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Active versus Passive……versus Common Sense!

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By Ted Schwartz, CFP®

The biggest shift (and debate) during my decades in this business is the move from active management to passive. Active management means that your investment has a portfolio manager who is tasked with picking your investment from the universe of choices. His job, obviously, is to be above average in his choosing so that you do better than average in the returns you receive versus the risk that you take. A passive investment merely tries to duplicate an index of investments with no decisions made by a manager. The idea here is to do average with as little expense as possible incurred.

The battle over which of these ideas is superior has raged for more than a decade with both sides presenting evidence that they have the superior position. Both sides have logical arguments to make, but…the field has been tilting towards the passive side. Investors have voted with their feet, leaving actively managed mutual funds for Vanguard low cost index funds and ETFs (exchange traded funds). My belief after watching this for twenty years is… in a good market (where the trend is clearly up), you are probably better off in low cost index investments that capture average returns. The data shows that relatively few active managers outperform in these markets and also shows that these instances of outperformance tend not to persist (i.e. this year’s winning fund is unlikely to be next year’s winner).

So, does that mean we should all only own passive investments with a buy and hold for the long term discipline? I think the answer to this is….use some common sense! Remember, passive investments include zero risk management and you will always capture an average share of all losses in market declines. Let’s say you owned a passive investment in the Nasdaq index in early 2000. Stock prices were well over ten times their normal valuations, but there were lots of pundits explaining that this was a “new paradigm”. Passive investors were set to lose 78% of their principal by sticking to their long term buy and hold strategy. The Nasdaq index was at 5048 in March of 2000 and is at 5058 as I write this in July of 2016. An optimist might say “see, I told you to just hold onto it and it would come back”. A realist would say that, including 16 years of inflation, you are nowhere near having the buying power you had in 2000 when you made this ill-advised investment.

Common sense would tell you that when stocks are selling for over ten times their normal valuations, you should own less of them than normal. The expected future return on investing in those stocks was at an all-time low due to their being so overpriced. To manage your future risk and returns, any rational person should have been thinking that they needed to actively manage their allocation to this passive index. This is common sense. Failing to use common sense in investing can be very costly.

One piece of good news is that we now have thousands of passive indices to invest in and some have been designed to control your risk better than the older indices. These are often referred to as “smart beta” products, a term that annoys me as much as fingernails running across a blackboard. That said, they tend to reduce your exposure to investments that have gone up the most (think overpriced) and therefore are worth considering as you allocate your money. They do not replace common sense! It is the investor’s job to manage risk and return by deciding how to allocate money in a portfolio. Diversification is definitely step one. You want to own assets which have low correlation to one and another, so you don’t end up with all your eggs in one basket. Second, it is an investor’s job to buy the eggs that are on sale and sell a few of the eggs that are overpriced.

Unfortunately, this process is neither simple nor always immediately pleasant. An investor who decided that technology stocks were way overpriced in early 1999 and sold some of his tech stocks would likely be kicking himself by the end of the year. Almost all of the returns that year came from tech stocks. The rest of the market languished all year and posted disappointing returns. In hindsight, that investor would have saved themselves a great deal of capital in the long run by sticking to the simple discipline of using their common sense. Market returns do not reflect common sense in the short term, but the long term payoff can be tremendous.

Our common sense answer is that a good portfolio… actively managed and makes use of as many low cost, passive investments as possible. The old adage that most return come from asset allocation decisions seems to be right on. However, the world is not static and your portfolio requires attention as the world turns.

FLOW: Volume 7 — One Month In; A Smaller Barrel

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In our most recent series written by Jamie Cornehlsen, Denver CFA and founder of Capstone, FLOW examines how we seek out investments and make selections based on current market trends and future forecasts. Part seven of our series unveils the significance of obtaining a sustainable cash flow in high-yield stocks.

It has been one month since I opened my FLOW account; investing $150,000 in high yielding stocks.

When I selected my 20 investments, I did not choose based on how each had performed in the previous month or year. The investment value was presented in each company’s ability to produce cash flow.

I had to remind myself that this was the goal after the value of the portfolio declined to $140,137 within the first week; a cool $10,000 loss, or about 7% in five days of trading.

But this investment was developed to increase cash flow through acquiring businesses that could produce. Rather than focus on price, the value of the underlying business is what we will instead choose to concentrate on.

Besides the downturn in the account, we also received our first dividend check. With the TD Ameritrade account I created, I requested that dividends be paid out each month. On February 2, $432.67 was deposited into my savings account. This represents an annual return of 3%. I expected this percent to increase once our investments reached the ex-dividend date, which is the date stock must be owned by in order to have a right to the dividend.

After a full month of investing, I predicted the annualized yield to reach 11%.

Sustaining a Steady Cash Flow

Fortunately, the portfolio is beginning to produce satisfactory results. By the end of January, the account value had reached $157,489. Although I expect the principal value to fluctuate, the cash flow should preserve the investment.

Here’s my FLOW investment summary:

  • 20 investment positions
  • 10 investment categories
  • Categories: convertible/preferred, covered calls, emerging markets, foreign governments, go anywhere (manager discretion), high-yield (junk bonds), REIT, mortgage debt, infrastructure, individual stocks (of the stock category, there are 6 individual stocks)

Since the last time of purchase made in the end of January, we have seen a spike in prices. Consequently, conditions for investing are not as favorable. However, for a cash flow yield, there are still opportunities with these 20 investments.

So, where does this leave us? In a slightly less favorable place, but a place that is still providing consistent cash flows.

The next step is to begin the weeding process. This is probably the most important practice of all, as it is where we evaluate the holdings to see if they are continuing to provide a consistent cash flow. If an investment shows a declining ability to produce a flow, we will then sell and replace with investments that we feel can generate the desired results.

In summary, I’m planning to keep my account open for the long haul, and expect to continue reaping the gains of the cash flow while I ride out the volatility of the stock market. I will be reporting back with updates as changes are made to the portfolio.

Past performance is not indicative of future results. This article is intended for informational purposes only and is not intended as investment advice. Individual investor experiences and results will vary.

FLOW: Volume 6 – Tracking the Portfolio’s Progression

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In our most recent series written by Jamie Cornehlsen, Denver CFA and founder of Capstone, FLOW examines how we seek out investments and make selections based on current market trends and future forecasts. Part six completes our series by taking a closer look at the specific investment opportunities that were chosen to enhance the performance of the FLOW portfolio.

When I chose the 20 investments for this portfolio, I did not choose based on how they had performed over the last month or year. Although the yield each investment presented was likely due to poor performance recently, the overall investment value was presented in each company’s ability to produce cash flow.

Despite reminding myself of this logic, the value of the portfolio declined to $140,137 within the first week of the initial investment being made — a cool $10,000 loss, or about 7% in five days of trading.

But this investment was selected for the cash flow opportunities and the faith that the chosen businesses could produce such returns. So rather than focusing solely on price, the value of the underlying business is what we will continue to concentrate on.

Identifying Success through Dividend Production

As a result, this means removing the S&P 500 as a benchmark for success. The success is created off of dividend income generated from a portfolio. Outperforming the S&P 500 doesn’t generate revenue; it’s the production of dividend income that leads to an increase in profits.

As the portfolio continues, buy and sell decisions will not be dictated by the performance of the S&P 500, or the 20 individual investments. In the future, we will either look into upgrading to higher quality investments with greater income-generating capabilities, or sell the investment if the company’s ability to generate cash flow no longer supports its ability to pay the dividend or if the price is much greater than the value.

As we progress, I will provide updates on the cash flow and will keep readers informed of the decisions I make, whether it’s upgrading to investments with higher cash flow or seeking other income-generating opportunities.

FLOW: Volume 5 – Understanding Price Movement

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In our most recent series written by Jamie Cornehlsen, Denver CFA and founder of Capstone, FLOW examines how we seek out investments and make selections based on current market trends and future forecasts. Part five of our series dives deeper into portfolio development and helps readers understand what creates value in today’s changing market.

The downturn the stock market experienced in the final weeks of 2015 and the first few weeks of 2016 set up a prime time to invest.

I went into the new year thinking that I would take on five investments at a time. If the market fell, I would buy the next lot.

As chance would have it, the first lot was purchased on January 12th. The following lots were purchased on January 15th, January 19th and January 20th.

The portfolio was invested more quickly than expected, but the declining prices in the market provided a favorable opportunity, with a jump in current yield occurring right off the bat.

Removing the Panic from Portfolio Development

The declining prices have led many investors to fret over their portfolios, with the anxiety and fear being that they will lose all their money. But if the investment was made with the belief that the company will not only continue to generate cash flow, but overall growth in the future, then the anxiety is more emotional and less analytical.

I have observed that poor investment decisions are often dictated by price movement. However, price movement is very different than a company’s ability to continue generating earnings and to grow those earnings over time. There are times when a decline in price reflects verifiable concerns, but price movements alone can be very misleading. A rising stock price may put an investor at ease, creating a false sense of security.

Investors make mistakes when they let emotion creep in and impact behavior and investment decisions. When plowed over by the hype from greed or the hysteria from fear, investors seldom make rational decisions. This type of behavior only creates optimal opportunities for those not falling prey to emotions.

Value is what you get; Price is what you pay

I seldom hear of investors providing the price they are willing to pay in order to generate a stream of cash flow. In our FLOW portfolio, we were willing to pay $150,000 for a stream of cash flow of $17,580 annually, or 11.72% of the portfolio.

I don’t know if this is what will eventually come of it or if the portfolio will be significantly lower, but I wanted to make sure the price of $150,000 for 20 different investments could create a value worth at least $15,000 a year (in this case $17,580).

Value is different than price because value represents cash flow to us. Since we are value-conscious investors, we are intently keen on paying attention to potential cash flows that are expected to be received. Unfortunately, few investors spend the time necessary to focus on this critical element. Instead, many financial brokers’ attention is placed on stock price and its up or down pattern of movement.

If you pay too much, you receive very little value. No matter the amount of cash flow a company generates, the overall impact felt is the price that was paid to buy that investment. When purchasing an investment, you can often determine the value by how much cash flow is being received now, as well as in the future.

As I mentioned before in FLOW: Volume 1, Warren Buffett’s investment philosophy is all about value in purchasing a stream of cash flow for as little as possible. His quote, “Price is what you pay. Value is what you get” clearly summarizes this.

With the $150,000 invested in cash flow generation, my thinking now turns to the possibility of buying the whole company as the investment process begins.

FLOW: Volume 4 – Building a Strong, Sustainable Portfolio

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In our most recent series written by Jamie Cornehlsen, Denver CFA and founder of Capstone, FLOW examines how we seek out investments and make selections based on current market trends and future forecasts. Part four of our series uncovers the various reasons why investors select particular investments when creating a portfolio, as well as the importance of each component.

In building a portfolio, I always ask: what is the purpose of this particular portfolio? It seems like a simple concept to be purposeful with what to invest, but often times this imperative thought escapes the process.

This question may seem like common knowledge to some, but it is of vital importance for an investor to ask.

What Are You Investing For?

Investing comes with many trade-offs. Generally speaking, higher yields often imply lower capital appreciation, and vice versa. 10% yields are eight percentage points above the S&P 500. Companies that are on a fast growth trajectory tend to retain the cash they have for further growth.

Investors do not have the same goals, needs or investment objectives. Some investors want outright appreciation in order to beat the stock market. Others are concerned with protecting the downside. And then there are the investors that want the highest income possible. Consequently, I believe investors should ask what purpose is this investment for?

For the FLOW portfolio, the investment objective is maximum cash flow with the current yield. For high-yield, investors should expect a lower rate of capital appreciation in order to achieve their goal. If you are looking for maximum capital appreciation or total return, you will not find it in a high-yielding portfolio such as this one.

Portfolio Characteristics

  • 20 Investment Positions
  • 10 Investment Categories
  • Categories: Convertible/Preferred, Covered Calls, Emerging Markets, Foreign Governments, Go Anywhere (manager discretion), High-Yield (junk bonds), REIT, Mortgage Debt, Infrastructure, and Individual stocks.

The main objective of the FLOW portfolio relies on the investment’s ability to create cash flow, which will either produce a capital appreciation over time, or will distribute a cash flow directly to the investor.

Consequently, the volatility in the value of this portfolio should not matter. It is only important that the investments continue to sustain the 10% or more cash flow distribution.

Future total returns will also be functionally related to the level of valuation that a company can be purchased at. Lower valuations can lead to higher future returns generated by price-to-earnings ratio (P/E) expansion as a result of a reversion to the mean. Consequently, if valuations are low enough, which could also be the source of an above-average current yield, this can result in high or above-average future returns that can be accomplished even through investing in lower growth entities.

Is Climbing the “Wall of Worry” Still an Option?

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By Ted Schwartz, CFP®

From March of 2009 until 2015, the stock market climbed a “wall of worry”, rising dramatically throughout the six-year period. In the wake of the strongest financial crisis since the Great Depression, we experienced great unknowns as we embarked on unprecedented government policies to stimulate the economy. This process was a slow recovery, as banks were reluctant to grant loans, and we were forced to face many other issues that caused a great level of economic uncertainty. Throughout it all, the market shrugged off the concerns, slowly ascending with little volatility as it marched towards ever loftier valuations of assets.

Since the middle of 2015, we have been in a downward spiral of decreasing markets and increasing volatility. Falling energy prices have gone from a positive for consumers to a negative for the economy. Slowing growth in China, ending government stimulation, and a general sense of unease have all steered the market downwards. It appears that we no longer have the ability to climb the wall of worry that remains in front of us.

Investing for the Long Haul

We are not sure what will turn markets and cause them to rebound from the doldrums. We are certain; however, that the fundamentals of investing have not changed and will not change. Stripped of emotions, you are investing now in order to receive a future income stream from your money. Reassuringly, the income stream you can expect from your investments is certainly higher now than it was at the beginning of 2015. With about half of all stocks having fallen 20% or more from their highs, both the dividends and valuations look pretty attractive for the long haul. That is the key for us. While stock prices are driven by emotions in the short-term, they are guided by earnings, dividends, and growth in the long run.

At Capstone, we think now is a great time to lock in cash flow to your portfolio. If you can add investments with attractive interest and dividends (especially dividends that are likely to grow over time), you can use that cash flow to help survive the current market turbulence and set yourself up well for the future. While markets are volatile and emotional over the course of shorter time periods, dividends and interest are surprisingly stable throughout market cycles.

If you can concentrate more on the cash flow (and pay less attention to the short-term market mayhem), we believe you will be richly rewarded in the long haul. As the famous investor Sir John Templeton pointed out, you want to buy investments at the “point of maximum pessimism”, which is where we seem to be now. It’s possible for things to get worse (there is no certainty of market emotions being reigned in before the damage escalates) but….we are somewhere in the area of making good long-term investments. It is a good time for contrarian investors to climb the wall of worry.

FLOW: Volume 3 – Taking the Financial Plunge into High Dividend Funds

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In our most recent series written by Jamie Cornehlsen, Denver CFA and founder of Capstone, FLOW examines how we seek out investments and make selections based on current market trends and future forecasts. Part three of our series evaluates how increasing risk and investing in high dividend funds can generate an increase in cash flow over time.

Below is my experience in finding an investment whereby I acted as the owner of a business and followed Warren Buffett’s true sense of investing.

As the stock market continued its downward spiral, I went off in pursuit of finding a reasonable investment. I thought about investing in a liquor store. I thought about a venture in the real estate industry.

Both opportunities likely would have delivered optimal returns, but I opted for something different. Instead, I discovered that the recent market decline had opened up the chance to dive in and explore some interesting investments that I had not seen in over four years.

With $150,000 set aside, I was eager…not to invest based on speculation, but rather, for the underlying ability of the business to generate cash flow.

Adopting a Higher Level of Risk for a Greater Return

In my search for investments that would grant financial independence, I decided to skip the liquor store investment and pass on the real estate venture. I knew I was more interested in learning opportunities with higher potential reward in exchange for more effort and risk. As a result, I settled on companies with high yielding dividends, master limited partnerships (MLPs), real estate investment trust (REITS), and closed-end funds (CEF), all of which I knew would provide me with a 10% return.

Ever since I heard Buffett and Munger discuss owning an investment as a business, I have thought about applying this philosophy to my financial choices. In Chapter 8 of The Intelligent Investor, author Benjamin Graham discusses the idea of buying a company with a partner. There may be some days when the partner comes running into your office saying the business is worth half as much as the day before and he wants to sell to you. The very next day, this same partner comes running in saying the business is now worth twice as much and he wants to buy out your share.

In reality, the business does not swing in value by that much. As I indicated in Flow #2, returns are based on three key factors: the cash flow that is generated and paid to you, the amount by which you can increase this payment each year, and finally, the price you are able to sell it for.

Selecting Investments That Work for You

In his book, Graham advocates that people should not partner with this type of person as they are proven to be fickle. Instead, he believes individuals should invest on their own and focus primarily on what the business can provide in cash and how it can increase that amount each year.

For me, detecting an investment that provided the beneficial outcomes I sought came in the form of high dividend yielding companies, master limited partnerships (MLPs), real estate investment trust (REITS), and closed-end funds (CEF). From here, I created a list of 170 investments to further evaluate. My goal was to narrow this down to 20 in order to limit the individual risk of each going out of business. Narrowing down my choices also allowed me to watch my basket closely and follow the progress of each investment.

Now that I knew what my investment would be, it was time to develop the portfolio…

FLOW: Volume 2 – Exploring the Real Estate Investment World

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In our most recent series written by Jamie Cornehlsen, Denver CFA and founder of Capstone, FLOW examines how we seek out investments and make selections based on current market trends and future forecasts. Part two of our series takes a look at the positives and negatives of real estate investing.

After deciding against purchasing the liquor store, my next move was onto real estate. I have several friends that thrive in the area of real estate investing and have learned that hiring a management team can provide relief from having to do the maintenance and the management yourself, so I began the search.

I focused primarily on residential properties as well as multi-family units.

I had determined that I wanted to get at least a 10% return with this investment. Looking at the real estate industry, I figured I could get a minimum of a 7% return and in some cases, as great as 17%.

Recognizing the Three Components of Return

All investments have three components of return: earnings or cash generated each year, growth of earnings, and (hopefully) increase in valuation. Earnings are the cash flow that is generated and paid to you. The growth of earnings is the increase in those expected earnings over a period of time. Last, the increase in valuation is the upturn in price per unit from the time you buy to the time you sell.

In terms of stocks, earnings are dividends that are paid to you. If a particular stock is paying a 10% dividend yield, you as the investor can expect 10% from dividends. The increase in earnings is the rise of dividends each year paid out to you. If the stock was purchased for $10 and the dividend was originally $1 per share, but increased to $1.30 over the course of five years, then the increase in earnings was 30% total, or 6% per year.

Last, you might have purchased the stock for 10 times a dollar of earnings and sold for 15 times a dollar of earnings. This represents a 50% increase in the valuation over five years, or 10% per year. As a result, you would have a total annual return of 26% per year: 10% for dividends, 6% from growth in earnings, and 10% for appreciation.

Wouldn’t a return like that be nice to get now a days? Unfortunately, the stock market has only averaged about 4.5% a year for the past 15 years.

Looking into the real estate market, I found homes that I could rent and expect to receive a 7% return from the rental income. I estimated I could increase the rent by 2% per year, and expect to see a 1% increase in the valuation.

I looked at buying a home for $150,000 and charging an annual rent of $10,750 or 7%. I could expect the rental income to increase from $10,750 in the first year to $13,450 at the end of a five-year period; roughly a 1% increase per year. At the end of five years, I could anticipate selling the property for $165,000, which in total would earn me a return of 10%. This would be good!

The Reality of Real Estate Investing

However, weighing into this grand plan would be the cost of annual maintenance, the expense of personally managing the home or hiring a property manager, and the toll of having a potentially unruly renter.

In the end, I decided that although I might be able to earn a great return on a real estate investment, I would still have to put up with the risk and hassle of managing the rental to some extent, in which the costs may outweigh the benefits of such a return.

My next FLOW post specifies how and what I decided to invest in.

Can You Chase a Winner in Investing?

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One of the most frequent behaviors in 401-K plans is for participants to move their money to the fund choices that did best in the past year. It is a good use of common sense — to think that the fund that did better has a smarter manager and is a better place for making money in the future than a manager whose fund did poorly last year.

Unfortunately, research does not back up this concept. S&P (Standard and Poors) keeps a scorecard that tracks whether or not outperforming funds continue their success over time. This month, they released their updated findings. Their research tracks funds across several time frames, various fund types, and also filters funds by top quarter and top half. The basic idea is that if fund managers’ good performance is due to their skill rather than luck, it will continue over time. Sadly, the research they do almost uniformly shows that this is not the case. For instance, of the funds that were in the top quarter of US stocks for a one-year period in September of 2013, only 4.28% remained in the top quarter in September of 2015. Far from persisting, there is some indication in these numbers that they do worse than you would expect by pure chance. There are some areas where managers seem to operate a bit better, such as emerging market bonds and multi- cap funds (that is, funds where the manager can decide whether to buy small, medium, or large size companies and can move amongst the areas according to their discretion).

Many would take this as a sign to always choose a passive index over an actively managed fund. At Capstone, we don’t think that is necessarily the best conclusion to draw from the data. We do think that expenses make it difficult for managers to outperform indexes over time, especially in large and transparent indexes. So, it makes sense that a great manager can show his mettle more frequently in thinly-traded emerging market bonds than in the S&P 500 Index. We think it also makes sense that managers can perform a bit better in a multi-cap fund, as they are able to use their skills more if they aren’t constrained in terms of what they can buy and sell.

We also think a healthy mix of passive indexes and skilled managers remains the best way to capture gains and regulate risks. Looking at who performed well last year delivers results that are largely due to chance. Looking under the hood of a fund at the philosophy, process used, culture of the people involved (e.g. is your manager putting your interests above his or hers, do they have skin in the game by investing in the fund themselves, etc.), and the performance of the fund can give you accurate long-term results.

Simply looking at how funds performed last year is why all fund literature reminds you that “past performance does not necessarily predict future results”. Research says much the opposite.

By Ted Schwartz, CFP®

How Impact Investing is changing the Financial Advising Industry

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For many individuals, financial investing and philanthropy aren’t often placed in the same category; however, more shareholders are turning to a new method of investing that merges values and promising financial returns together.

Impact investing, otherwise known as ESG (environmental, social and corporate governance) investing, is the act of making investments into companies, organizations, and funds with the intention of producing a positive social or environmental impact alongside a financial return. This form of socially responsible investing serves as a guide for various investment strategies. Simply put, impact investing is about identifying a meaning behind your money.

Earlier this month, a company called ImpactAssets launched two new products with the idea of impact investing in mind. According to the company, the Microfinance Plus Note and the Global Sustainable Agriculture Note were developed to offer minimal interest rates and provide a strong liquidity feature and are available to end-investors with a minimum investment of $25,000.

The Microfinance Plus Note allows ImpactAssets to lend to regulated emerging market organizations that generate small business loans, while the Agriculture Note is designed to encourage sustainable farming cooperatives that help farmers around the world stabilize their profits and farm productively.

These two products are just some of the examples of the blooming impact investing options for end-investors, many of whom anticipate their investment dollars to closely match their personal values and also wish to see the value of their investments expand.

The Enticement of Impact Investing

Impact investing challenges the long-held beliefs that social and environmental issues should only be addressed by philanthropic organizations, and that market investments should focus entirely on delivering the highest of financial returns.

What makes impact investments so appealing to advisors and investors alike is that they do not focus primarily on philanthropy, but rather an alternative investment with a socially and economically beneficial twist. While many advisors are skeptical of the success of such investments, the truth of the matter is that more and more brokerages are getting into impact investing. Firms are experiencing a demand from more of their clients to create products that generate a positive impact and advisors are losing assets to larger firms.

To learn more about impact investing and how to incorporate strategies into your investment opportunities, contact us today.

Stay tuned for part two on how impact investing is changing the way millennials spend their dollars and prepare for retirement.