Saturday Dec 08, 2018
Chapter 5 – "Investing"
Saturday Dec 08, 2018
Saturday Dec 08, 2018
In this episode, podcast host and author of “Control Your Retirement Destiny” covers Chapter 5 of the 2nd edition of the book titled, “Investing.”
If you want to learn even more than what there is time to cover in the podcast series, you can find the book “Control Your Retirement Destiny” on Amazon.
Or, if you are looking for a customized plan for your retirement, visit us at sensiblemoney.com to see how we can help.
Chapter 5 – Podcast Script
Hi, this is Dana Anspach. I’m the founder and CEO of Sensible Money, a fee-only financial planning firm. I’m also the author of "Control Your Retirement Destiny," a book that covers all the decisions you need to make as you plan for a transition into retirement.
The book has outstanding 5-stars reviews on Amazon. If you like what you hear today, go to Amazon and search for "Control Your Retirement Destiny." Or, if you are looking for a customized plan, visit sensiblemoney.com to see how we can help.
In this podcast, I’ll be covering the material in Chapter 5 on investing. We’ll continue the case study of Wally and Sally, and look at how the plan we created for them in Chapters 2 through 4 becomes the blueprint for how they should invest.
Let’s get started.
When I meet someone new, almost without fail, the conversation goes something like this.
They ask, “What do you do for a living?”
“I’m a financial advisor,” I say, or “I own and run a financial planning firm.”
From there the typical reply is along the lines of,
“Oh, what do you think of the markets right now? What should I be buying? What are your thoughts on Apple stock? What will happen if so and so wins the next election? What should I be investing in?”
“You should be investing in a good financial planner,” is what goes through my mind.
Investing is like a prescription. It’s what you do after you’ve gone through a thorough exam and diagnosis.
This where I think most of the financial services industry gets it wrong.
Take a thirty-year-old as an example. They are investing in their 401k. They are nervous about losing money. They either fill out an online risk questionnaire or meet with a financial advisor - and this is supposedly the exam part. They express their concern about losing money if the market goes down. Then the diagnosis part. The computer model or advisor recommends they invest in a balanced fund that maintains an allocation of about 60% stocks and 40% bonds.
This is not a terrible recommendation - but to me - it seems like a recommendation made for all the wrong reasons.
At age 30, under normal circumstances, the earliest you can withdraw from your 401k is age 59 1/2 - about thirty years in the future. You would think the primary goal would be the investment mix that maximizes the potential for return over a thirty-year time horizon. Yet, almost the entire financial services industry focuses instead on minimizing the downside risk, or volatility, that you might experience in any one year.
Why? It makes no sense to me.
Why would I structure my investments to reduce short term volatility for an account I’m not going to touch for thirty years?
Contrast this with someone who is age 65 and about to retire. One popular rule of thumb says take 100 minus your age and that is what you should have in bonds. I’ve also heard a version of this rule that says take 110 minus your age. Following this type of rule, you come out with a 65 - 75% allocation to stocks and a 25-35% allocation to bonds. In many cases, it is the same recommendation made to the thirty-year-old. Is this recommendation aligned to your goals? It might be. But in many cases it still doesn’t add up.
For example, suppose in your plan you are drawing out of a taxable brokerage account first - then your IRA when you reach age 70, then your spouse’s IRA, and he or she is five years younger than you. Suppose you also each have a Roth IRA, but you don’t plan on touching that account at all. Should all of these accounts be invested with the same risk profile, with about 60% in stocks and 40% in bonds? In my mind that makes no sense at all, yet that is the type of investment recommendation most often given.
What does make sense to me is to assign each account a job description and invest that account according to the job it needs to do. That means if your spouse is age 60 and won’t be touching their IRA until age 70, which is ten years away, that account can be invested differently than the account you’ll be drawing out of next year.
To make better investing choices that are more aligned to your goals, there are a few key things to know. Here are the ones we’ll be covering in this podcast.
How to measure risk - And the two most important questions you can ask before making any investment.
Something called “The Big Investment Lie” - and why we are so prone to believing it.
The importance of tracking results relative to your plan.
We’ll start with measuring risk.
There are two questions I’d love to hear everyone ask before making an investment. The first question is “Can I lose any money?”
If you are retiring next year, and will need to withdraw $50,000 to help cover your living expenses, when it comes to HOW that $50,000 is invested you want the answer to the question “Can I lose any money?” to be NO. In most cases, if it is money you need to use in the next five years, you want it invested safely.
On a scale of 1 to 5, I think of this as a Level 1 risk. A Level 1 Risk represents a safe investment. it may not earn much interest. But you also know it won’t go down in value.
The next question to ask is “Can I lose all my money?” This question is more difficult to answer. What if you bought 100 shares of a stock? Can you lose all your money? Yes. Many great publicly traded companies have gone bust over the years. I call this a LEVEL 5 RISK. I recommend most retirees avoid taking Level 5 risks.
Now, what about a Level 4 risk? This one is trickier. Let’s look at an example.
Suppose I told you of an investment that for over 90 years has an average return of 10% a year? Sounds good, doesn’t it. You invest $100,000. A year later it is worth $60,000. You sell it, fearful you’ll incur more losses. You call me a liar, and decide investing doesn’t work. From that day forward, you keep your money in the bank, where it safely earns a few percent a year.
Now, instead, suppose I describe an investment that gives you the potential to earn more than double what bank savings accounts are paying. I explain to you that this investment is not something you should use if you need your money in the next few years. I also tell you that in any single year, this investment could be down as much as 40%, or, up as much as 40%. I also explain that your results can vary widely depending on how the next 20 years turns out. I show you that in the past, during the worst 20 years this investment earned a return about the same as safe investments, and over the best 20 years, it earned returns much, much higher.
You are now taking a calculated risk with the expectation of volatility. You invest $100,000. A year later it is worth $60,000. You don’t like it, but you knew this could happen and you’re in it for the long term. You hang on, and by the end of ten years it is worth $191,000.
Both scenarios reflect the same investment - an investment in an S&P 500 Index Fund. The difference in the results are due to investor behavior - not due to the investment.
The S&P 500 measures the performance of the stocks of 500 of the largest companies in the U.S. When you own an S&P 500 Index fund, you own a little piece of each of the 500 stocks. Can you lose all your money in this investment?
Hypothetically, yes. All 500 companies would have to go bankrupt at once for this to happen. If that happens, I believe the world as we know it has ended, and we’ve got much worse problems on our hand than how much is in our 401k account.
With a risk level 4 investment, like an index fund, you know you’ll experience ups and downs. The primary factor in how well you do, will be your behavior - how you use this investment. When used with reasonable expectations, level 4 investments usually help you achieve your goals.
In the earlier chapters of the book we began following a couple, Wally and Sally, who were planning their retirement. Let’s see how this concept of risk levels and aligning investments to a goal works for Wally and Sally.
After projecting several potential withdrawal plans, Wally and Sally could see that drawing funds out of their non-retirement account in their first four years of retirement would be the most tax-efficient choice. As they will need these funds soon, they invest this account, about $250,000, all in safe investments.
Next, their plan has them withdrawing from Wally’s retirement accounts starting in about year five of retirement. When they get to year five, they don’t want to be concerned about the market being down – instead they want to know the first five full years of planned withdrawals from this account are safe. Those withdrawal amounts add up to $105,000. The total account value is $365,000. They invest the $105,000, or 29% of the account, in safe choices. The remaining 71% of the account is invested to growth, or Risk Level 4 choices.
They don’t plan to touch Sally’s retirement account for at least six years. But when they get out to year seven, where they will need to use it, they want her first three years of withdrawals in safe choices, which amounts to $90,000. Her account size is $546,000, so her allocation is 16% to safe choices, and 84% to growth.
Notice each account is invested differently, depending on the job it must do.
When you look at their entire household, they now enter retirement with the first 8 years of withdrawals 100% covered by safe investments. Their household allocation is 38% to safe choices and 62% to growth. They have the comfort of knowing the growth portion has eight years to work for them - and that during that 8 years when it has good years they will take the gains and move them to safe options. And when it has bad years, which they expect, they will leave it alone and give it time to recover. They are able to do this because their withdrawals are coming from the portion of their accounts invested in low risk choices.
This is how you create a job description for an account and align the investment choices to the particular plan for that account.
Now, Wally and Sally have a bit more learning to do when it comes to the growth portion of their account. They need to make sure they don’t fall for The Big Investment Lie.
The Big Investment Lie is the title of a book written by Michael Edesess. As he introduces the book, he shares a story about his first job at an investment firm. Here’s what he says,
“With my new Ph.D. in pure mathematics in hand from Northwestern University, I reported to work at Becker in July 1971. Immediately after starting, my bosses gave me books to read on stock market theories. I was the only mathematician with a Ph.D. in the firm, so I quickly became chief theoretician. I was assigned to work with a young assistant professor at the University of Chicago named Myron Scholes (later to become famous for the Black-Scholes option pricing model). I was sent to conferences on quantitative finance, where I rubbed elbows and sat on panels with future Nobel Prize winners. But within a few short months I realized something was askew. The academic findings were clear and undeniable, but the firm—and the whole industry—paid no real attention to them. The evidence showed that professional investors could not beat market averages. Professional investors couldn’t even predict stock prices better than the nearest taxicab driver.”
When I read this book of Michael’s, luckily, I already knew that it was not possible for anyone, professional investor or novice, to predict stock prices or consistently pick winning stocks.
My frustration, and what Michael Edesses calls The Big investment Lie, is the ongoing belief that so much of the public continues to hold – which is that some person, some firm, or some software program, can beat the stock market or spot stock winners.
“Well”, you might be thinking, “if I’m not hiring an investment professional to pick stocks or beat the market, what am I hiring them for?”
If you’re hiring the right kind of professional, you’re hiring them to make a realistic financial projection for you, help you take the steps needed to make that projection become a reality, and they’re going to use a disciplined time-tested Investment process - and stick with it even when times are tough.
A disciplined time-tested investment process that holds up under scrutiny usually uses a form of what is called “passive” investing for the growth part of the portfolio.
What does “passive” mean? It means you are not choosing mutual funds or investment advisors that are trying to pick stocks or trying to beat the market. An S&P 500 Index fund, for example, is a passive type of investing. This kind of fund owns the 500 stocks listed in the S&P 500 index. It isn’t trying to pick the best of those 500. It simply wants to capture the collective returns of all 500 stocks packaged together.
Contrast that with an actively managed large-cap fund, which might be trying to pick the best 200 stocks out of the 500 listed on the S&P. The actively managed fund has much higher expenses - as it must pay an entire team of people to do research in an attempt to identify the best 200 stocks.
The data shows that overwhelmingly, these active funds are not successful at earning an after-fee return higher than what you would get if you simply bought the index fund.
Another part of The Big Investment Lie has to do with a belief in market timing. A belief that there is an expert who can successfully move your money out of the market before the next downturn, and then invest it back in at the bottom.
A great book on this subject is Future Babble - Why Expert Predictions Are Next to Worthless by Dan Gardner. One of the points that Gardner makes is that predictions get attention - and if an expert succeeds at a prediction - they can make page one of the news. If they fail, no one pays attention... so why not throw a lot of predictions out there until one sticks?
When it comes to The Big Investment Lie, I have one final thing to say. I’ve been delivering personal financial advice since 1995. Every scam or bad investment I’ve ever seen someone make was because they fell for some version of The Big Investment Lie. Someone told them a tall tale - and they believed it. Don’t let this happen to you.
Develop a set of reasonable expectations and invest in a boring systematic way. You may not get rich quick, but you also won’t go broke overnight. And that’s pretty important as you near retirement.
The last thing I want to cover in this podcast is the importance of tracking your results. And knowing what to track against.
What do you think you should track against? Does it make sense to track your results against the S&P 500 Index which is so widely reported on by the media?
That is what a lot of people do. I’m not sure why. Is the Index customized to the financial goals of your household?
Imagine if you were training for a sport. Would you set your performance standards against a nationally followed average? Or would it make more sense to measure your athletic performance against your fitness goals and take into account your age, personal experience, level of fitness and health considerations?
I’d venture most of us would prefer a customized approach.
A customized approach makes sense for your finances too.
The way to make a customized benchmark for your finances it to first make a financial projection of your income, expenses, taxes and account values. Wally and Sally did this and they now have a clear picture of how much should be remaining in each account at the end of every year from now throughout life expectancy.
Their financial projections use the assumption that investments earn 5% a year on average. How did they come to use a 5% return? They looked at a lot of historical data on how stocks and bonds have performed over the past. They wanted to be conservative - which meant they did not want to use a rate of return assumption that only reflects average to good times. Instead, they wanted to use something that was reflective of the worst 1/3 of historical times.
Their research led them to feel quite comfortable that if their household allocation remained at about 60% in growth investments, after all fees, a 5% rate of return was a realistic assumption to use.
Using this 5% return projection, they can see after taking their needed withdrawal, how much should be left in each account.
Each year, they compare what they have to what their projection says should be remaining. They are now measuring against their path - against their goals. We use this same way of measuring in our financial planning process at Sensible Money.
In addition, we create a secondary projection called a Critical Path. Critical Path is a trademarked term used by our investment partner, a firm called Asset Dedication. We do the planning and send Asset Dedication the financial projection for each client. In turn Asset Dedication sends us back the Critical Path - which is the minimum amount of financial assets that need to be remaining each year for the plan to work throughout the client’s projected lifetime.
The Critical Path is even more conservative than the standard projection using 5% returns. In Chapter 5, you can see an example of what Wally and Sally’s Critical Path looks like.
Once you have a customized projection, you use it to make decisions along the way. When our client are ahead of their Critical Path, that is our signal to sell some of the gains and buy more bonds.
When clients get significantly ahead of their path, we begin conversations around gifting, or spending a little extra on things that really matter to them.
Using a personal projection is far better than measuring against a benchmark like the S&P because it tells you how well you are doing compared to your goals. It also takes the focus away from month-by-month or even year-to-year performance - and instead, looks at where you are positioned relative to your lifetime goals.
It also allows you to make appropriate adjustments along the way. If you need to spend more during any one year, if you are following a plan that adheres you to a 4% withdrawal, you may be reluctant to take any additional funds out. Yet that might be fine and have little impact on your lifetime plan.
By using a personal projection, instead of an arbitrary benchmark, decisions can be customized to you.
To summarize, you’ve now learned the two most important questions to ask before investing. They are “Can I lose any money,” and “Can I lose all my money?”
You’ve also learned about the all-too-human tendency to believe in The Big Investment Lie - the belief that there is an expert out there that can accurately predict upcoming market moves. Steer clear of any such too-good-to-be-true claims.
And, you’ve learned why it makes sense to measure results against a personalized financial projection instead of a benchmark. With a personal projection you always know how well you are doing relative to your goals.
Thank you for taking the time to listen today. Chapter 5 of "Control Your Retirement Destiny" has additional content which covers several other investment types and it includes great examples of Wally and Sally’s Critical Path projection. Visit amazon.com to get a copy in either electronic or hard copy format.
Or visit us at sensiblemoney.com to see how we can help you plan your transition into retirement.
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