Four Traps for Your Retirement Account
But You Have Advantages …
An Especially Successful Stock
Many investors have been effectively brainwashed (maybe that’s too strong, how about “persuaded?”) into thinking that the only realistic way to handle the equity side of their retirement capital is to put the money into an index fund, or funds, and leave it there.
The Index Trap
The argument goes that individual investors don’t have the research skills (or any other skills) to improve on the performance of a good index fund or group of index funds. It goes on to point out that if you’re trying to beat the performance of the S&P 500 Index, which is a very popular proxy for the general trend of U.S. large-cap stocks, you’re competing against actively managed funds run by seasoned professionals who have research skills and information sources that you can’t possibly match.
I’m not going to do a long critique of this idea. I’ll just point out that any strategy that had investors sitting on their hands during both the bursting of the Tech Bubble in 2000 and the deflation of the Housing Bubble in 2008 is … ummm … flawed. It’s like telling you not to get into your boat when the flood comes because you probably wouldn’t know how to use it.
I think you can do better than sitting like a lump in index funds and I’ll tell you how at the end of this article.
The Fee Trap
Everybody talks about taxes, but nobody seems to talk about fees. And that’s wrong.
Fees are what an asset management company charges you to look after your money for you. They are typically deducted from your account either quarterly or annually. They can run from a quarter of a percent to as high as 1.3% or more. And it makes a difference. I read an analysis of the power of fees recently. It took a hypothetical 25-year-old worker making the U.S. median income for that age ($30,500 per year) who makes a 5% contribution to a 401(k) every year and gets a matching 5% from an employer. If this hypothetical investor got an annual raise of 3.6% per year and investment returns averaged 6.8% per year, the amount in his/her retirement account at age 67 (full Social Security retirement age) would vary by $96,000 depending on the annual fees they paid. If fees were at the low end (0.25%), the amount saved would be $476,745. If fees were at the high end (1.3%), the amount would be $380,649.
I can’t do anything about getting you a 5% match from your employer on your retirement account. Judging by the people I talk to, this is increasingly rare. I also can’t help you with getting the regular 3.6% raise every year. That may also have gone the way of the dodo.
But I can certainly tell you how to avoid fees, especially if all you want to do is buy index funds.
The Bond Trap
One of the mainstays of the planning that financial advisors do for clients in their 50s and 60s is to move an increasing portion of their retirement fund into fixed income securities (bonds). The idea is to reduce exposure to the higher volatility of equities, thus avoiding drawdowns that can threaten capital. Of course it works, especially if the bonds are U.S. Treasuries. All I can do to counter this idea is to point out that the yield for five-year Treasuries is 1.73%. Ten-year Treasuries have a yield of 2.74%. 30-year Treasuries carry a yield of 3.54%.
The best guesses I’ve seen put the inflation rate in the U.S. (now at 1.6%) at around 2% by the end of the year. And that means that inflation is now eating up the yield from a 5-year Treasury and it will actually begin losing ground to inflation by the end of the year.
My question is: how financially helpless do you have to feel to accept that kind of return in exchange for absolute safety?
The Passive Trap
The passive trap is really a summing up of all three previously mentioned traps.
You accept the volatility of indexes because financial advisors have told you that you can’t consistently beat the indexes, so you shouldn’t try. You accept the penalty of fees because you prefer (or are required) to turn over the job of buying your indexes to an asset manager who charges you for the service. And you acquiesce to the bond trap because you fear that equity market volatility will eat up your capital and leave you eating cat food in your unheated apartment during your retirement. And it’s generic cat food at that.
Your Two Advantages
The one big advantage that your 401(k) has is that you invest using pre-tax dollars, which lowers your taxable income. But this is undercut by the big disadvantage that if you need to make a withdrawal before age 59 and a half, you incur a 10% early withdrawal penalty on top of any taxes due.
So, what do I think you should do? Well, you have two advantages over the investment houses that want to manage your money. First, you can invest in index funds (if that’s what you choose) all by yourself, and shift your allocations in response to market changes.
The second big advantage is that you can get out of the market at any time and go to cash. And if you don’t think that’s a big deal, just think about the monster selloffs of the major indexes during the Tech Bubble bursting and the Housing Bubble meltdown. In the 30 months of the Tech Bubble decline, the S&P 500 lost 49% of its value. In the free-fall that followed the Housing Bubble collapse, it fell 56%. And if you had been sitting passively in index funds (and I know many of you were), those declines hurt. You may even be working longer than you intended to because of it.
The Advantage You Could Have
The other big advantage that you could have is the Cabot family of investment advisories. These advisories run the gamut from growth to value equity investing and from small-caps to options and dividend investing.
The opportunities are enormous, offering you the chance to leave index funds far behind. Cabot China & Emerging Markets Report, which I write, enjoyed 50% returns in 2013. This year, as the market for Chinese stocks has weakened, I have pushed the Report’s portfolio more heavily into cash; the cash position is now 65%. That ability to go to cash has been enormously important in letting subscribers have access to the opportunities in China and other emerging markets while limiting the potential downside.
Cabot’s investment advisories let you escape the Passive Trap, giving you bigger gains when markets are in uptrends and more protection when conditions turn sour.
Avoiding these four traps can help your retirement portfolio get healthy and stay healthy. And adding Cabot to your list of advantages can allow you to be both active and confident.
As a way to illustrate the kind of possibilities I’m talking about, here’s my stock pick for this issue. It’s AerCap Holdings (AER), a Dutch company that leases aircraft and aircraft engines to commercial passenger airlines and cargo haulers. The company has a fleet of 378 aircraft, making it one of the largest leasing and finance companies in the aviation world.
But if big is good, enormous is better, and AerCap is in the process of taking over International Lease Finance Corp. (ILFC) from AIG in a $5 billion deal. The merged company will have a fleet of nearly 1,400 planes, creating an instant rival for Gegas (GE Capital Aviation Services), whose 1,630 planes will remain the largest in the world, at least for now. Along with ILFC’s planes, AerCap will acquire the company’s early orders for Boeing 787s and Airbus A320s and A350s. When all 385 planes now on order are delivered, AerCap will own the crown as the largest aircraft leaser in the world.
Here’s a chart showing the performance of AER against the S&P 500 Index over the last two years. This shows the potential advantages of individual stock ownership compared to an index. You may say that I’ve cherry-picked an especially successful stock to make my point, but that is exactly my point. If you want to beat an index, of course you look for uncommonly strong stocks to own. That’s the way it works.
AER was recently a featured stock in Cabot Top Ten Trader, which comes out every Monday and details the strongest stocks in the market.
Chief Analyst of Cabot China & Emerging Markets Report
and Editor of Cabot Wealth Advisory