Ask Liz Weston

Dear Liz: You suggest that wealth can be accumulated by regular savings and earning an average rate of return of 8%. Where can a safe 8% return be found?

Answer: The same place leprechauns hide their gold.

There is no truly “safe” investment. Investments that have no risk of principal loss, such as federally-insured bank accounts, typically offer such low returns that they expose you to “inflation risk” — in other words, your deposit’s buying power is eroded over time.

If you want to stay ahead of inflation over the long run, you need some exposure to the stock market because that’s the only investment class that’s consistently outperformed inflation over time. According to Ibbotson Associates, the stock market has returned at least 8% on average annually in every 30-year period, starting in 1928. So even if you invested on the eve of the Great Depression, you could have knocked out an 8% return if you just hung on long enough.

Dear Liz: I have twin boys and have been looking for a college fund to set up for them. Most bank saving accounts don’t pay much interest. The only thing I have found that is halfway decent is a certificate of deposit. My grandmother set up a trust for me, but I don’t know whether that’s a good idea these days. Do you have any ideas that would help?

Answer: You’re actually asking two questions. The first is what vehicle to use for college savings, and the second is how to get a decent return on your money.

Let’s take the latter question first. Bank savings accounts or certificates of deposit are fine if your kids are headed off to college in a year or two, but these low-risk investments won’t give you much growth on your money. In fact, you’ll almost certainly lose buying power over time when you consider inflation. If your money is in a taxable account, you’ll lose that much more.

Many parents opt to take more risk in order to accumulate more funds. If college is 10 years or more in the future, investing at least some of the money in stocks or stock funds makes sense.

The vehicle you use is also important. If you expect to get financial aid, you’d be better off avoiding custodial accounts such as Uniform Transfers to Minors Act (UTMA) or Uniform Gift to Minors Act (UGMA) accounts. These were popular accounts years ago when tax rates were higher, but they count heavily against you in financial aid formulas.

Many families find 529 college savings plans to be the best choice. These state-run accounts allow your contributions to grow tax-free for college and are treated favorably in financial aid calculations. These plans typically offer a choice of investment options, including age-weighted options that start out more heavily invested in stocks but that ratchet back exposure to risk as college draws closer. For more information, visit SavingForCollege.com.

Dear Liz: Maybe you can settle an argument a co-worker and I are having. We live in New York and work for a hedge fund administrator, but we’re not really savvy investors. Let’s assume my co-worker has $400,000 in cash, no debt, some money in a 401(k) and wants to purchase a home for $200,000.

Should she use 50% of her cash for this purchase even if she has the credit rating to get a great mortgage? She believes that not having a mortgage payment means she is debt free and better prepared in the event that she loses her job or meets hard times.

I believe that a mortgage is good debt and having $400,000 cash on hand is best so that I’m ready for the right investment opportunity. Who has the right idea?

Answer: You both do.

It’s pretty easy to make the case that you’ll make better long-term returns investing your money in a diversified portfolio of stocks and bonds than you would by paying off a low-rate mortgage.

But some people simply sleep better at night being debt free.

This, by the way, is not a scenario most people will face. Few have sufficient savings to pay cash for a house. Once they have a mortgage, they probably will have many, many better things to do with their money than pay down low-rate, tax-deductible debt, such as save for retirement, pay off high-rate debt, bolster their emergency fund and buy adequate insurance.

The invest-versus-pay-off-debt mortgage debate is less relevant than whether they have all their financial bases covered.

Target-date funds can be a good choice for people new to investing, or those who simply don’t want to mess with the details of picking asset allocations and rebalancing their portfolio. Many big-company 401(k) plans now offer target-date funds, as do most big mutual fund companies and brokerage firms.

These funds do all the heavy lifting for you, gradually adjusting the investment mix over time so you take less risk as you approach your “target date”–typically a year near when you plan to retire.

But apparently a lot of people have misconceptions about target-date funds and what they can accomplish.

Behavioral Research Associates interviewed 250 Americans and found that many thought the investment option offered some kind of guarantee. For example:

•    Over 60% of employees say that investing in target-date funds means they will be able to retire on the target date.
•    38% think target-date funds offer a guaranteed return.
•    30% of workers think they can save less money and still meet their retirement goals if they invest in a target-date fund.
•    Over 23% of workers believe that there is little to no chance that they will lose money either before or after the target date.
•    41% think there is little to no chance of losing money in any one-year period, and
•    70% think they are equally as likely or less likely to lose money in any one-year period, as compared to investing in money market funds.

Obviously, none of these misconceptions is true. Target funds adjust your risk over time, but they certainly don’t eliminate it. Even when you approach your retirement date, your target fund may still have half or more of its assets in stocks.

That doesn’t mean you should bail on your target-date fund, but–as with all investments–you should understand the real risks and rewards.

You can CLICK HERE to read the researchers’ comments to the SEC and Department of Labor about their findings.

For more on this topic, read:

• One-fund retirement: Buy and forget
• Don’t shy away from target-date funds
• Target-date funds come under fire

Some interesting stats emerged from Hewitt’s latest report on 401(k) savings and investing habits of more than 2.7 million employees. Mostly, the report shows our investing habits haven’t changed all that much. Why? Some say inertia (who knows what to do), while others say some employees continue to hold faith in slowly building their 401(k)s over time.

No matter what, “the losses workers have sustained are so extraordinary, they’ll need to be much more proactive about saving to build their nest egg back up to pre-recession levels,” says Pamela Hess, director of retirement research at Hewitt Associates.

Here are some of the study’s key findings:

• The median rate of return in 2008 for 401(k) plans was a 28.3% loss—with the average 401(k) balance dropping from $79,600 in 2007 to $57,200 at the end of last year.
• Only 11% of employees were able to break even or gain in their 401(k) portfolios. Forty-four percent of employees lost 30% or more of their savings in 2008.
• 74% of employees participated in their 401(k) plan in 2008, which is consistent with previous years’ findings.
• The average 401(k) contribution rate dropped only marginally, from 7.7% in 2007 to 7.4% in 2008. Just 5% stopped contributing to their 401(k) plan altogether in 2008.
• There was a slight increase in the number of workers who made any trade in their 401(k) plan last year: 19.6% in 2008 vs. 18.7% in 2007.
• Nine of the ten most active trading days were the day after a large downturn in the market, or days with an average return of -4%.
• Employees’ average equity exposure dropped to just 59% in 2008—which is an all-time low since Hewitt began tracking it in 1997. Stable-value funds—which are considered less risky investments—experienced an 11% increase in asset allocation in 2008.
• 18% of employees took a hardship withdrawal from their 401(k) plan in 2008. The number of employees taking out 401(k) loans (23.1%) in 2008 remained similar to levels in prior years.

For more advice of investing, check out my columns below:

• 5 life lessons from the recession
  

• Under 35? Hurray for the meltdown!

• What’s the best way to reduce risk as I approach retirement?

I used some T. Rowe Price/Ibbottson research in my recent MSN column, “Under 35? Hurray for the meltdown” to show that long-term returns for stocks kicked butt–even if you started investing right before the Great Depression, which knocked nearly 90% off the Dow.

If I can ever figure out how to get PDFs into WordPress, I’ll post the whole chart, which shows the average annualized returns for every 30-year period starting in 1926.

What it shows is that if you held stocks for 30 years, you not only wouldn’t have lost money, but you would have seen at least an 8% average annualized return.

Some interesting numbers:

• The best 30-year period: 1974-2004, when the S&P 500 averaged a 13.7% average annual return
• The best 30-year period, adjusted for inflation: 1932-1961, where the real return averaged 10.6%
• The worst 30-year period: 1929-1958, when the S&P averaged 8.5%
• The worst 30-year period, adjusted for inflation: 1965-1994, where the real return was just 4.4% (although the nominal return was 10%)
• The percent of 30-year periods where S&P 500 returns exceeded 10%: 81.5%
• The percent of 30-year periods where the return was greater than zero: 100%

The take-away? If you’ve got 30 years until retirement, you’ve got plenty of time to recoup your losses and profit from today’s low prices. If you’re closer than that, I’d recommend a session with a fee-only financial planner to make sure you have enough stock exposure to capture the gains sure to come along with bonds and cash to cushion any downdrafts.

I don’t invest in individual stocks anymore. I don’t have the time to monitor companies and have no faith in my ability to beat the market, so I stick with index mutual funds and exchange-traded funds.

Still, learning about individual stocks is a great way to grasp important investing principals, learn about how the market works and improve financial literacy in general (that’s why schools use The Stock Market Game).

If you feel intimidated by the stock market, or are hesitant to invest real money, check out WeSeed, a virtual investing/social networking hybrid that uses the tag line “The fun, free, risk-free way to get a clue about the stock market.”

You can explore various stocks based on your interests or profession or the products you use, then deploy a portfolio of fake money to buy your choices and watch what happens next in real time. You can interact with other virtual investors to see what insights they’ve gained, and share your own.

Then check out the games, particularly Stock Price Cage Match, where you determine which of each pair of competing stocks has the higher price. (The best I scored was 77%, a solid C–which helps explains why I don’t buy individual stocks!)