Tippy sleeping

Like Tippy, pictured above, most people would sooner fall asleep than read about different types of retirement accounts. However, they are vital to well-funded retirement and can save you money, too.

The individual retirement arrangement (IRA) is an account you set up on your own at a brokerage such as Vanguard, Fidelity, or Schwab, or at a bank such as Ally. Any American with earned income can contribute to one (even minors), and one can have both an IRA and a 401(k). The investment options are wide open; your choices range from investing in an index-tracking mutual fund of the whole U.S. stock market, as I recommend on this website, or something as safe as certificates of deposit (CDs), which presently pay 2–3% each year without risk of losing money.

IRA contributions come out of your bank account without involvement of your employer. Like 401(k)s, IRAs function as commitment devices, penalizing you for withdrawing money before Age 59 and 1/2. Like 401(k)s, they also offer tax benefits, although a key difference is that with IRAs, these benefits are restricted to people earning under approximately $125,000 per year.

In contrast to IRAs, 401(k)s are employer-sponsored. Your employer offers instructions on how to set up an account (perhaps on their website, Intranet, or at the HR department). The investing options are more restrictive than with IRAs, although usually there is at least a low-cost S&P 500 index fund available. You might be compelled to use a particular brokerage, such as Fidelity or Prudential. With 401(k)s, you must direct your employer to take money out of each paycheck to contribute.

The key benefit of a 401(k) is an employer matching contribution. About 4 in 5 employers offer to match a portion of employee contributions, which is free money. For example, some employers will match up to 100% of up to 5% of each paycheck. If your gross wages are $2,000 every two weeks, this means if you contribute 5%, or $100 of each paycheck to your 401(k), your employer contributes $100 per paycheck as well. This is like giving yourself an instant raise. Even if you have credit card debt to pay off, an employer 401(k) match should be prioritized first.

For teachers and certain other nonprofit employees, the 403(b) replaces the 401(k) but is basically the same. The Thrift Savings Plan for federal employees also functions similarly.

IRAs and 401(k)s are both offered as “traditional” and Roth versions which is the difference between being taxed when withdrawing the money in retirement (“traditional” version), or now, in the current tax year (Roth version). Generally, Roth contributions are preferable if you are in a low tax bracket now, because income tax works on a year-to-year rather than cumulative basis.

With 401(k)s, it is still somewhat rare for employers to offer the Roth option. Traditional contributions are useful if your income is a bit higher, both for lowering taxes and for lowering your income to qualify for child tax credits, Health Insurance Marketplace subsidies, et cetera.

Retirement contributions offer another tax benefit: you may also qualify for the Retirement Savings Contributions Credit, which can be worth over $1,000. Unlike with most 401(k) plans, you can make an IRA contribution for the 2018 tax year up until April 15, 2019. However, you should make 2018 contributions to your IRA before filing your 2018 tax return; otherwise you would need to file a superseding or amended return to claim the saver’s credit, and income deduction if making a traditional (not Roth) contribution. When contributing, banks and brokerages will ask you whether you want to designate the contribution for tax year 2018 or 2019.

Many people do not know that you can make contributions to both 401(k)s and IRAs, up to the maximum for each. In 2018, this was $18,500 for 401(k)s and $5,500 for IRAs ($24,000 total), and in 2019, the limits increase to $19,000 for 401(k)s and $6,000 for IRAs ($25,000 total). The vast majority of Americans never get close to either of these limits. Who has $6,000, let alone $25,000, of income to give up in a year? Surveys show about 40% of Americans are hard-pressed to even come up with $400 in a pinch.

Because most people will not approach the limits for either type of retirement account, it is generally fine to have only an IRA if your employer does not offer a match, or to have a 401(k) to contribute only up to the match and then put additional contributions, if any, in an IRA. Americans switch jobs often, particularly among emerging adults, and the plan rules vary widely between employers and 401(k) providers, which makes managing or rolling over orphaned 401(k)s a nightmare.

I have previously characterized retirement contributions as buckets like below, encouraging readers to max out their contributions for each year:

Full retirement buckets

Although this is the fastest path to financial independence, almost no one has the disposable income to do this. Consequently, I recommend paying high-interest debt such as credit cards, private student loans, and unfavorable auto loans before contributing to an IRA. If you have a 401(k) employer match available, this should take priority over high-interest debt, but beyond this, the math favors paying high-interest debt now and increasing retirement contributions later. Full buckets, as pictured above, are unlikely to be a problem.

One of the main goals of my writing is to share and discuss the preparations necessary to be a successful investor—knowledge, emotion, psychology, arithmetic, and more. There will be years like 2002, 2008, and 2018 where you lose tons of money, but on balance, many other profitable years make investing worthwhile over multiple decades. With retirement accounts, it is easier to envision being invested for the long-term because there are penalties for withdrawing money before Age 59.5. In addition, retirement accounts offer tax benefits now, which can make it easier to save or invest for retirement.

You can contribute to an IRA while putting your money in a CD, a completely safe investment with no risk of loss. Some 401(k) plans may also offer safe investments such as U.S. government debt. Within your IRA and 401(k), you are free to move money around between investments at a later time. Therefore, you can start contributing to retirement accounts now, while making risky investments in stocks later, when you are ready—or never.

The retirement accounts established by U.S. lawmakers are labyrinthine and unfortunate. There are many bizarre phenomenon, such as being able to withdraw Roth contributions early without penalty but not traditional contributions, being able to withdraw from your last employer’s 401(k) without penalty if quitting after Age 55 but not from an IRA until Age 59.5, and illogical rules that change year-to-year regarding contribution thresholds and limits. Although you could restrict yourself to taxable brokerage and savings accounts, you must participate in the labyrinth to reap the tax benefits enshrined in U.S. laws and the tax code. Although politicians pretend that retirement accounts benefit the middle class, in practice they benefit the wealthy. Half of Americans do not even have stock investments, which are likely to grow the most over decades (compared with savings accounts, CDs, bonds, etc.) and make the tax advantages of retirement accounts especially profitable. This is one item I and others hope to change through financial education.

Decisions and outcomes are not necessarily related. One can make a good decision that results in a bad outcome, but this does not mean the decision itself was bad. This can be represented by a simple table:

Good OutcomeBad Outcome
Good Decision
Bad Decision

Here are a few examples that come to mind:

Good OutcomeBad Outcome
Good DecisionEating a salad and not getting sick
Planning for retirement and being able to retiring early
Eating a salad contaminated with E. coli
Investing a lump sum in an index fund on the Friday before Black Monday

Bad DecisionBuying a lotto ticket and winning big
Driving drunk without incident
Speculating in BitCoin and losing
Driving drunk and causing an accident

We know that investing a lump sum now is better than dollar-cost averaging your way into stocks or timing the market by attempting to “buy the dip” (e.g., Williams & Bacon, 1993; Panyagometh & Zhu, 2016). Although lump-sum investing is the preferable decision, there is a nontrivial probability of an inferior outcome as compared to investing at a later time. If a bad outcome occurs, it is more salient than had a good outcome of equal magnitude occurred. However, this should basically be chalked up to bad luck. A bad outcome does not mean a bad decision was made.

Separating decisions from outcomes goes against our nature. It is contrary to human psychology. In her 2018 book, Thinking in Bets, poker champion Annie Duke calls the human prediction to judge decisions by the resultant outcomes “resulting.” Resulting is akin to confusing causation for correlation in science.

Making a bet where the odds are in your favor is a good decision, even if you lose. With more and more such bets, a result commensurate with the prudence of the decision approaches inevitability. In the stock market, you can think of each trading day as a bet, with these bets stacking up over time. Below, probabilities from Bloomberg data, compiled by Vanguard, show the probability of positive returns for S&P 500 investment time frames within the selected dates (1/04/1988 to 2/16/2018).

S&P 500 investment during 1/04/1988–2/16/2018Probability of positive return
One day.54
One week.58
One month.64
One year.83
Ten years.91

Although start and end points matter, the pattern has been shown to hold even over the duration of the stock market’s history, including the Great Depression. Above, we see the probabilities of positive returns averaged across all day, week, month, year, and 10-year periods within a 30-year range. A 54% chance of positive returns on any particular day increases to a 91% chance of positive returns during any particular 10-year period within the 30-year period sampled.

Of course, this data nevertheless shows a 9% chance of losing money in a 10-year span. However, if you are unlucky enough to have invested the bulk of your money at an unfortunate time, this does not mean your decision was bad—just that you happened to have a bad outcome. It takes longer than 10 years for the probability of positive returns to approach inevitability—more like 30 years. Time will tell whether the recent market peak on September 20, 2018 will require months, years, or more than a decade to overcome.

The financial industry is built on confounding decisions with outcomes. A hedge fund manager is said to be “hot,” endowed with stock-picking genius, if his speculations pay off in a given year. Even for investors who were lucky enough to pick him, their decision was certainly bad; picking a low-cost index-tracking mutual fund and sticking with it for many years is a better decision. The speculator’s success is based on chance and luck, not skill. The speculator’s decisions are always bad, although their outcomes may be good, for a time. Eventually, good luck will inevitably run out, leading to underperformance of the index-tracking mutual fund, or worse, a spectacular capital wipeout à la Enron or Bernie Madoff.

We must all take a step back to carefully consider whether a good outcome was actually the result of a good decision, and whether a bad outcome resulted from a bad decision, or from a good decision that should be repeated despite a bad outcome occurring this particular time. On the whole, as a series of good decisions lengthens, good outcomes become inevitable, and as a series of bad decisions lengthens, bad outcomes become inevitable. In making such determinations, our psychology and the limited information available may work against us.

Generally, the amount of time you are invested in the stock market determines your returns, with higher probabilities of positive and larger returns if you are invested longer. This distinguishes investing from gambling. However, you cannot have rewards without risk, and it is entirely possible to lose money in a quarter, year, or even a whole decade.

In 2018, we saw what many define as a “bear” market; the S&P 500 index, which contains stocks of 500 of the largest U.S. companies, reached an all-time high on September 21, 2018 (intraday high), but fell 20.06% from this peak by close of trading on December 24, 2018. Although it went up a bit in the last week of 2018, it was still down 6.2% for the year.

Market declines invite counterfactual thinking—thinking what could have been if you had timed the market correctly, selling at the peak and buying at the lowest point. But, timing the market transforms investing into gambling; no one can consistently beat a “buy and hold” approach. If you try to time the market, the odds are against you; your returns are more likely to be lower than if you had bought and held.

Even Warren Buffett cannot time the market correctly; he had long been saying stocks are over-priced and had been holding much of Berkshire Hathaway’s assets in cash, but plowed much of this cash into Apple, banks, and other stocks in 2018 Q3. However, he would have saved billions by waiting until December 2018. Similarly, corporate stock buybacks have been enormous in recent years, and in hindsight, most were poorly timed.

It is not comforting to look to gains in prior years as recompense for 2018’s losses. Even if you invested in 2009, you still lost money this year, despite tremendous gains in prior years. Many more of us who invested over the past couple years saw our accounts in the red this quarter, erasing all gains and even part of our principal—if we could go back and put the money in a savings account or even under a mattress, we would be doing better now.

To survive a bear market, holding for the long term is critical. Preparations should start in the good times, far before panic strikes. When you invest, you should kiss your money goodbye for at least a decade or preferably even longer; if you’ll need it sooner, it’s too risky to put in equities. The Bogleheads, followers of Vanguard’s founder, Jack Bogle, call this principle “never bear too much or too little risk.”

To ensure you will hold, not sell, in a bear market, you must have at least the following: (a) education, (b) mental preparation, and (c) free cash flow. Without mental preparation, even if you have financial education and funds available to cover your expenses without selling equities, you might still sell in a panic. Without free cash flow, you might be compelled to sell to cover your debts or loss of income. Without education, you might have all your money in one stock (a horrible risk), BitCoin, or with a financial “advisor” who is plundering your portfolio with fees.

Free cash flow can be generated by selling the conservative parts of your portfolio during a market downturn. Depending on how conservative these parts of your portfolio are, they might experience no erosion of principal at all—savings accounts, certificates of deposit, and Treasury bills/bonds come to mind. The idea of asset allocation is to maintain a certain percentage of your portfolio in equities; to stay at this percentage, you would automatically buy more stocks when the market is down (“rebalancing”), because equities have declined as a proportion of your portfolio.

When is timing the market appropriate? Some would say never, but the insidious form of market timing really is jumping in and out of the market instead of holding. Assuming that you are not bearing too much (or too little) risk, timing the market can be appropriate on the way in, if it would cause you to invest earlier, or on the way out, if it would cause you to divest later. Although there is a whole industry built around timing stock purchases based on variables such as price–earnings ratios and geopolitical happenings, these are not much better than astrology. Generally, the longer you are invested in an index fund of the whole stock market, the higher your returns. Therefore, the only good forms of market timing are the ones that cause you to be invested for a longer duration.

The S&P 500, which is about 80% of the U.S. stock market by valuation, returns an average of about 10% each year. Adjusting for inflation, the average real returns are around 7–8%. However, if you were to take a portfolio of 100% Vanguard Total Stock Market Index Fund and withdraw 10% of the balance each year, you could easily run into sequence-of-returns risk (or for short, sequence risk). You could get lucky and have many years of good returns at the start, but you could head toward a complete capital wipeout with a few years like 2018 (or worse, 2008) in the first decade of your experiment. Market timing, via refraining from divesting stocks during market downturns, is an essential tool for retirees, including members of the FIRE community (financial independence, retire early), to mitigate sequence risk. Because this approach to market timing involves holding (not selling) and extending the duration of doing so, it is beneficial or at least benign, rather than malignant.

Ten percent is nice, but neither spectacular nor guaranteed. A savings account can now yield you over 2% per year, guaranteed. With stocks, you might earn 10% in 2019, earn 25%, or even lose 40%. Although credit card companies lose money when people default, overall they are wildly profitable because they collect returns on debts that approach 30% per year. Before you invest, you should pay your credit card debts. Even mortgages and student loans with interest rates around 5% per year might be paid first before investing in stocks; this is a guaranteed return, while stocks may lose value. Of course, if your employer matches 50% or 100% of 401(k) contributions you should do this up to the cap before paying more than the minimum payments on your credit cards, but this is a rare example. Usually, money does not grow on trees.

Take solace. In an index fund of the whole U.S. or global stock market, your investment will not go to zero, and it will eventually come back up. On the other hand, if you have the bulk of your investments in your company’s stock, you could certainly lose everything. Even an entire market sector could get wiped out (e.g., fossil fuels). You can’t have rewards without risk, but you can have risk without rewards. An “investment” can be both risky and more likely than not to be a loser (e.g., lottery tickets). It is your responsibility to learn and know the difference, implement this knowledge, and follow through, especially in a bear market.

Continued from Part 1, here are several more terms and my definitions for them.

Financial Freedom: For Americans, at a bare minimum this should mean one can “come up with $2,000 in 30 days,” a question that Peter Tufano found only half of Americans can answer yes to. A baseline of six months’ living expenses (an “emergency fund”) is more appropriate. This gives you the freedom of not living paycheck to paycheck or being compelled to work at a bad job.

Financial Independence: I look at financial independence as a term of art meaning you have enough savings/investments to live off of in perpetuity with no earned income and no sustained drawdown of real principal. Typically, financial planners and writers say you should have about 25 times your annual expenses to do this, which is $1 million if you spend $40,000 per year. This is pretty much the same as a financial endowment at the institutional/organizational level, but instead at the personal level.

There are 329 million people in the United States (November 2018) and U.S. households and nonprofit organizations hold an aggregate net worth of $107 trillion (2018 Q2), which is about $325,000 per person if evenly distributed, or about $425,000 if only distributed among adults—enough for $17,000 per year if income at a 4% withdrawal rate.

FIRE: FIRE stands for financial independence, retire early, a grammatically convoluted acronym that indicates achieving financial independence and then exercising the option to cease having earned income (“retirement”). Of course, one can be financially independent while continuing to work, and many who “FIRE” themselves end up continuing to work on a part-time basis.

Earned Income and Unearned Income: I would just use the Internal Revenue Service (IRS) definition for these. Earned income comes from work or pre-retirement long-term disability benefits, while unearned income includes bank account interest, dividends, and capital gains (e.g., from stocks).

Securities, Stocks, and Bonds: A security is an umbrella term that encompasses equities and debts, also known as stocks and bonds. Buying “stocks” actually means buying shares of a corporation’s stock, which confers ownership and possibly shareholder voting rights. If investing in an index-tracking mutual fund or exchange-traded fund (ETF), voting rights are conferred to your custodian rather than to you (e.g., Vanguard, Fidelity, BlackRock, etc.). Corporate bonds, another type of security, represent an obligation by a corporation to repay with interest, but confer no ownership rights. Stocks are generally more profitable than bonds, but if a corporation files for bankruptcy protection, bondholders get paid first. Many argue that U.S. Treasury bonds are the best type of debt to buy, because they are backed by the full faith and credit of the U.S. government, and that the reduction in risk compared to corporate and municipal bonds outweighs the lower yield. Municipal bonds may be useful to those with higher income who are subjected to state and/or local income taxes, due to their tax-advantaged status.

Emergency Fund: An emergency fund is money that is liquid, accessible, and protected from loss of principal. This is money that you have set aside for emergencies. Because the emergency fund could be needed at any time, it usually should not be invested in stocks because stocks can experience substantial short-term declines. See “The How and Why of Emergency Funds” for more information. If you have credit cards available, most emergencies can be paid for by credit card and then repaid by the statement payment due date, without interest, as long as you have been paying the full statement balance in full each and every month (otherwise, interest begins accruing from the date of the charge). Therefore, you can use an online bank for your emergency fund with limited or no ATM/cash access and pay back the credit card using the bank account.

Inflation and Nominal and Real Value of U.S. Dollars: “Nominal” just means numbers, so when we talk about nominal returns, this means we are not adjusting for inflation. Although the Austrian school of economic thought defines inflation as an expansion of money available (e.g., the monetary supply and quantitative easing programs of the Federal Reserve), this definition is unusual and not in common use. The predominant definition/measure of inflation is based on market prices of consumer goods, represented by the U.S. Bureau of Labor Statistics’s Consumer Price Index (CPI). Nowadays, the Federal Reserve aims to achieve 2.0% inflation per year, which means prices of consumer goods should increase by 2% each year. As of November 2018, many online savings accounts are paying an annual percentage yield (APY) of 2.0%. If inflation is 2%, this means that although the nominal account balance will increase 2% in a year, the real value will remain flat. When talking about past money, it is common to use CPI data to talk about the equivalent in today’s dollars. When talking about future money, discounting returns by about 2% per year to come up with a real, present day value of future money is common. If the stock market returns 10% in nominal returns in a particular year, this is probably about 8% in real returns, due to inflation.

Here are some items I intend to define in future posts:
Market Timing, Retirement, Sequence Risk, Single-Stock Risk, Index Fund, Tax-Gain Harvesting, Mutual Fund, Exchange-Traded Fund, Diversification, Tax Brackets, Payroll Taxes, Income Taxes, Tax Avoidance, Investment Management Fees, Load Fees, Dividends, Capital Gains

Here, I will seek to define several common personal finance terms that are often conflated and misunderstood.

Financial Literacy: There is no consensus definition of financial literacy, but I would say it is mainly concerned with having financial knowledge. However, personal finance is an eclectic field; having a high level of financial literacy requires knowledge in other areas, such as behavioral economics, psychology, information literacy, law, and even nutrition. Although financial literacy is usually correlated with good financial practices, this is not a given; one can easily have expertise but fail to apply it, or succumb to believing they are exceptional and can earn more in the stock market than others, or miraculously avoid a probable, deleterious outcome.

Financial Capability: I would define this as financial literacy combined with demonstrated financial competence, which hinges on consistently making good financial decisions, given one’s available choices and opportunities. What constitutes a “good” financial decision is not always clear, but we can often put items in rank order. For example, taking a payday loan is objectively worse than taking a credit card cash advance, because payday loans have far higher interest rates. One can have financial capability but not be able to do much with it—for instance, marginalized peoples and those in adverse situations. Conversely, privileged people may squander a portion of their privilege due to low financial capability. To be financial capable, one must not only make good financial decisions but also know why their decisions are good, and why they selected them over alternative courses of action. Such expertise should result in repeated beneficent decision-making, whereas someone of low financial capability might make a good choice by chance, but is unlikely to reliably do so.

Gambling: Many people conflate gambling and investing, but they are not the same thing. I define gambling as an act or series of acts where you are more likely to lose money than not, meaning that your expected returns are negative. However, there is an exception for insurance that insures against unmanageable losses, including losses that may potentially be unlimited (e.g., health insurance). Obviously, insurance companies have to come out ahead overall, but insurance is worthwhile to insure against unlikely but highly deleterious financial events. Returning to the element of likelihood, any student of statistics knows that if you gamble $1 with a 49% probability of coming away with $2 but a 51% probability of coming away with zero, your odds of making money are close to 50:50. But, if you keep making this bet again and again, your probability of losing money overall gets closer and closer to 100%. This is how lotteries and casinos produce guaranteed profits. When you invest in a broad swath of the stock market (e.g., an S&P 500 index fund), your probability of making money on any one trading day is about 54%. However, in a given year, it is about 83%, and in a given 10-year span, it is about 91%. Assuming you don’t need the money for a long time, this is investing, not gambling. However, if you try to pick stocks or put all your money in your company’s stock, your expected return might be negative, and there is a large risk of catastrophic loss. This is gambling. A kinder word is speculating, but it is certainly not investing.

Speculating: If you pick individual stocks or even entire market sectors, you are basically speculating. Buying gold, silver, oil, or corn futures is speculation. Buying BitCoin is speculation. These assets don’t have a solid track record of producing real returns (after adjusting for inflation). Modern portfolio theory tells us that holding uncorrelated (diversified) assets can be advantageous, so it makes sense to have gold—but not more than a small percentage of your assets. Speculation is often better than gambling, but certainly worse (as a decision) than investing. Although you might have fantastic results from speculating, this just means you had the unlikely fortune of making a bad decision that resulted in a good outcome. However, if this inflates your ego, it can easily lead to future misfortunes!

Investing: Over time, investing results in a probability of real returns that approaches 100%. As Vanguard mentions, for an S&P 500 index fund, which consists of 500 of the largest U.S. public companies invested proportionate to the companies’ market valuations, your probability of positive returns on any given day is 54%, but in ten years it is 91% (based on 1988–2018 data, but others have shown similar results even going back 100+ years). Besides the stock market, one can be successful at investing in real estate, or even one’s education, as those with more education tend to be more happy and successful in life, including financial success. Of course, there is presently a student loan “crisis” going on, and it is important to avoid high-cost tuition and housing expenses while also finishing your degree. On another note, investments must have a high probability of succeeding within a reasonable timeframe, and what is investing for one person could be gambling for another based on how soon they need the money (e.g., older people should have “safer” investments meaning less risk of short- and medium-term losses and lower expected returns).

I will follow this up with a Part 2 in the near future.