Phase 7 is all about how to save outside of retirement accounts. You’ll be making similar investments, but they won’t be locked away in an account that you can only access once you’re 59-1/2 years old. This type of account is simply called a brokerage account because it is managed through a brokerage firm–a company that sells investment products.
Why aren’t we saving more for retirement?
It is important for your financial health to save outside of retirement accounts. There are other things that we need to focus on in life besides retirement. Houses, used cars, or even the prospect of retiring even earlier than when you’re 59-1/2 years old!
The way to build wealth for non-retirement is not by just stashing money in your checking account. You want your money to make even more money and the easiest way to do this is by investing it in the stock and/or bond market.
A lot of gurus out there are always talking about passive income. “Make passive income by flipping houses!” or “Generate passive income streams from an online business”. Give me a break. These “passive” income strategies really are not that passive and require a lot of hard work in order to be successful with them.
The stock market on the other hand? It really can’t get any more passive. Especially if you’ve got your accounts set up to automatically buy investments at a regular interval. After 20 minutes of setting everything up, congratulations, you’re an investor. Very little maintenance is required. What kind of returns will you get? The average annual return of a S&P 500 index fund from Jan 1, 1980 through December 30, 2014 was approximately 10.13% (source). To put this in perspective, if you had invested in an S&P 500 index fund with $1,000 on Jan 1, 1980 and only contributed $100 every month, you’d be sitting on $329,786 on December 30, 2014. That’s money you can use at any time.
Your selection of investments in your brokerage account is probably going to be different than what you’ve got in your retirement account. The difference is due to your timeline. Retirement for many people is 20 years or more away. When you have a horizon that is further away, you don’t need to worry as much about the month-to-month or even year-to-year volatility of the stock market.
If the time that you want to spend your invested money is closer to something like 5 years away, you probably don’t want as volatile of a portfolio. Let’s look at the year 2008 since that year was one of the worst for stocks in history. If you had invested in Vanguard’s 500 Index Fund which tracks the S&P 500 (100% stock fund), you would have lost 41.4% of your investment. Nearly half. On the other hand If you had your investments in Vanguard’s Conservative Growth Fund, which has a 20/80 stock/bond mix, you would have lost 13.9%.
As a side note, if you don’t have a solid understanding of how stocks and bonds make you money, check out the Securities and Exchange Commission (SEC) website which has more information on stocks and bonds.
Keep in mind that 2008 was a truly terrible year for the stock market It’s important to take a look at the good years as well. If you held that same Vanguard 500 Index Fund from January 1, 2008 through December 31, 2014, you would have seen a return of 39.5% on your money. Compare that to a return of 4.7% with Vanguard’s Conservative Growth Fund. If you didn’t need your money right away, you can see that if you waited it out, you would have benefited your bottom line. But if you needed the money sooner, you’d be out of luck.
Over long periods of time, the stock market as a whole is almost always a money maker. Betting against the stock market over 20 or more years is essentially betting against human progress over the same period.
At this point, you’re probably wondering “what’s the ideal stock/bond ratio for me?”. The answer is… “it depends”. It depends on your goal timeline or when you expect to utilize the funds you are stashing. Here is a graph that shows a guideline for stock/bond ratios according differing timelines:
Let’s talk about a real-world application of asset allocation. You’re 45 years old. When you turn 55, you want to buy a sweet Winnebago and travel the barren desert of the southwestern United States. You’ve got 10 years until you want to spend your money so your goal timeline is 10 years. Using the graph above, you decide to use a 40/60 stock/bond ratio to help you save up initially. When you turn 50 though, your goal is only 5 years away! Being the prudent investor you are, you shift your money over to a more conservative 20/80 stock/bond ratio. The bottom line is you need to always reevaluate your goal timeline and adjust as necessary.
If you haven’t figured it out already, I’m a huge fan of Vanguard’s Life Strategy Funds. Why? They keep things simple by automatically adjusting holdings to match the stock/bond ratio that you prefer and have super low expense ratios.
There are plenty of other target-date options out there. Here is a list of some brokerages that offer target-date funds:
|Broker||Fund Name (Symbol)||Expense Ratio||Minimum Initial Investment|
|Charles Schwab||Schwab Target Funds||0.50% through 0.82%||$100|
|Fidelity||Fidelity Freedom® Funds||0.16% through 0.70%||$2,500|
|Vanguard||Vanguard Life Strategy Funds||0.14% through 0.17%||$3,000|
If you’re willing to do a little work, you can always create your own “target date” fund by examining the holdings of the funds listed above. This method can usually save you a little bit of money on overall expense ratio, but you lose the benefit of the fund automatically rebalancing itself to keep your preferred stock/bond ratio. You can rebalance yourself, but not having to worry about it may be worth the small extra cost. Personally, I’d rather set it on cruise-control and sit on my butt.
Let’s sum things up
We went into a lot of detail in this post. Even though the goal of Phase 7 is to save outside of retirement accounts, a lot of the information on stock/bond ratios is applicable to your retirement accounts as well. Remember to keep your timeline in mind and invest in mutual funds with low expense ratios.
When you complete Phase 7, your account structure will look something like this:
- Checking account – Normal day-to-day expenses
- Savings Account – Contains enough money to cover 3-6 months of living expenses
- 401(k) – A retirement account with money you cannot touch until you’re 59-1/2. This money will be taxed when you start taking distributions.
- Roth IRA – Another retirement account with money you cannot touch until you’re 59-1/2. This money will not be taxed when you start taking distributions.
- Brokerage Account – An account that holds stock and/or bond mutual funds that you can touch before or after you are 59-1/2. You’ll pay taxes on dividends you earn throughout the year, but this will have a pretty small impact on your income. You’ll also pay taxes on any capital gains when you sell it off.
- Open up a brokerage account.
- Select the appropriate stock/bond mix for your goal
- Target Date funds can make this selection much easier
- It makes sense to do this at the same brokerage you use for your Roth IRA
- Set up auto-pay and make sure to reinvest dividends
*In case you were wondering, I do not make any money by recommending Vanguard. They do not offer affiliate services for blogs. Save outside of retirement accounts.