Jonathan Clements- Main Street Money- 21 Simple truths that Help Real People Make Real Money

In a nutshell

This is vintage Clements writing. It’s about principles and concepts, but has enough detail to move “do it yourselfers” to action. He covers the obvious, the not so obvious and the counterintuitive with equal clarity. Clements intends this book to be “accessible to even the financially phobic”. He also provides on page 101 an “elaborate balanced portfolio (for American readers.) It’s a very quick read (fewer than 200 small pages), but no doubt you’ll go back to use it as a reference. He covers the what, why, how, where and pitfalls of money, sharing his wisdom and knowledge accumulated over about 25 years of writing about personal finance and as CFA charter holder. Well worth your time! Highly recommended.

Beliefs

Clements starts with his list of seven beliefs: (1) money is a means to an end (what are you trying to achieve), (2) don’t neglect today (balance is important), (3) we should think harder about what we want, (4) money is emotional, (5) our financial lives are bigger than we think (e.g. human capital, pensions, etc), (6) focus on what you can control (cost, spending, saving, asset allocation), (7) simplicity is a financial virtue

Then some of the obvious and not so obvious parts of his 21 truths:

-Assets include financial and human capital; liabilities include retirement, children’s education, mortgage and various loans. The source of your income and the risks associated with it affect your risk tolerance.

-Life is about choices (you can’t have it all): buy or not, now or later…you should separate musts from wants. When making choices Clements suggests giving priority to experiences over material things (“hedonic adaptation” will prevent happiness by acquiring things)

-The four basic financial goals are: (1) home, (2) children’s education, (3) retirement savings and (4) emergency savings+ insurance. Of these, priority #1 is retirement savings because children can borrow/save and a big home is not an investment (but an expense, i.e. consumption) and by the way you better start saving by the time you are 30. “Diligent savers need smaller retirement nest-eggs, because they need less money to retire as they are accustomed to lower standard of living”. Always use “pay yourself first” always since budgeting doesn’t work for most people

-“Time is as valuable as money” because after a number of years, once sufficient capital has accumulated, investment gains start becoming greater than annual savings. Retiring later helps in two ways, it allows you to save more and you have fewer years in retirement

-Risk is everywhere: “no investment is free of all risk”

-Assets classes – he suggests there are four classes: (1) stocks, (2) bonds, (3) cash and (4) hard assets (gold, commodities, real estate…). Returns for stock is (Inflation +7) %, bonds is (Inflation+2 to 3) %. Each separately has associated risk, but together the risk is somewhat reduced. Bonds/cash give downside protection, stocks help overcome corrosive effect of inflation and hard assets and TIPS give protection against inflation. As an aside, he mentions that you run the other way when you hear “downside protection with upside potential” as it usually ends up to be the worst of both worlds, low return and high cost. Real estate, hedge funds and private equity appear to give higher return and be more stable, but only because there is no daily pricing (and they are not as liquid)

-Asset allocation: divide your assets into ‘safe’ and ‘growth’ dollars, and make sure that the ‘safe’ pot is in safe assets. Allocation (among the four types of assets) drives risk (volatility) and returns. Stock/bond mix is determined by “how much risk can you reasonably take and how much you can truly stomach” (i.e. ability to take risk + willingness to take risk= overall risk tolerance). Stocks are an option only for portion of assets that you don’t expect to need for 7-8 years. Rebalance portfolio as different asset will be moving at different rates/direction but try to do it in a tax deferred account. Rebalancing doesn’t just mean sell something to buy something else; often you can achieve required balance by buying assets with interest and/or dividend received. Near retirement reduce stock allocation, but don’t abandon stock (inflation is corrosive).

-Stocks: Components of stock market returns: earnings growth, dividends, market return (P/E expansion, though over the long term this is not the dominant element). If you are in the accumulation phase, falling stock and bond prices should make you more enthusiastic about buying them (since they are on sale). Stock market investing is not about beating the market, it is part of a long-term plan to achieve your objectives

-You must overcome the headwinds in investing: costs (management fees, trading costs, bid-ask spreads), taxes and inflation. Differences in fund fees are key determinants in fund performance. 8% returns can quickly become 1.5% after fees, taxes and inflation.

-Advisers/planners/brokers: find out how much you are paying (all costs) and what you are paying for? Clements identifies the advisers’ role as : design an appropriate portfolio, driving you to save enough so that you meet your objectives (this means that she had to ask you what your objectives were), help you to deal with market swoons, and to reduce your expenses to 0.2% or less!

-Great list of 10 reasons why it’s so difficult to beat the market, which by the way should drive you to low cost index investing. Reason #10 particularly should make you think: “Big winners mean you are likely to lose. Popularity leads to failure. Success contains the seeds of its own destruction. Past performance doesn’t repeat. Information isn’t necessarily helpful….maybe it’s no great surprise that there are so few Warren Buffetts.” William Bernstein, in the Foreword to the book, writes that the “investing game is not to get rich, but not to get poor”.

-“Wild investments” like commodities, REITS, emerging markets, counter intuitively can stabilize the portfolio (because they tend not to be correlated with the traditional asset classes like stocks and bonds; however in times of financial crisis correlations tend to increase among all asset classes.

-Portfolio: At one end of the spectrum his simple portfolio is 42% US total stock market, 18% foreign stock index and 40% US total bond market. His model for the elaborate portfolio (given on p.101) is 55% stocks, 10% hard assets and 35% bonds (1/3 TIPS) with suggested sub-allocations in each asset class. He argues that the exact percentages are less important than your willingness to stick with it, as it forces you to buy low and sell high!

-Short term volatility can hurt- the classical example is the ‘sequence of returns problem’ which he illustrates with two 10 year return sequences (8%, 8%,8%…..8%) and (32, -16%, 32%, -16%….32%, -16%) both of which average 8% however the cumulative return of the first sequence is almost twice of the second one. The most challenging time is around retirement when adverse sequence of returns can dramatically affect retirement age and/or standard of living! This is due to the need to sell stocks when they are down just as you start drawing funds from the portfolio, which could result in a significant drop in the size of the portfolio. Clements suggests that near retirement you should have cash and short-term bond reserves for 5 years of expected draw or about 25% of the portfolio. He also reminds readers that almost nobody follows many planners’ model of spending 5% of initial assets indexed annually for inflation. Instead in “good” years spending is increased and in “bad” ones reduced.

-Longevity risk (in addition to inflation, market and ‘requirements’ risks), resulting from one’s unknown date of death, leads to inability to precisely plan one’s spending profile. So one could spend too much and run out of money if longevity is longer than planned for, or cutting corners throughout retirement and then leaving a large estate. Male and female life expectancies at age 65 are about 18 and 20 years, respectively; however for couples what counts are joint life expectancy. (depending on whose mortality data you use, e.g. IRSthere is a 50% and 25% chance respectively that at least one of a 65 year old couple will be alive at age 90 and 95) So he suggests that for planning purposes you should use at least a life expectancy of 90 (95 is better). To deal with longevity risk, he suggests TO delay taking social security, if you don’t have a pension consider an annuity, if you don’t want an annuity then take 20% of your assets to cover expenses after 85, and spend the remaining 80% until 85. If you die <85 then you have an estate, if you die >85 then you’ll have accumulated asset to live off or annuitize at that time.

-Inflation is a killer because 3% inflation halves your buying power over 23 years. But then here is the clincher: “general standard of living rises not with inflation but per capita economic growth which is typically (Inflation+2%)…so retirees tend to feel poorer as others around them get richer, even if their spending keeps up with inflation.” (Of course it is also worse because ‘senior inflation’ is different (usually higher) than general inflation as the senior purchase basket is different than that of the general population.) So to have a growing income in retirement, one must consider one’s willingness and need to take risk, available assets, pensions and desire to leave an estate; and he suggests that you need to keep horizon in mind when you consider risk;   a 65 year old may have a 30 year retirement but her estate has a 50-80 year horizon.

-Behavioral finance: here explains many of the “behavioral errors” (like saving too little), behavioral concepts (like loss aversion, home bias, etc). Basically you learn about behavioral errors that one should watch for and avoid. This is not about behavioral finance to beat the market.

-Latest 401(k) plans help with target-date funds, automatic enrollment, default funds and of course often matching employer contributions. You should also aim for some tax diversification by funding both 401(k) and Roth IRA.

-Homes are not a great way to make your money grow since over 30 years they only appreciated by inflation (3.8%) plus 0.9% and there a significant carrying costs (property taxes, maintenance, insurance and mortgage interest)

-“Paying off debt (especially credit cards and personal loans) could be our best investment”

-Savings priorities: (1) 401(k) contribution which is eligible for employer match, (2) pay off debt, (3) pay off mortgage (especially true for Canadians who don’t even get mortgage deductibility which Clements says is over-rated anyways especially if you are retired). You should start saving early to maximize power of compounding.

-Taxes: try to delay them as much as possible: fixed income in tax sheltered retirement accounts while equities in taxable accounts, if possible don’t sell winning/taxable investments without selling loser which counterbalance with capital losses. Use first 2-3 years in retirement when taxes are starting to be lower to do some tax management

-“Insurance is to protect against financial risk we can’t shoulder ourselves” (e.g. if house burns down, but don’t bother with service contracts or LTCI with short waiting period). Buy term life insurance and get rid of it if no longer needed, when you are older. He suggests that as your assets grow your need for insurance may decrease

-Importance of considering estates, wills and power of attorney are emphasized in addition to the complications associated with divorces, elderly parents, etc

-He closes off with thoughts about importance of money (less so than family), wealth (expensive cars big house are signs of spending not wealth), lifestyle choices (diet, exercise, smoking, etc), luck (good and bad, being in the right/wrong place at the right/wrong time) and he warns that we should “ensure money enhances our lives rather than getting in the way”