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It’s Not Always Necessary to Shoot For the Moon
By JLP | April 1, 2008
In a paper on the importance of having an investment policy statement*, Larry Swedroe gave the following example that illustrates that it’s not always necessary to shoot for the moon when investing to meet a goal like retirement:
In a discussion with a new client, a 55-year-old investor I learned the following:
- He currently had $2.5 million of net assets.
- He wanted to retire in 10 years.
- He was a long-term investor with a high tolerance for risk, evidenced by his current portfolio’s equity allocation of almost 100%.
When asked how much money he felt he would need to comfortably retire. He responded: “$4 million.” I then asked him whether his lifestyle would change much if instead of $4 million he ended up with $6 million. He said: “No.” I then asked him if his lifestyle would change if he ended up with just $3 million. He said: “Yes, I would have to keep working.” Clearly the reward of his ending up with more dollars than his goal was far less than the pain of ending up with less. In other words, while he had a long investment horizon (the second to die life expectancy between he and his wife was about 30 years), and he apparently had a high risk tolerance (as evidenced by his current 100% equity allocation), he was clearly a risk averse individual. I then showed him that to achieve his $4 million goal in 10 years, including the savings from his salary over that period, he would need to earn less than the rate of return on a money market account. He didn’t need to take the risk of an all-equity portfolio to achieve his objective. Financial economists would say that his utility of risk was very low. The marginal benefit of the upside was very low, while the pain of a downside outcome was severe. He ultimately decided to substantially reduce his equity allocation. An irony about investing is that the very people who can most afford to take risk (the very wealthy) have the lowest utility of risk, and therefore the least need to take it.
Since this guy’s goal was $4 million and he already had $2.5 million, he didn’t need to take on the unnecessary risk associated with a 100% stock portfolio. Of course not everyone has that option. For people who have a small retirement plan balance, they will need to 1) invest more, 2) invest more aggressively (but not stupidly), and 3) accept the volatility.
I think this example shows the importance of having a goal to shoot for when saving for retirement. If your goal is a $4 million retirement balance by age 60 and you are now 30 and have a balance of $100,000 in your plan, you can calculate how much you need to save per year based on your expected rate of return as the table below shows.
NOTE: I ignored inflation, taxes, and contribution limits in my calculations.
I don’t know too many 30-year olds that could afford to sock away $4,500+ per month. Therefore, it’s important when you are younger to take advantage of the better returns usually offered in stocks because you have time on your side, which lessens the impact of volatility. In other words, if you have a few bad years, you have DECADES to make it up.
One other thing is that if you know what your retirement goal is, you can gauge your performance to see if you need to make any changes. For example, we can calculate where you should be at age 35, using the numbers from the table above:
It’s important to note that I used straight-line appreciation when calculating the growth. In real life it would be much more variable than that. That said, the last table could give you an idea of where you should be based on your goal and your required rate of return. Then, as you get closer to retirement you can assess your situation to see if you can adjust your allocation and put less of your portfolio at risk by moving it into more conservative asset classes, which is what Larry suggested in the story above.
This is a pretty broad topic. Just putting this post together has given me more blog post ideas, which I’ll be adding later. If you have questions or comments, please leave them below.
*I plan to make that paper available as soon as I get it formatted properly.
Topics: Asset Allocation, Investing, Retirement Planning |
April 2nd, 2008 at 10:45 am
$2.5 mill for 10 years in various insured cd’s at 5%, not counting compounding and taxes, gets your client to $3,750,000
with, you might say, not too much risk, eh?
April 2nd, 2008 at 11:01 am
muddlehead,
Actually, 4.81% compounded annually would get you from $2.5 million to $4 million in 10 years. So yeah, you were pretty close.
I would recommend that this guy take a little more risk and anything over $4 million would just be icing on the cake. You really can’t have too much money. If he did have too much money he could give it away or use it to help others.
April 3rd, 2008 at 2:29 pm
I think it might have been interesting and worthwhile to explore why this individual was set on the $4 million amount. A planner versed in behaviorial finance might be able to dig out the root issues here which could perhaps provide some real enlightenment to the client rather that just concentrating on the nuts and bolts question of reaching $4 mil.