Monday, October 19, 1987—aka Black Monday—was a fearful day for investors across the globe. The damage exceeded 20% in stock market declines by the time the exchanges closed. In the wake of such steep declines, investors too often are driven to act by their emotions. In this case, fear. Fear that the decline will continue. Fear that their hard earned savings will be sucked dry by the markets. A more recent example of this fear was invoked by the financial crisis. In both cases the markets recovered in short order. But, the market never recovers for those who sell out of it. Clearly, fear selling is a bad idea.
Fear is not the only emotion that muddles our investment decisions. Greed is just as dangerous.
The 1990s seemed too good to be true. Investors could not lose money in technology stocks. Valuations seemed to have changed and the exponential rising prices were within the new norm. People got greedy. Some went so far as to use their home equity to purchase stocks. And then, just like that, the party was over. The end of the decade saw technology stocks come crashing down. Those who got greedy and concentrated all of their holdings in technology stocks paid the price.
Anytime the sky is falling or the markets seem too good to be true, remember the mantra—be greedy when others are fearful and fearful when others are greedy.
While fear and greed top the list of emotions that can wreak havoc on your investments, there are others: angst and excessive pride, for instance.
The issue with angst is if you wait for events to happen (government shutdown, fiscal cliff, quantitative easing, etc.) or for the markets to “normalize,” you often miss the boat.
Excessive pride can sometimes drive people to buy individual stocks. It’s the classic cocktail party conversation where someone tells you they bought Microsoft stock in the 1990s or Apple stock at the turn of the century. They do not tell you about the other 10 stocks they bought that went south. By focusing on the one home run, people subconsciously convince themselves that investing in individual stocks is a wise venture. It’s not. In fact, it’s speculation, not investing. Do not let pride get in the way of making smart investment decisions.
Clearly we cannot let our emotions guide our investment decisions. Emotional investing is not successful investing.
Follow these steps to help avoid the pitfalls:
1) Build a plan. Write it down and stick to it. If the markets turn over, do not deviate from your plan. If anything, rebalance your accounts back to their initial targets.
2) Turn off the news and tune out the financial pundits. In the age of information, the evening news is not going to give you a leg up on investing. That is, everyone knows everything and it is all factored into the price of securities.
3) Do not assume things are correlated when they are not. GDP is not nearly as highly correlated to stock market returns as people think. Nor, for that matter, are political events.
4) Diversify your portfolio. Put another way, do not put all of your eggs in one basket. Remember what happened to technology stocks in the 1990s.
5) Focus on what you can control. You can control how much you save and whether or not you succumb to your emotions. You cannot control the markets and politicians.
Here’s the exciting part: if you can keep your emotions at bay, invest wisely and let the markets work, you can reduce your stress and increase the likelihood of a successful retirement period.
I recently had the good fortune of being featured in this article which appeared on the front page of the Seattle Times Business section, and I want to share it with you.
A.J. and Amy are a young couple burdened by debt who did not have the resources to pay for a financial planner. The Seattle Times reached out to me through my affiliation with the Puget Sound Financial Planning Association and asked if I would build them a plan. After several meetings we were able to identify and build a plan around their short and long term goals. I am thrilled to report that they feel like they are finally in control of their debt and retirement savings. Most importantly, they have developed peace of mind around their finances.
Please keep in mind no two investors are alike, this article referenced above is a specific recommendation based on A.J. and Amy’s personal finances. If you would like to give the gift of financial peace of mind, I am always more than happy to help your friends and family develop their own personal plan.
The news media conditions us to think about our retirement savings need as a fixed number. At a recent graduation party someone told me they had $1.5MM saved for retirement,” and then came the big question: “Do you think that’s enough?” As a financial planner, this question has always perplexed me. With only that snippet of information, how in the world am I to know how much this person needs in retirement? The key is to know your “number” in the context of your goal-centric plan — not in terms of your demographic, neighbor or brother. So, let’s look at some factors that will affect your “number.”
1) Your cost of living. This is first for a reason. If you don’t have this figured out, take the time to work on it. There are numerous online tools to help you with it. The tool I often recommend to clients is Mint.com. The point here is simple: If you are going to spend $200,000/year in retirement, your nest egg needs to be much bigger than if you are going to spend $100,000/year.
2) Social Security. Just having this income stream will a lesser burden on your nest egg. The question is: How much less? The maximum figure you can expect to receive in today’s dollars is around $30,000 per year. Get a personalized estimate here. You can begin taking this benefit as early as age 62, or as late as 70, depending on your unique set of circumstances.
3) Other private and public pensions. Just like Social Security, these income sources will reduce the withdrawal burden or allow you to achieve a successful retirement period on a smaller nest egg. Pensions typically afford more flexibility than Social Security. One example is the single or joint life benefit option (read more on this from my colleague, Jeremy Burger, here). Another option is to take a lump sum. Your decisions on these options will have important implications for your retirement plan.
4) Distribution rate and portfolio allocation. 4% of your portfolio is generally considered to be a sustainable withdrawal rate. But what is your portfolio made of? A 60% equity, 40% bond allocation? How about 100% equity? Beyond that, how should you allocate the respective equity and bond components? These are important questions that you need to answer. Your advisor can help. One thing is for sure: With increasing longevity, you are going to need some long-term growth in the portfolio. And, since you will be distributing, you must shield your portfolio from the short-term volatility of the equity markets. The key is to find the perfect balance.
Having worked with hundreds of clients over the past several years, I can tell you that this is just the tip of the iceberg. Few people have the tools or know-how to coordinate all of this effectively, and one simple fact stated in the middle of a party is clearly not enough information to solve it all. If you’re not sure what your “number” is, be sure to ask an advisor for help.
My grandmother was born in 1927. At that time, the life expectancy for women was about 60 years, but here we are in 2013 and she is doing amazingly well. During the last 80 years, technological and medical advances have tacked another 26+ years onto her life. Already she has lived 50% longer than the initial expectation.
My son was born in the fall of 2012. He is expected to live about 80 years. Following my grandmother’s case, he would live to 120 years of age. Put another way, he can expect his pre-retirement and retirement periods to be about the same. Clearly, retirement nest eggs and pensions are going to be stretched a lot further than they ever have been.
This is the trend that we need to plan for. The following are key areas of consideration for our increasing life spans.
Inflation. At 3% inflation, a $100,000 annual income need today becomes $242,726 30 years down the road. This substantial difference requires careful consideration. Do your pensions have an annual cost of living adjustment built in? Have you built inflation protection into your retirement accounts?
Health care costs. Along the same lines, the estimated rate of inflation for health care in 2014 is 6.5%. Should you insure to protect against this risk?
Portfolio withdrawal rate. What is a sustainable rate that can last throughout your retirement period? Is your portfolio structure congruent with this rate? That is, do you have the appropriate mix of stocks and bonds with sufficient diversification?
Your end of life wishes. Statistically speaking, the majority of medical costs occur in the last five years of life. And, there is little doubt that advances in medicine and technology will afford increasingly difficult decisions. Having a clear medical directive can save significant emotional and financial resources.
Savings rate. Pensions are becoming a thing of the past. This has shifted a huge responsibility to the saver. If you are still in your accumulation years, figuring out the savings rate that corresponds to your retirement goals is more important than ever.
As life expectancies increase, so do the complexities of retirement planning. Inflation protection and an appreciable return that keeps up with your distribution needs are just the beginning. If you have not already done so, take the time to meet with your advisor to build a goal-centric plan that is specific to your unique retirement needs.
Bear markets can get ugly. Unfortunately they will, just as they have in the past, continue to plague the markets. You can prepare for their arrival and understand how your investment plan dictates navigating through them. The hard cold facts of bear market history provide direction.
For those unfamiliar with the term, a bear market is not a simple market correction, which is more benign and happens with greater frequency. It’s a peak to trough loss of more than 20% in the broad equity markets. In total there have been 13 bear markets since the end of the Second World War. That is one every five years or so.
Here is the promising part: In May of 1946 the S&P 500 was at 19.3, and at the end of March, 2013 it was at 1570. In total, over 81 times higher than where it started 67 years ago. And, this number excludes dividends, which historically make up around 40% of the total return.
So the question is not of avoidance, but one of preparation and acceptance. Accept that in the next 30 years we can expect to experience several bear markets. Embrace the fact that they will be temporary setbacks to a long-term trend of rising prices. Finally, prepare a plan that fits your unique set of circumstances.
For investors in the accumulation phase, take advantage of bear markets. Fight the inclination to sell investments in fear and do what you would do at any other sale – buy more stocks at their newly discounted prices.
For those in retirement, formulate a flexible income plan. Include a cash cushion in this plan that allows your portfolio to stay dormant during the tough times and to thrive as the stock markets resume their long-term ascent. Most importantly, do not let a temporary setback ruin your long term plan. And remember that over time, equities are the best hedge for inflation, which is so important for the long-term viability of your portfolio. Life expectancies are increasing and fixed-income investments (aka bonds) are just that, fixed.
There is always going to be some perma-bear forecasting the death of equities and a market optimist predicting a new era of exponential returns. Neither of them knows the specifics of your retirement plan and they rarely understand that “this time” is never different. Do not get enamored of prognostications based upon remote possibilities. Rather, work with your advisor to build a plan around the historical probabilities of the markets and your unique retirement needs.
The return-centric environment in which we live too often gives little credence to an equally important measure – risk. Professionals and individual investors alike can often quote the return of a given stock or index, followed by silence when asked to recite its relative measure of risk. The financial crisis shouted to us the importance of understanding and controlling risk. If you did not hear the call – and hopefully you did before the fall – it’s not too late to answer it.
Two quantifiable means of controlling risk are diversification and asset allocation.
Proper diversification stretches well beyond your region and your country of residence. It has little to do with individual stock positions or individual sectors. It consists of all types of stocks – large, small, value, growth, etc., which are located all over the world. Global diversification is the goal.
Diversification is equally important for bond allocations. A bond portfolio consisting of high-yield bonds differs from one invested in U.S. treasury bonds. Obtaining an adequate amount of diversification on both sides of your portfolio is essential in controlling your risk.
Asset allocation speaks to the percentage of stocks and the percentage of bonds in your portfolio. While the specific mix has many variables, age and retirement goals are often large factors. Each investor’s situation is unique and there is no “one size fits all” solution. A good place to start is by answering the following questions:
At what age do I begin adding bonds? 40? 45?
How often do I add bonds and how much do I add?
What is an appropriate allocation once I am retired?
If you are struggling to answer these questions, it may be time to seek professional guidance. The answers are essential to your long-term investment success.
Investor discipline is a less tangible but equally important component of risk mitigation.
As stocks outpace bonds, a portfolio’s risk increases. At some point, there will be a need to sell the stocks to buy bonds and maintain the target allocation. In essence, this follows the golden rule of investing – that is to sell high and buy low. The same logic holds within each asset class of the portfolio, such as when international stocks outpace domestic stocks or small cap stocks outpace large cap stocks.
I can almost guarantee that when the time comes, rebalancing will not feel like the natural thing to do. Why, for example, would you want to buy into an underperforming asset class? Despite our rational brain, loading up on the winners will feel like the right thing to do at that moment. There are two questions you must ask yourself:
Do I have the discipline to rebalance my portfolio?
What mechanical process will I use to rebalance?
Your long-term investment success hinges on your answers to these questions. If you do not know how to answer them, seek guidance.
Investing is about risk and return. Understanding how much risk you can afford to take and how much risk you’re willing to take is the key. Quantitatively, two ways in which we control risk for clients is through diversification and asset allocation. Keeping clients disciplined in their goals and executing on a well thought out rebalancing process is another, less tangible means of controlling risk.
As Warren Buffet famously said, “It’s only when the tide goes out that you learn who’s been swimming naked.”