While the book is overall a good one, unfortunately, it contains a lot of generic financial advice which I decided not to include in the summary.
Choose a sound financial lifestyle
- Borrowers borrow money from the future in the form of credit loans till the lifestyle collapses, consumers consume money paycheck to paycheck, keepers focus on accumulating wealth over time.
- The focus on net worth mentality over paycheck mentality actively works in keepers favor.
Start early and invest regularly
- Compounding is key to building wealth, people who save and invest early on gets a huge advantage.
Know what you are buying
- Stocks represent ownership in a corporation.
- Bonds are equivalent of lending money to a corporation who returns you interest on that till it finally pays you the original value. Short-term bonds are <1 year. The intermediate term is 2-10 years, and the long-term ones are ten years or more.
- Treasury bonds can be purchased directly from treasurydirect.gov – Series I and TIPS are recommended as inflation-protected bonds.
- Municipal bonds are the state and federal tax-exempt.
- Bond funds are a collection of bonds with varying maturity dates, the weighted average maturity of them is called duration. A bond fund with a duration of 4 years is expected to lose about 4% in value if interest rates go up by 1%.
- Bond fund – short-term – 1 to 4-year maturity, intermediate-term – 4 to 10 years maturity, long-term – 10 year or more in maturity.
- A 27-year old should hold ~27% of net investments in bonds.
- Mutual funds buy securities (equities, bonds or could be hybrid).
- Fund of funds buys other mutual funds. Famous fund of the funds is Vanguard life strategy funds.
- Mutual funds are priced at the end of the day (based on the value of equities/bonds they hold).
- Annuities combine insurance with investment, mixing the two is a bad idea. Therefore, people are better off considering things like 401(K), IRA, etc. rather than annuities.
- ETFs are like mutual funds, but they are traded continuously in the market (which means they can be valued at higher or lower than the value of underlying securities).
Protecting against inflation
- Inflation erodes the real value of money over time.
- Series I bonds have an inflation component, they are bought and sold directly from US treasury.
- The market controls TIPS rates. The only way to guarantee no loss of principal is to buy them in Treasury auctions. Holding them in a taxable account is bad since its inflation adjustment produces taxable phantom income.
- Since TIPS are market traded, they must be held to maturity to guarantee no loss of principal, unlike I bonds which have to be held only for one year.
How much do you need to save
ashishb’s note: This chapter references some calculators which take numbers like future inflation rate, future returns rate after a person turns 65, I think those numbers are just too varied to have any certainty on deciding how much to save.
Keep investments simple
- In the rest of our life, we try to be better than the average, go with guts and take action when a crisis happens – all of these are bad for investing.
- The best option is to buy index funds which track a particular index. Buy one with low expense ratios – since in the market you get what you don’t pay for.
- A lot of actively managed funds have good pre-tax but bad after-tax returns since they trade heavily leading to high turnover and pass the realized gains to investors.
- Time and again various studies have shown that experts cannot predict the market.
- A study showed that among four factors – asset allocation of stocks, bonds, and cash, individual security selection, market timing, and costs – 93.6% returns were controlled by asset allocation, active management lead to a reduction of 1.1% in returns.
- Another study by Vanguard showed that 77% of the variability of a fund’s return was determined by asset allocation.
- For large domestic stocks, returns between 1935-2013 varied between -43% to +54% – for one year period and -1% to +20% for 10 year period.
- Risk tolerance is an important consideration – when market crashes, all “experts” say that worse is yet to come and if that fear can lead you to sell than you are better off with a more conservative bond-focused portfolio.
- The international stock allocation should be about 20-40% of the portfolio.
- High yield bonds are also known as junk bonds are speculative and not worth the risk. Given that yields are tax-inefficient, people should buy safer bonds instead.
- From front-end sales commission, deferred sales charge (back-end loads), purchase fee, exchange fee, 12b-1 fee, and several other such fees are charged irrespective of how the fund performs.
- Funds with higher turnover produce bad after-tax returns.
- Always try to invest in lower cost funds.
- Stock dividends are taxed at a lower rate than regular income.
- Bond dividends are taxed as regular income.
- Long-term capital gains are taxed at a lower rate.
- Unrealized gains/losses are taxed only on realization.
- Focus on tax-efficient placement.
- tax-managed funds try to focus on improving after-tax returns.
- Tax-loss harvesting uses short-term losses to reduce tax liabilities.
- If you have to buy bonds in your taxable account, buy either munis or US Savings Bonds – Series I or Series EE.
- Retirement accounts – (ashishb’s note: I have written them in Finance 101)
- Always buy mutual funds after their distribution date.
- Sell profitable shares after year-end to delay tax payments for a year.
- Diversification reduces the risk of being over-exposed to certain sectors; the best diversification is to hold the entire market.
Performance chasing and market timing
- Best performers of the past did not correlate with best performers of the future, the worst performance in the past though have some correlation with bad performance in the future.
- Time and again, public contests held for timing the market have shown that no one can time the stock market, all those “Three stocks to own now” are pure bull-shit.
- Predicting interest rates to time the bond market is equally harder.
- “Inactivity strikes us as intelligent behavior” – Warren Buffett
Investing for college
- UTMA/UGMA are bad accounts since the child can do anything with them once they turn 18.
- Saving Bond, I or EE, are good since their earnings are tax-free if used for educational purposes.
- Coverdell ESA has an annual contribution limit of 2000$ after-tax contribution and tax-free growth, if used for educational purposes, can be contributed only till the child is not 18 and must be used before the child turns 30 or can be transferred to another child after that.
- 529 plans allow much more substantial contributions, five times the annual gift tax limit once every five years) the growth is tax-deferred and withdrawals tax-free if used for educational purposes. There is a 529 prepaid tuition plan as well which allows one to pay tuition at the current rate for a state college/university.
Managing a windfall
- Inheritance, real estate sale, lottery are difficult to control; the first step one should take is to deposit it somewhere and leave it for six months, then make a wish list of short, intermediate and long-term goals and get professional help to manage it.
- If you are planning to have one, go for one with CFA/CFP title, go for fee-only advisors (not fee-based or anything else) since they are paid by no one except you.
- One time fee or hourly rate is another good arrangement.
- As asset allocation goes out of the assigned limits, rebalance.
- Rebalancing can be time-based, for example, once every 18 months or event-based, for example, if portfolio diverts by more than 5% than rebalance.
Tune out the noise
- All forecasting and “get rich quick schemes” are noise.
- Recency bias – If the market has done poorly in the past year, we believe the same for the next year.
- Overconfidence – 70% of the Americans believe they are above average. The same gets reflected in decisions about investing.
- Loss aversion – we feel the pain of the loss of 100$ twice as much as we feel the gain of 100$.
- Paralysis by analysis – too many choices of funds to invest in confuses us.
- Endowment effect – Feeling safer and overrating what we already own.
- Following the herd – It makes us feel safe to buy what everyone else is buying.
- Mental accounting – Its the habit of treating money coming from different sources as different.
- Anchoring – Holding onto investments which have badly lost its value and might never recover just because we are anchored to its past price.
- Financial negligence – Being preoccupied with other things in life is no reason to ignore finances.
Spending during retirement
- Better underspend than overspend and run out of money in retirement.
- Keep fixed living expenses as low as possible.
- Have a viable way to earn income, if needed.
- Don’t take social security paychecks till the age of 70.
- The annuity could be useful for people older than 75.
- A safe withdrawal rate is 4% of the initial value (or 5% of the current value of the portfolio)
- Disability insurance is more important than life insurance.
- Buy insurance if downsides are huge even is chances are low, e.g., flood insurance.
- Buying insurance for narrow things like specific diseases is a bad idea.
- The cheapest insurance is always self-insurance.
- Carry largest affordable deductible.
- Cash-value insurance like universal insurance is a bad idea since it mixes insurance and investing, its best to keep the two separate.
- Rather than life insurance prefer buying term insurance.
- If your employer offers, consider HDHP for health insurance.
- Illness and medical bills cause 50% bankruptcies.
- An umbrella policy of $1 million is a good idea to deal with potential litigations.
- If over 50, give serious consideration to buying long-term care before turning 60 since 60% population will require nursing home stays.
- Currently, up to $5 million is tax-exempted from inheritance.
- Will takes care of passing on the assets else they will be stuck in probate which can be lengthy and expensive.
- A living trust makes the process much smoother. Transfer assets to trust, make yourself and your spouse cotrustee and children successor trustee.
- Power of attorney for finances and health care is a good idea as well – they become active only if the person is incapacitated and unable to make decisions. for oneself.
- Charitable Trust is another option for donation to charities with better tax treatment.