Retirement: A Full-Time Job

Going Broke Safely

I finally got around to watching my recording of “The Retirement Gamble” on PBS’s Frontline.  It confirmed what I already thought about actively managed mutual funds being a rip-off for people like me, and probably most people, who just have no idea how to select which of the sliver of mutual funds will outperform the market indexes. 

I’m not even sure there exists a person that can consistently do that.  Besides that challenge, even if you are lucky enough to choose the outperforming fund, it has to way-outperform the index to make up for the cumulative expense hit from the fund's operating fees.  So why pay exorbitant fees that will erode the value of your investments when you can pay one-tenth the cost and simply match the market?

In any case, the show did a good job of explaining why actively managed mutual funds are a generally a bad deal.   Vanguard’s granddaddy, John Bogle has been saying this for years, and he got a chance to make his point loud and clear on this program.

But as the wise Steve Vernon asks in his recent piece for CBS MoneyWatch, while the show did a great job of exposing this issue, the real question is, what will you do about it? 

If your answer is to steer clear of Wall Street all together and stash all your retirement funds in the safety of cash, well there’s a name for that.  I just heard it last weekend in an investing seminar.  It’s called “going broke safely.”  Unless your pile of cash is huge, you’re just not going to be able to keep up with inflation’s bite over the long haul.

Even worse than that approach is throwing up your hands and saving nothing in response.  Vernon says that the majority of workers who participate in 401(k) plans aren’t even contributing enough to receive the free money of their employer’s match.  And that’s just the folks that are participating, what about the workers that aren’t participating at all?

This is the real retirement gamble, as Vernon points out:

This points to a much bigger problem for our collective retirement security: People just aren't saving enough for retirement. Your employer may offer a plan with the best funds in the world, but if you haven't saved enough money, it won't matter because you won't have a secure retirement. On the other hand, if you have enough money even in a crummy 401(k) plan, you have a good shot at a secure retirement. Once you retire from your employer, you can always roll over your accounts to a financial institution that offers investments with low fees and good investment performance history.

Excessive mutual fund fees are just one of the culprits eroding our retirement security.  Some people profiled in the show had invested all of their 401(k) in their company’s stock.  The show's reporter had dipped into his retirement to fund his kids’ educations.  Many of the folks just didn’t feel up to the daunting task of investigating their investment options. 

Seems to me, despite the many flaws of our 401(k) system of retirement, we are really our own worst enemy.  And that part, we can do something about.

Related Posts:

            How Not to Bet on the Stock Market

            Balancing Risk and Reward

            Buy Low, Sell High

 

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(Photo details:  Wynn/Encore Las Vegas)

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A Do-Over in the Stock Market

If you’ve been watching the U.S. stock market lately, you know that it’s hovering near all-time highs.  The Dow is within 2% of its October 2007 high, and the S&P 500 is not far behind that.  The S&P has bounced nearly 125% off its March 2009 low.  Investors holding bonds have done very well over the last 10 years, bonds are also at new highs.  And for the first time in years, money is flowing back into stock mutual funds.

All of this has some people worrying that we’re heading toward another pop of the stock bubble, although others see it as the beginning of a longer trend upward.  There seems to be a little more consensus on bonds, that they are poised for a fall as interest rates are expected to rise at some point; which would take a big bite out of the value of bond holdings, especially those with longer durations.

So if you think stocks are overpriced and you sell to beat a crash, how would you feel if next year finds the stock market even higher?  If you hold on to stock and bond funds and we do get a big tumble in both, how would you handle that?   And even if you sold everything now, where would you stash the proceeds?

I have no idea what’s going to happen.  But I read Jason Zweig’s piece in the Wall Street Journal a couple weeks ago suggesting that we take this moment to design a portfolio that will make us happy (or at least less sad) under any market conditions.  Instead of trying to predict the future, the idea is to allocate your assets across “buckets” that diversify across various economic outcomes:

"Thinking about diversification in a different way—what we might call "differsification"—might change your views entirely. Instead of spreading your bets to protect against a plunge in the U.S. stock market, you should regard your portfolio as a set of bets on basic economic conditions and create one bucket for each: expansion, recession, inflation and deflation."

Read the full article for suggestions on how to design your own buckets.

This got me thinking abut what steps can I take now, now that I’m pretty much back where I started five years ago, to make sure I’m at least content no matter which way the winds blow.  Here's my plan:

Make sure my asset allocation is appropriate for my risk tolerance.

As I’ve lamented before, my asset allocation was a little equity heavy in 2007 for what I learned in 2008 was my actual tolerance for risk.  I’m shifting from a 70/30 allocation of equities to bonds and cash to a 60/40 allocation.  Sure, the market may go higher, but at these levels, basically where I was in 2007, I now get a chance for a do-over.  My allocation is now where I wished it had been in 2007.

Make sure my allocation is still where I designed it to be.

No matter what risk-appropriate allocation you designed for yourself, after January’s 6% rise in U.S. stocks, your intended allocation may be out of whack.  It’s hard to sell stock when they're high I know, but that’s the beauty of periodic rebalancing.  It forces you to do what you might not feel like doing.

I’m paying off the mortgage.

When I retired five years ago, I hadn’t paid off the mortgage.  I had the cash set aside in a CD that paid a higher rate than my mortgage rate.   And after the market tumbled non-stop, I was pretty happy I that didn’t use up that big chunk of cash.  As it turns out, I needed it to live on during that roller coaster time.  If I had paid off the mortgage, my only alternative would have been to sell stock at rock-bottom prices to fund living expenses over those years. 

Of course in retrospect, it would have been a better move to sell stocks on day one of retirement and pay off the mortgage.  That would have prevented that chunk of my portfolio from nose-diving, as it would have been safely stashed in my house.   

But now, just as then, I have no idea what direction the market is going.  But I lock in a 2.875% return on that money if I pay off the mortgage now.  It doesn't sound like much, but as opposed to 2008, that’s more than I'm earning in cash accounts now.  Who knows whether it’s better or worse than what I’ll earn in the stock and bond markets.  Which is why I’ll be taking the money from both sides of the equation in 60/40 proportion.  I’m not trying to time the individual markets, just take this moment to keep in balance.  I'm basically rebalancing into my house, something that will give me comfort no matter what happens with the markets.

Today the market shed the last two weeks of its gains.  With congress just about to head into another series of Washington-manufactured crises, it’s tempting to try and outsmart the market in advance.  But those investors that tried that during the European debt crisis or before last year’s fiscal cliff negotiations have missed out on some pretty nice returns.  I prefer to take a break from following what's going on in Washington for the time being.  I'll just take my do-over and hope for the best.  

 

Related Posts:

How to Lose Money in the Stock Market:  Don’t Invest in it

A Note About “Losing” Money in the Stock Market

What About the Mortgage?

 

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Fighting Inflation the Hard Way

Can you live comfortably on half of what you are living on now?  I guess the bigger questions is, would you want to?  That’s the question you have to ask yourself if your retirement plan ignores the effects of inflation.

When you’re figuring out how much money you'll need for retirement, you’ve got to forecast a few inputs that you can’t really predict with certainty.  You won’t really know whether you were right about your predictions until after you’ve gotten to the end, which is a little late for retirement planning.  You’ll need to guess how long you’ll live, what return you’ll make on your investments, and how much you plan on spending over those retirement years.   And spending will include inflation, whether you include it or not.

Life Expectancy 

According to U.S Census Bureau data I can expect to live another 33 years.  That seems a little low to me.  I’m pretty healthy and two of my grandparents lived well beyond 82.  Of course you never know what is going to happen, but I’m planning for 100 birthdays, just to be safe.  The last thing I want to do when I wake up on my 83^rd birthday is have to go look for a job.

Return on Investments

You can’t really know with certainty how much you’re going to earn on your investments either.  Depending on your risk-tolerance and your resulting asset allocation though, history can give you a little bit of guidance.  And when you use William Bengen’s Safemax approach, you’re betting that you will experience the worst historical combination of returns and inflation over your projected time period.  So that should provide some comfort.  Unless of course you think things are going to be even worse.  In which case, you should adjust for that. 

If you’re basing you retirement plan on double-digit expected annual returns though, I’m going to predict that you’re not going to make it to the end with enough.  (Or alternatively that you wind up at Club Fed for insider trading, which of course is another way to take care of your retirement.)

Inflation

And if your plan to beat inflation is simply to shave down expenses each year by the inflation rate, you’d better be prepared to spend only half of what you are spending today. 

The annual inflation rate has been pretty low over the last couple of decades, between 2 and 3%.  Some people think that the Federal Reserve’s current easy monetary policy is going to cause those numbers to skyrocket in the future.  But even in these relatively low inflationary years, the cumulative effect of inflation over the last two decades is almost 82%.  The basket of goods that cost you $100 in 1990 would cost you $182 today.  Because some items are going up faster than other items, your individual basket may vary.   

In my case, health insurance has been going up by double digits each year, and this line item is a pretty hefty chunk of my basket of goods.  My retirement plan assumes a 3.5% inflation rate, which would roughly double my expenses two decades from now.  I can try and combat some of this, sure.  I just bought a car that gets double the gas mileage as the old one, so there, I cut that expense by half.  But 20 years ago gas was about one-quarter what it is today, so after inflation, I’m still behind on that line item. 

As inflation goes up, you can switch from beef to chicken, wine to water, and dining out to dining at home.  You can give up vacationing, concerts, and sporting events.  You can downsize from two cars to one, from four bedrooms to two, or move from California to Kansas.  But what do you do if you already live in Kansas with one car and two bedrooms?  Or what do you do if the things you give up don’t offset the increased cost of health care, long-term care, or things you have to pay others to do because you can’t physically do them anymore?

Even if you can slice and dice to try and whip inflation, the question is, do you really want to bake that reality right into your retirement plan?

Related Posts:

            See Dick and Jane Retire

            See Average Joe Retire

            Building Your Retirement Budget

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Battling the Wealth Effect

(Posted in Money Mondays)

Several years ago, I got hit in the head with a hockey puck at the San Jose Sharks game.  Maybe it was kind of a Karma thing.  My friend had done some legal work for the arena, and she scored some excellent tickets for us in row seven, right on the blue line.  And maybe I sort of bragged about it all day long to my friends, and especially to my husband.  I was very excited to get to enjoy such a great vantage point to all the action.  Well it turns out, a kind of dangerous vantage point, the protective glass stopped at row six.  I enjoyed five minutes of the game before I was taken to the emergency room to get the gash in my forehead stitched up.  

So it seems appropriate that the National Hockey League was the one to knock me upside the head again today, this time about the dangers of the wealth effect.

It’s taken five years, but my retirement nest egg has finally surpassed the balance it held on the day that I retired.  It may seem strange that simply catching up to and squeaking past where I was five years ago would make me feel wealthy.  This is not how I thought things would shake out back when I retired in early 2008.  I figured five years later those accounts would be higher, I mean a lot higher.

But you all know what happened in 2008.  By the end of that first year, The Very Big Recession had knocked my retirement accounts down more than 20%.  The wealth effect means that when you’re not feeling very wealthy, you make cutbacks.  That part of the wealth effect was very good for my retirement actually.  That first year, we spent a lot less than I had budgeted for, only about three-quarters of what we spent the year before I retired.

Even as the years marched on, and the stock market crept up, the post-traumatic stress effect of having experienced that very big market decline kept us from feeling like we were out of the woods.  In fact, each of the first three years of my retirement, we kept spending less than the year before.  Even the year I picked up my little part-time retirement gig I didn’t loosen the purse strings at all. 

But fast forward to 2012.  We started to feel more comfortable.  The combination of a climbing stock market, the extra cushion that the part-time job provided, and the fact that our first four years of retirement spending had come in way under budget led us to experience the wealth effect the other way.  Even though we had only gotten back to where we started in 2008.  We took a couple extra vacations, splurged on a few nights at a fancy resort, and even bought a new car.

Just getting back to where we started may seem like a move backward, but the fact is, now we have five fewer years to cover (or put another way, we are five years closer to the end of our retirement, if you know what I mean.)  So that actually means we’re in better shape than we were when I first retired.  And that’s why I feel the wealth effect working in the other direction, the dangerous direction. 

That’s where the NHL comes in.

Last month, when I thought the hockey season was cancelled, I took my newfound wealth, the savings from this season’s tickets, to buy a new couch.  But then yesterday they settled the strike, so there really was no newfound wealth.  Which I suppose is better than an actual puck in the head, but it reminded me that maybe I should rein the spending a bit, and perhaps move behind the protective glass.

 

Related Posts:

            How Much Money Do You Need to Feel Rich?

            Downsizing to Retirement

            Are Retirees More Financially Agile?

 

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The Wealth Effect

Tuning in to Your Tolerance for Risk

I enjoyed my first foray into live radio last night with an appearance on Lance Roberts’ streettalklive broadcast.  (To listen to my segment, click here:  Download Streettalk Live 2).  We chatted about retirement, and he shared his wisdom on important issues like how much money one needs to retire, and how retirees should allocate their nest eggs between stocks and bonds. 

I’ve discussed the importance of determining your own tolerance for risk in order to figure out how much of your portfolio you should allocate to stocks.   And by risk tolerance, I am referring to how much you feel like killing yourself when you see your nest egg shrink.

As I’ve mentioned before, I may have been a little too risk tolerant when I initially set up my own retirement portfolio.  When the stock market lost about half of its value in the first year of my retirement, I might have felt a little more comfortable with a slightly more conservative allocation.  Live and learn.  But what if you don’t want to learn the hard way like I did?

You already know how to target the size of your retirement nest egg.  Let’s say you are retiring at age 65 and are targeting a 4% withdrawal rate.  You’ll need a nest egg equal to 25 times your annual expenses that aren't covered by other income sources such as Social Security, rental income, or part-time work.  But how do you allocate those assets among stocks and bonds in a way that will allow you to sleep at night during a market tumble, before you actually suffer through a market tumble?  That’s where Lance has an interesting suggestion.

First, look at your projected expenses.  Then figure out how much money you will need just to cover your “Alpo diet,” meaning the absolute minimum you need for basic expenses before you have to start eating dog food.  Maybe not such an appetizing image, but you get the drift.   Perhaps some of this is covered by your Social Security or other income.  But to the extent that it is not, invest enough of your nest egg into the safe part of your asset allocation to generate the income you'll need to meet your basic needs.

Then to keep up with inflation, you will want to allocate the rest of your nest egg to equities.  This part of your nest egg will cover the wants rather than the needs.  That way, if the market runs into trouble, you’ll be able to makes some adjustments to your spending on discretionary items, while still ensuring that you get to eat normal food for dinner.

I took a look at how this approach would translate to my own allocation.  Sixty percent of my budget is for non-discretionary items, housing, insurance, utilities, groceries, health insurance--things like that.  A little more extravagant than an Alpo diet, but that represents the basic cost of operating our life as is right now.  The other 40 percent of our expenses are for discretionary expenses, things we could cut in a pinch, but really wouldn’t want to. 

That would translate to a 60% bond allocation and a 40% stock allocation.  Which is a little too conservative for my taste, especially since I’ve got potentially 50 years to cover.  But consider the same breakdown if I were 67 years old.  That would be when I am eligible for Social Security.  Social Security should cover about 20% of my expenses.  (I will not earn the maximum Social Security benefit since I did not work long enough to earn the full benefit.)  In that circumstance I would only be aiming to cover 80% of my expenses with my own nest egg.  After applying a little math, that translates to a 50/50 split between stocks and bonds.  (Since the first 20% of my budget would be taken care of by Social Security, only 40% of my expenses would remain to be covered for basics and 40% for fun stuff.)

While this approach may not exactly hit the mark for me now, it seems a pretty reasonable way to tackle the issue, perhaps with a little fine tuning to really make it your own.

Related Posts:

            My 15 Minutes of Fame

            How to Lose Money in the Stock Market:  Don't Invest in it

            A Word About Asset Alloction

 

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Buy Low, Sell High

 

(Posted in Money Mondays)

This is the final part of my three-part series on how I invest my nest egg.  First I talked about decreasing your risk with diversification across asset classes.  Then I discussed matching your risk tolerance to your own allocation among asset classes.  But this is where the magic happens.

Part Three:  Periodic Rebalancing

You've probably read the stats that a surprisingly small number of trading days determine a large percentage of the stock market's gains.  From 1963 to 2004, 1% of the trading days accounted for 96% of the market's gains.  In the period from 1990 to 2005, a buy-and-hold investor would have realized average annual returns of 11.5%.  Contrast that with someone that was going in and out of the market during that 15-year stretch and managed to miss the 10 best trading days of that period.  He would have realized only an 8.1% return.  Now it's true that if he had managed instead to miss the 10 worst trading days, he would have realized a 15.3% return, but it turns out that people are notoriously bad at getting in before the gettin' is good and getting out before the market tanks.

While the market has doubled since the bleakest days of 2008, mutual fund outflows were at record highs during that same period.  Investors pulled nearly $260 billion out of U.S. equity funds since then, missing an awful lot of upside.  The percentage of households that hold stock has fallen each year since the financial crisis hit, to a new low of 46.4% in 2011.  Unfortunately, investors tend to sell as the market is tanking and buy as it is rising.  That's why over the two decades ending in 2010, investors' average annual equity returns were 3.8%, even while the S&P 500 returned an average of 9.1%. 

There's a perfectly good explanation for this:  People are human.

So what to do about this predicament?  Remove the emotion.

Once you have determined what your ideal asset allocation is, you have to do a little work to keep it there.  Let's say your risk profile provides for a 50/50 split between stocks and bonds.  Let's say it's 2009 when the stock market returned 26% and the bond market returned 11%.  At the end of 2009, your 50/50 allocation is out of whack.  At that point, you would hold 53% stocks and 47% bonds.  Rebalancing just means you sell some stock to get back down to 50% and move the difference into bonds, getting you back to your target asset allocation.  Conversely, at the end of 2008, after stocks went down 37% and bonds went up 20%, you'd have a 34/66 allocation of stocks to bonds.  In which case, you'd sell some bonds and move that money to stocks.

In both of these cases it wouldn't feel very good to do, abandoning some stocks after an upswing, or dumping money into stocks after the've just tanked.  But it would force you to buy low and sell high on that portion of your portfolio that needed rejiggering.  That's rebalancing.

Now, if you decide that the eurozone turmoil, or the Fed's quantitative easing, or potential election results mean that stocks are going to tank, and you decrease your stock allocation down to 20%, that is not rebalancing.  That's market timing.  You feel that it's a bad time to be in the market, and you are making judgment based on what you think is going to happen to that market.  That's fine, it's not for me, but it may be for you.  In any case, it's not rebalancing.

When I retired, I had 30% allocated to fixed income and 70% to stocks.  As I mentioned before, I found that allocation to be a little aggressive for my risk tolerance.  I will be shifting my allocation to a 40/60 split to more accurately reflect my risk tolerance.  As I get older I expect to shift that even more in favor of bonds.  That is not rebalancing, that is adjusting my asset allocation.

But rebalancing, that prevents me from moving with the pack.  Which is good when the pack doesn't seem to be making very good decisions.

Related Posts:

     Back to the First Day of My Retirement 

    Retiring Into a Down Market--Part III (or Armageddon)

    The Market:  This Time is Different

 

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Wedding Rings and Retirement

All right, so I know I owe you a third post in my three-part series on how I invest my nest egg.  But I got distracted today by Penelope Trunk’s blog post on bed bugs.  Professional hazard I guess.  Anyway, it led me to want to write a post about diamond wedding rings, which is much more fun to write than a post about periodic rebalancing.  So I’m writing about wedding rings.

Actually her post was only sort of about bed bugs, it was more about understanding your relationship with money, illustrated through bed bugs and a great photo of a bed bug-sniffing Beagle.

But the part that got me distracted was the part about Laura Vanderkam’s new book All the Money in the World.  Because I didn’t know the book was out yet.  Severall months ago, Laura Vanderkam interviewed me for the section of her book about rethinking retirement.  And so of course, I spent the next three minutes purchasing and downloading the book to my ebook reader.  Because obviously I wanted to read the part about me, page 70 by the way.

And then I was distracted because I wanted to start reading all the pages before and after my part too.  I got as far as the first chapter about diamond rings, which distracted me from reading the rest of the book, because then I wanted to write another post about wedding rings and retirement instead of reading the rest of the book or writing a post about periodic rebalancing.

Because I totally identified with the point of her first chapter.  If you buy a diamond wedding ring, that’s money you can’t spend on other stuff.  She writes that the average cost of an engagement ring in 2010 was $5,392.  That got her thinking about what a couple could have spent that money on instead, later in the marriage. Like a babysitter for 107 nights when the kids are little, or several years of a housecleaning service, or years and years of surprising your wife with flowers. 

I so identified with this chapter because I tried to explain exact same concept to my sister-in-law many, many years ago.  A couple years after my wedding, she asked me when we were ever going to get me a diamond wedding ring.  She thought it was a money issue when it was really a what-money-can-buy issue. 

When Doug and I got engaged I told him I didn’t want a ring yet because we were saving for a house.  After we bought the house, I said I didn’t want a ring yet because we needed a new car.  After that it was a new deck and who remembers what it was after that. 

Spending money on a diamond ring means you’re not going to spend that money on something else, something now or something later.  By thinking about what I’d rather have each time the subject came up, I finally realized that I never really wanted a diamond ring.  For me it was something you were just supposed to have, not something I really wanted. 

Which brings me, in more ways than one, to retirement.  Not spending money on something I didn't really want, got me closer to having money for something I did really want, retirement.  Which isn't to say that you shouldn't buy a diamond engagement ring if you want it.  Just that you should know what you really want and spend the money you have accordingly.  

Accordingly, I wear my mom’s wedding band, and I’m just as married as I would be with that diamond ring.

Related Posts:

            Did an Engagement Ring Turn into Retirement

            Am I Drinking My Retirement Savings Away?

            Retirement and the “B” Word

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Balancing Risk and Reward

(This is part two of a three-part series on how I invest my nest egg.  Part one on Diversification is here.)

Part Two:  Asset Allocation

I learned the hard way about risk tolerance. 

When I retired, I had 70% of my portfolio in stock funds (a mix between U. S. large, medium and small cap, foreign emerging and developed markets, and a small dose of REIT and commodity funds), and 30% in bond funds and cash. 

In 2008 the S&P 500 Index fell 37%.  My own portfolio fell 28%.  In retrospect, that may have been an overly aggressive mix for my individual risk tolerance.  Sometimes it’s hard to know exactly what your own tolerance for risk is until you’ve lived through a recession that tests it.  Lesson learned.

When I talk about asset allocation, I am not talking about a method of investing that will achieve the highest returns.  I am talking about an approach that matches your investments with your own individual tolerance for risk. 

For those that don’t know, risk tolerance is defined as how much you want to kill yourself when you see your nest egg shrink.

I am not advocating any specific mix of investments.  That’s for you to determine after you decide how much risk you are comfortable with.  There is an old rule of thumb that says you take your age and invest that percentage in bonds and the difference between 100 and your age and put that percentage in equities.  That’s a little conservative for me, but if it matches your risk tolerance, that’s what you should do.

A person that is a very aggressive investor might decide on a portfolio that includes 80% equities and 20% fixed income.  In my early working years, when I had a long time-horizon and a steady paycheck, this was my risk-profile.  An aggressive portfolio would be expected to achieve pretty high returns over the long haul.  But a this point in my life, the year-to-year swings of that portfolio would have me slitting my wrists way too frequently. 

Slide to the other end of the spectrum, and an 80/20 split in favor of bonds over stocks would involve a lot less volatility.  But I am willing to assume a bit more risk to achieve a higher return.  It’s all about what gets you to your goal while allowing you to sleep at night. 

Here’s another way to look at risk tolerance.  Each time I get in my car to go to the grocery store, to visit a friend, or to head to the movies, I’m taking a risk that one of those crazy tailgaters is going to kill me.  But I assume that risk because it’s not that likely, and the reward:  food, companionship or entertainment, outweighs my perception of that risk.  I can tolerate that level of risk.  Contrast that to sky diving.  The reward of having that experience is not at all attractive to me, so I’m not willing to take on the risk of splattering to my death, however small it might be. 

You can poke around on the Internet and find suggested portfolio allocations for various levels of risk tolerance.  Here and here are a couple examples.  Or, if you need more guidance, you might meet with an investment advisor who can help you determine your own risk profile before designing your specific portfolio.

By allocating your portfolio among various asset classes, you have basically decided that you are not going to try and predict winners or bubbles.  You have decided to target the least amount of risk for the return you are trying to achieve.  Some might even say you have decided to be lazy, I’ll accept that characterization too (although the rebalancing part, up next, requires a little action on your part.)

Up next :  Periodic Rebalancing 

Related Posts:

             A Word about Asset Allocation

             Don’t Let Fear Paralyze Your Retirement Plan

             A Note About "Losing" Money in the Market

 

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How Not to Bet on the Stock Market

Part One:  Diversification

When I was a young, impressionable tax accountant at the now defunct accounting firm of Arthur Andersen & Co., I fell in love with a chart like the one above at a training session for those of us in the family wealth planning group.  To see a larger version of the table, here’s the original I pulled from Callan Associates’ website.  We were being trained to help our clients with asset allocation and periodic rebalancing.

Every investment mistake I have ever made was because I tried something different than what I learned that day.

I hope I can make you love this chart too.

As a starting point, look at the column under 1993.  That year, the top performing stocks were international stocks, the emerging market index was up nearly 75%.  The worst performing category was U.S. large cap growth stocks.  At the end of that year you might have decided to put all your money in emerging markets and to sell off your large cap stock funds in frustration.  But wait, the next year international emerging markets was the worst performing asset class and U.S. large cap stocks were among the best, although nothing was really stellar that year.

In 1995 through 1998, U.S. large cap stocks consistently came in at the front of the pack and international stocks at the back.  But chase that performance and you would have been burned from 2001 to 2007.  Bonds performed well from 2000 to 2002, but followed at the bottom of the heap in 2003 through 2006.

I hope you are starting to see the pattern.  That is, there is no pattern.

By diversifying across all asset classes, you guarantee that you won’t have the best or the worst performance, you’ll have something in the middle.  Yes, you give up the possibility of betting on the winner for that year, but you reduce the risk that you will be the biggest loser. 

The more heavily that your portfolio is weighted toward stocks, the more the potential reward over the long-term, but the more risk you are assuming.  If you weight your portfolio more heavily in favor of bonds, you decrease the portfolio’s risk, but at the expense of returns in the long-term.

Put me on record here:  I have no ability to predict how the market will do from year to year.  For the last several years, I have been expecting interest rates to increase.  Instead they have decreased.  Politics, oil prices, European debt, inflation, natural disasters, or unforeseen shocks to the financial system, I have no idea what’s going to happen.  The only way I can stay calm through the ups and downs is with asset allocation and periodic rebalancing.

Tomorrow--Part Two:  Asset Allocation

Related Posts:

    Beginners' Guide to Asset Allocation, Diversification, and Rebalancing (From the SEC)

    How to Lose Money in the Stock Market:  Don't Invest in it

    How to Recession-Proof Your Retirement Savings

 

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How Safe Do You Want to Be?

During this blog's recent discussion of "how much is enough" to safely retire, one of my readers correctly pointed out that if, instead of using a first-year withdrawal rate of 4% or 3% you used a 2.4% rate, you would be virtually assured of never running out of money over a really, really long retirement span.  A span most people wouldn’t even live all the way through.  The result over most reasonable lifespans is that you would not only die with money, you would likely die with more money than you even started with.

That is indeed a very safe approach.

When you aim for any of these first-year withdrawal rates, you can back into the amount your nest egg would need to be by dividing the withdrawal percentage into 1.  For example:

 

            A 4% withdrawal rate (1/.04) = nest egg multiple of 25 times expenses*

            A 3% withdrawal rate (1/.03) = nest egg multiple of 33 times expenses*

            A 2.4% withdrawal rate (1/.024) = nest egg multiple of 42 times expenses*

 

*Again, to prevent any major heart attacks, the multiple above at is the multiple of your annual retirement budget that is not already covered by other income sources like Social Security or pensions.  You just need the nest egg to support the spending that will not be covered by some other income source.  This is the portion of your retirement savings that you are ultimately responsible for.

For example, if you plan on starting out with a $50,000 spending level when you retire and your Social Security checks will total $20,000 per year, you’d need to multiply the difference, $30,000, by whatever multiple above, that achieves your desired withdrawal rate.

Clearly, the higher your multiple is, the safer you will be in retirement, and the more money you will likely leave to heirs. 

For most folks though, the prospect of saving 25 or 33 times your desired spending is daunting enough.   To reach the hurdle of 42 times my retirement budget, I would have had to work many, many more years.  And what would I get out of it?  When I die, I’ll have a nest egg that could be even larger than what I began with. 

Which is a problem for me, because for all those extra years on the job, I’m rewarded with a bunch of money I can’t use anymore.  Because of course, I’m dead. 

Related Posts:

            See Dick and Jane Retire

            See Average Joe Retire

            See Syd Retire

 

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