Advice to My Children

July 1, 2014

In our last newsletter, I wrote about the investment advice that I learned from my father. In this issue, I will pass on the investment advice that I would like to share with my three children in the hope that it might also benefit the children and grandchildren of some of our Fiduciary Group readers.

I have always expressed to my children the importance of saving for future needs. Saving for retirement is probably the most important future need because your retirement account will be your primary source of income when you are no longer working. Moreover, you will likely need to live off of your retirement savings for 25 years or longer. A lifetime committed to disciplined saving will allow you to build the necessary wealth to retire comfortably. The process of building wealth usually leads to increased self-satisfaction, and the outcome— sufficient savings to fund your retirement—will lead to greater financial security when you need it most.

On a safari in South Africa recently, my wife and I noted a major difference between animals and humans that bears on the topic of retirement savings. The game drives took place in the early morning hours and again near dusk and early evening, when most of the larger animals move about in search of food. We noted that for these large animals— lions, leopards, buffalo, elephants, and rhinos, among others—their daily job was to go out and search for food. If an animal could no longer “work,” the animal didn’t survive. These animals don’t have the ability to save.

Humans, on the other hand, have two big advantages. First, we don’t have to go out and search for food every day. We go to our job, do our work, and collect a paycheck which we can then use to buy our food. Second, we have the ability not only to save, but to put our savings to work so that by the time of retirement, we will have much more than the amount we actually put into our retirement account. Humans have the freedom to retire, which means living a rewarding and productive life even when we are no longer working. Unlike the animals in the wild, we don’t have to work until we die.

Saving is extremely important to enjoying a financially secure life. When you are young and just starting your working career, the focus on saving for a retirement which is decades away requires commitment, particularly because retirement is not the only thing you are saving for. There are children’s education expenses, home purchases, and many other discretionary expenditures which may also come into play. It takes a determined effort to build savings into the budget, but it is a necessary effort if you are going to accumulate enough money to replace your income one day.

Since your income is normally steady and reliable, you need to become an expert in managing your expenses, which tend to be a bit more variable. You have a lot more discretion and control over the “outflow” side of your budget than you do over the “income” side. Managing your expenses is what will allow you to save. Every dollar that you spend is a choice that is yours to make, so choose wisely. Books like Stanley and Danko’s The Millionaire Next Door make it clear that it is the ability to save that leads to wealth, not a high income.

You need to put aside as much money as you can in your employer’s defined contribution retirement plan, as those contributions can be made on a pre-tax basis and the income (capital gains, dividends, interest) is not taxed (which means you can grow your savings even faster). As David Bach writes in the The Automatic Millionaire, “the single biggest investment mistake you can make is not using your retirement plan and not maxing it out.” The IRS currently allows you to defer up to $17,500 per year on a pre-tax basis. And most companies will provide a company match or contribution on top of your salary deferrals, which is essentially free money to you and allows you to grow your savings even faster.

Don’t ever look at your retirement plan account as a savings account that can be tapped for emergency or other expenses. You should never borrow from your retirement account or take early distributions. Your retirement account should not be used to pay for children’s educations, buy a house, or pay off credit card debt. It is the one account you will have that is protected from creditor’s claims. It is there for one purpose and one purpose only— to pay you income in retirement. Set up separate savings accounts for all those other purposes, and don’t raid your retirement account for other uses.

There is a wonderful secret to growing your wealth and it is the power of compounding. Put in its simplest terms, compound interest means that you earn returns not only on your savings but also on the earnings produced by your savings. Compounding allows you to put not only your savings to work, but all the earnings your savings have ever earned are put to work for you too.

Significant wealth can be generated over time through the miracle of compound interest. If you earn an average of 7% per year on a compounded basis—a very reasonable and achievable goal if you invest properly—you will double your money every 10 years. The earlier you start to save, the longer the power of compounding will work its magic on your savings. As the primary goal of retirement saving is to build an investment account that produces sufficient income to replace your income in retirement, your investment horizon is your working life, which can be 40 years or more. That’s a long time, and you can build incredible wealth in that time, provided you save and invest.

Given that you will be investing your savings over such a long period of time, you should invest the majority of your assets in investments that offer the greatest returns over the long-term. The asset class that will be your “growth engine” is stocks because stocks are essentially “compounding machines” as Chuck Akre, a mutual fund manager, calls them. Stocks are investments in businesses that can boost their value by earning high rates of return on their capital…the historic annualized average return on stocks is 9%.

My investment philosophy is grounded in the maxim that I only want to invest in daily traded, publicly available investments that are transparent and highly liquid. I advise others to do the same and to avoid investing in private, non-daily traded, illiquid investment vehicles. Real estate ventures, limited partnerships, start-ups and so forth can sound attractive—particularly when a friend, family member, or business associate suggests them—but they are fraught with risks that you don’t have in the public markets.

I am also an advocate of utilizing experts wherever possible for important matters such as health, finance, and law. You should always rely on professional investment managers to invest your savings. A professional investment advisor will invest your assets pursuant to a sound plan, free of emotional biases, and will insure your assets are appropriately allocated and diversified. And your investment advisor should always be a fiduciary investment manager who is properly trained and who provides conflict-free advice for your investment and savings questions.

Following the simple advice outlined in this article—save sufficiently, invest appropriately, and don’t use your retirement savings for other purposes—will help you achieve financial security and personal well being for your entire lifetime. As P T Barnum wisely said: “A penny here, and a dollar there, placed at interest, goes on accumulating, and in this way the desired result is attained. It requires some training, perhaps, to accomplish this economy, but when once used to it, you will find there is more satisfaction in rational saving than in irrational spending.”