Advice IQ: Avoid your own financial destruction
Every time the market swoons, as it has recently, there is a lot of hand-wringing, as if the natural order has disintegrated. What we are seeing is a process called "creative destruction," and it is healthy.
The junk bond crash of the early 1990s, the tech wreck of the late 1990s, the housing bust of the last decade – all were necessary weeding out of economic structures that had outlived their usefulness.
Successful investing is a topic rooted in common sense. After all, if you could not invest with a reasonable expectation of success, why would you bother? How do you invest in a chaotic world of change so as to increase the odds of a favorable outcome?
First, recognize that change is a constant. Creative destruction, a concept that economist Joseph Schumpeter originated in the 1940s, holds that capitalism destroys old things in favor of new ones, and that is ultimately good.
This constantly reorders the investment universe. Look at what the Internet and digital advancements has done to old-line standbys like Sears Holdings (SHLD), Eastman Kodak (KODK) and RadioShack (RSH).
A 2012 article by Richard Foster, "Creative Destruction Whips Through Corporate America," indicated that on average a company in the Standard & Poor's 500 stock index is replaced about once every two weeks.
As Foster, lead director of consulting firm Innosight, noted, "In 2011, a total of 23 companies were removed from the S&P 500, either due to declines in market value or through an acquisition. At the current 'churn rate,' 75% of the S&P 500 firms [listed] in 2011 will be replaced by new firms entering the S&P 500 by 2027."
The index dropped RadioShack in June 2011 as its stock value sank below the level needed to stay in the large-capitalization benchmark. The electronics chain now trades below $1 a share, as bankruptcy threats loom.
Creative destruction may be a good thing if you are paying attention, or you have professional money managers watching the market for you. International Business Machines (IBM), which became the original computer giant, was founded in 1911. Did this successful behemoth see Microsoft (MSFT), founded 1975, or Apple (AAPL), 1976, coming? Microsoft, with its personal computers and its desktop software, and Apple, originator of cutting-edge mobile devices, pushed technology further ahead than IBM could.
Longstanding enterprises, mired in complex legacy systems, rarely are the innovators. The U.S. Post Office did not see FedEx (FDX) or United Parcel Service (UPS) coming, either. The two delivery companies could route packages to people much faster than the postman.
Along with the maligned 1%, the dynamic U.S. stock market gives ordinary Americans an amazing opportunity to build wealth if they will take advantage. The American Benefits Council estimates that nearly 80% of full-time workers have access to employer-sponsored retirement plans. More than 80% of those workers participate, on average saving 6.8% of pay while employers kick in 4.5% of pay. Capitalism at work.
The purpose of saving is not to buy stuff. That may be the end result but the big picture purpose is financial independence, freedom from stress and worry, and the satisfaction of meeting personal obligations. A goal of investing is to accumulate future buying power, and that influences rate of return targets and the necessity for taking risk.
Take a simple goal of growing savings at 3% annually over the rate of inflation and taxation, whether taxes are paid currently or are deferred. If inflation is averaging 2.5% annually, and you add 3% over inflation, your after-tax target is 5.5%. If your average tax rate (federal, state, local) is 25%, leaving you with 75% to spend, you must invest to achieve 7.33% annually as an average over time. (5.5/.75=7.33). Obviously, you cannot achieve that without some risk of loss and volatility. You must manage risk.
In light of the churning nature of capitalism, here are some rules to avoid your own financial destruction:
1. Only lend to relatives or friends if you are content merely to be a nice person or suffer ill will when you have the audacity to expect repayment. Second, the ultimate risk is complete loss of any investment. Ask yourself, "If I lost all of my money on this investment, would my lifestyle or that of my family suffer measurably?"
2. Resolve to accumulate enough liquid capital to allow you, and your family if married, to live a year or more with no income. That's peace of mind in case of a career reverse or some other challenge.
3. Keep debt under control. Marketers want you to spend freely and will provide the credit. "Freedom" can be dangerous at times, as parents know. Janis Joplin, in her 1971 hit single, Me and Bobbie McGee, sang, "Freedom is just another word for nothing left to lose." How to use money and credit wisely is a constant learning experience.
4. Have sufficient reserve funds and insurance so you can handle the slings and arrows of life. In counseling clients, a true financial planner will start with the "what if?" questions, making sure that your personal or family security foundation has all bases covered with up-to-date legal documents in place.
5. Diversification will minimize the risk of loss from any one thing, but volatility is a reality. Investments, especially stocks, fluctuate, as we have seen in September and October. There is upside as well as downside volatility. Seek information and education. Money isn't everything, but it helps.
MORE:Living with higher volatility
Lewis Walker, CFP, is president of Walker Capital Management in Peachtree Corners, and a member of the AdviceIQ Financial Advisors Network, which is a USA TODAY content partner offering financial news and commentary. Its content is produced independently of USA TODAY.