establishes a consistent track record of paying them, its management is understandably reluctant to cut or eliminate them for fear of alienating current and future shareholders. Moreover, as a company’s financial outlook brightens, its payout is likely to increase at a rate that handily outpaces inflation. Annually, dividend payments generally range from 1% to 5% of a stock's purchase price, which is pretty good compared to the anemic returns of money market savings accounts. Dividends are dandy for another reason as well. Thanks to the passage of investor friendly tax legislation by plutocrats in Congress, qualified dividends are subject to a skimpy tax rate of just 15%. Is that good? Well, to put this tax rate in perspective, consider this: a dollar of earned income will, after taxes, (provided you’re in the 33% combined State-Federal tax bracket) put 67 cents in your pocket. That same dollar, if received as dividend income instead, however, would translate to a 27% pay raise and your pocket would fatten to the tune of 85 cents. Now, a few measly pennies difference one way or another may not seem to make much difference, but, to reframe the issue, which would you rather have, 85% or 67% of your income?

Curiously, though stocks have proven to be fantastic wealth-building vehicles over a multi-decade span, not everyone is comfortable owning them. Some people are justifiably put-off by their volatility; others, however, are inexplicably drawn to them by the allure of higher long-term returns. To the uninitiated, the stock market is an understandably perplexing place. For starters, there’s all that pretentious jargon to wrap one's head around. Closely followed stock metrics like net profit margins, price-to-earning ratios, market capitalizations and debt-to-equity ratios are, for a great many ordinary people, a surefire cure for insomnia. Moreover, these metrics relate to numbers and various other factors that are in a constant state of flux. Considering all of the dynamic variables that are in play with stocks and their erratic day-to-day price swings, there’s justifiable cause for apprehension on the part of a non-investor.

Ironically, though the idea of periodically spoon feeding a bit of money into the stock market might seem scary; investing successfully over time isn’t. In fact, given the vast arsenal of tools that ordinary investors now have at their disposal, investing—and doing it right—really isn’t that hard. Once you’ve studied the stock market's buoyant long-term record and are comfortable with its sporadic short-term volatility, you’ll one day look back and wonder what all the initial fuss and consternation about investing in the market was all about. Done right, investing occurs automatically, as if on autopilot. Oppinions to the contrary notwithstanding, investing isn’t particularly sexy or exciting. In fact, it's a lot like watching paint dry or bread toast. Over one or more decades, however, investing perks up and becomes a lot more exciting. Ultimately, cashing-in on capitalism doesn’t require an abundance of shrewd analytical genius, but rather, metric tons of patience, a healthy dollop of initiative, and a cast-iron stomach for volatility. Simply put, investing successfully over the long haul requires two things: 1) a basic understanding of how financial assets like stocks, bonds, real estate and commodities work, and 2) the intestinal fortitude to establish, fund and stick with a broadly diversified investment strategy—in good times and bad.

Now, despite what the ongoing parade of talking heads on CNBC would have you believe—what with their power ties, vaguely authoritative news anchor demeanors and neatly quaffed hair—you don't have to be Gordon Gecko (that swaggering cocksure money manager artfully portrayed by Michael Douglas in the movie Wall Street) to do well in the stock market. Resist the urge to swing for the fences. Don’t be that swashbuckling yahoo who incautiously puts everything on one or even multiple stocks because they’re the toast of tinsel town and everybody in the business media seems to breathlessly fawn over them. Beware silver tongued pitchmen touting “can’t-miss” investment advice. Want a stock tip? Don’t listen to stock tips... First off, the well-paid hucksters out there who hawk investments products don’t know you. Secondly, and perhaps even more importantly, they aren’t paid to champion your interests. More often than not, they’ve got an entirely different agenda in mind and are only looking to cash-in on the market activity that their overtly public advice will generate. The takeaway point? Trust no one—except maybe yourself; and then only after you’ve done your homework, have stockpiled emergency savings in the amount of three-to-six months worth of current living expenses, and are absolutely clear on the fact that you won't be touching your invested capital for the next ten or so years.

If you’re a beginning investor, you shouldn’t even consider owning individual stocks. Why would you when you can so easily and inexpensively assemble a broadly diversified portfolio? Content yourself with getting on first base. Be patient, sit back, and let time do its thing. Of course, when you invest, the time and money you're putting at risk are yours. Because nobody is as invested in your own interests as you, it stands to reason that you’ll suffer the greatest losses if you fail and reap the greatest rewards if you succeed. Once you’ve figured this out, and have familiarized yourself with the basics of investing (the library's a good place to kick-start this process) you can safely follow your own instincts. Over time, this is a better wealth-building strategy than relying on the kindness of strangers and investment tips offered by media spokespeople, acquaintances, and, in some cases, complete strangers.

Now, the stock market is an oft used term that, I fear, isn't particularly well understood. To dispel any confusion on the subject, it's worth asking what, exactly, the stock market is and how it operates. In short, it’s an unfathomably complex living-breathing thing. Its moment-to-moment gyrations are driven by a bewildering confluence of mostly unrelated and largely unpredictable factors. Of all these dynamic variables, two of the most relevant are investors’ shifty perceptions about stocks’ future prospects and, from a broader 30,000 foot perspective, the underlying health of the economies in which they operate. Of course, for every seller of a stock there must be a buyer—and vice versa. When you multiply this fairly straightforward concept by the trillions of dollars that are speedily sloshing around across time zones on the world’s bourses, it’s much easier to understand why the term “stock market" is unfathomably complex. But, for convenience's sake, suppose we pushed all of this mind boggling obscurity aside and reached for a tidier explanation for the stock market’s manic behavior. Generally, if the collective activity of those who buy stocks exceeds the sell side activity then market indexes like the S&P 500 and Dow Jones Industrial Average tend to rise. Conversely, if net trading activity favors sellers over buyers by a wide margin, then the process works in reverse and valuations tend to fall. It’s both that simple and that complex. Ultimately, the stock market is like a referee; it doesn’t offer an explanation for its decisions and its verdict is all that counts. Longtime Barron's columnist Michael Santoli aptly defines the stock market as: "An ongoing argument over the future, staged over six-and-a-half hours each weekday, among people who can't even agree on what's most important to be arguing about."

Usually, when people contemplate investing, it’s within the context of achieving distant financial goals; the kind that seem so vanishingly remote that viewing them up-close would require the aid of hi-tech equipment, like a tricked-out Hubble telescope. Rightly or wrongly, for most Americans, the economic burdens of retirement appear to be light-years away. Unfortunately, young-adults and newly minted professionals are especially prone to this virulent strain of fiscal myopia. And the facts broadly bear this out; according to Vanguard, only 42% of employees between the ages of 25 to 34 participate in 401(k) plans. By and large, it seems, young people aren't preoccupied with how they’ll make ends meet many decades from now in retirement. This is mildly unsettling because, though bankrolling their golden years may not rank highly on young peoples' list of day-to-day priorities, there are many reasons why it should.

You see, unlike life’s other big-ticket purchases, like, say, for a house or a car, banks don’t offer retirement financing. And sadly, this fact isn't likely to change anytime soon. Of course, students and newly minted professionals will (if all goes well, of course) gradually age. As they do, chances are fairly good that they'll someday want to bid a fond adieu to the grueling monotony of the work-a-day-world. Troublingly, that's a colossal feat. Incubating and ultimately hatching the kind of nest-egg required to support a desireable future quality of life without the ongoing support of a steady paycheck is a daunting and widely underappreciated challenge. For reasons that will be glaringly apparent to young people half a century from now, they can't afford to procrastinate till they're middle aged to adopt a healthy wealth ethic and begin scrimping and investing for the future. Regrettably, if teens and twentysomethings don't discover this untill they're old enough to collect social security, whatever pitiful sum that future amount may be, they'll be greatly aggrieved to wake one morning to realize that they’ve foolishly squandered much of their greatest asset: the wealth building power of time. You see, with one-third to one-half of their economically productive years behind them, they'll be in a tough financial spot. As any professional money manager worth his or her salt will tell you, at a certain point in the wealth building game, it's nearly impossible to compensate for not having proactively established sound fiscal habits early in life. Naturally, the dreary prospect of grinding poverty in old age doesn’t elicit much cheer. Nevertheless, given our society’s increasingly prominent ownership bias, this seems to be the default life path for those who don’t aggressively plan against it. Because squirelling away enough wealth for retirement--even with the powerful economic stimulus of a steady paycheck, a multi-decade investment time horizon, and generally favorable market returns--is a tremendous lifelong challenge, it’s best to begin this process as young as possible.

For students and newly minted professionals who aspire to a cozy retirement, the notable absence of retirement financing products is understandably irksome. But, as long-term economic challenges go, an inability to simply borrow the cash necessary to bankroll the good life many decades from now may well be dwarfed by other more worrisome economic concerns as today's students and tomorrow's professionals approach middle-age. As many people who're nearing retirement nowadays will loudly attest, having enough cash set aside to cover basic necessities--like keeping food on the table, a car on the road, and a roof overhead--isn’t the only thing they worry about. Inflation, which steadily erodes the purchasing power of a buck (and, by extension, the value of one's life savings) is a real wild-card in the economic calculus of everyday life. Another sizeable point of concern is the ultimately unknowable future trajectory of taxes and health-care costs. Collectively, these factors raise the bar a good fifteen feet when it comes to the level of practical hands-on financial expertise young people will need to successfully pole-vault their way over the retirement hurdle a few decades from now.

Though many teens and twentysomethings will cavalierly dismiss the looming enormity of the economic challenges they face, the greater irony is that many of them will be around to blow out the candles on their 100th birthday cakes. Thanks to rising life expectancies and continuing advances in health care, future generations of retirees could spend as much as a third of their lives in retirement. From a social and economic standpoint, this is unprecedented. Going back to the early 1800s, most people didn't worry about having enough money for retirement. Curiously enough, life-spans and work-spans were largely one and the same. Nowadays, however, most people have loftier expectations for their sunset years. But, just as the question of retirement and how to pay for it looms more menacingly in the minds of a graying U.S. population, the government and private sectors have somewhat indiscreetly begun to tip-toe away from their once affordable socio-economic commitments. The rapid obscolescence of employer-sponsored pensions (according to the Center of Retirement Research, among workers with retirement plans, those covered by pensions has plummeted from 83% to 30% over the period from 1980 to 2006) coincides rather suspiciously with a growing social reliance on tax advantaged and self-funded retirement, education and healthcare savings accounts. Despite a growing chorus of concern about the post-boomer solvency of pay-as-you go entitlement schemes like Social Security, Medicare and Medicaid, people nearing retirement today are likely to receive much of the largesse that generations of politicians have promised over the years. Future generations of retirees, however, may want to rethink how they'll provide for their own future economic welfare. Outraged tax-payers might angrily respond “But how could this be?” Well, interestingly enough, the answer to this vexxing question has everything to do with people—lots of them.

In 1930, when life expectancy in the U.S. was about 60, the number of persons age 65 and older accounted for a mere 5.4% of the U.S.'s population. Today, this figure is 13%, and rising. Demographers refer to baby-boomers (the children of World War II veterans born between 1946 and 1964) as the “pig-in-a-python” generation because their numbers, when plotted alongside those of neighboring generations, produces a conspicuous bulge in an otherwise flat population distribution. In 1935, when Social Security became law, the future solvency of this program seemed ironclad because the ratio of workers paying into the system vs. those drawing against it was 40 to 1. In 2030, this ratio is expected to reach just 2 to 1. Although this may seem problematic, it so happens that Social Security is the least of the U.S.’s fiscal woes. And a once high-ranking government economist plainly agrees; in a March 2007 appearance on 60 Minutes, David Walker, the United States’ former Comptroller General—a.k.a. Uncle Sam’s chief accountant—cautioned that the financial problems facing Medicare and Medicaid are roughly five times greater than those facing Social Security. Esteemed number crunchers at the Congressional Budget Office calculate that, by 2026, Social Security and Medicare obligations will add roughly $6.6 trillion to our burgeoning budget deficit. In short: though the New Deal era legislation boldly enacted by FDR in the aftermath of the Great Depression enabled a higher minimum standard of living for all U.S. citizens through a widespread sharing of social costs, then the New-New Deal era which seems to have replaced it—which, in turn, is characterized by the embrace of tax-advantaged and self-funded retirement savings accounts—points to a radical departure from FDR’s vision. No-doubt, in future years, millions of retirees will exit the workforce and, as they do, will collect healthcare and social security benefits. Though economists often quibble about such things, there's legitimate concern that the long-term cost of meeting these obligations will force our government’s already leveraged financial house into a worsening state of fiscal hawk.

In response to this unabashedly bleak assessment, social safety-netters might rightly ask, “But, aren’t U.S. federal government finances prudently managed?” Towering budget, current account and trade deficits would certainly seem to suggest otherwise. In answer to the question, “is the U.S. bankrupt?” Lawrence Kotlikoff, professor of economics at Boston University, crunched the numbers and answered in the affirmative. “The way to judge a nation’s solvency isn’t to measure its’ fiscal inflows and outflows from one year to the next—as our government is fond of doing it—but rather, to examine the lifetime fiscal burdens on current and future generations. Based on this broadened criterion, the current U.S. fiscal gap is roughly $65.9 trillion—more than five times U.S. GDP and almost twice the size of national wealth.” Somewhat helpfully, Kotlikoff goes on to suggest that “eliminating the current federal budget and trade deficits would require an immediate doubling of personal and corporate income taxes, or a 66% reduction in Social Security and Medicare benefits.”

The writing, as they say, is on the wall; and the message is clear as a bell. What are the economic tea-leaves whispering to generations X, Y, and Z? Welcome to the ownership society. Of course, this isn’t exactly a well-kept secret. Uncle Sam, who may have anticipated the potential for future financial hardship for millions of ordinary working class Americans, took preventative action many years ago through a generous rewiring of the tax code and by offering tax-deferred (and, get this, even tax-free) retirement savings accounts. The good news is that these wealth building vehicles do indeed offer conscientious savers a tremendous long-term advantage. The bad news, however, is that they only benefit those who bother to use them.