A Retirement Tale: "How Should I Plan for My Retirement"

Posted by Carlos Sera on Aug 13, 2015 11:21:00 AM

a-retirement-tale-how-should-plan-for-my-retirementLet me introduce you to three families. One family loves to take risk and they live life certain that whatever comes their way they can handle it. The other family is super cautious. If there is any danger in sight, they can smell it a mile away and stay clear of it. The last family takes a balanced approach to life. They don’t make hasty decisions, examine all the facts and weigh their options. It obvious, these three families will have a very different perspective about how to invest their money. One will gravitate towards risk, the other towards risk aversion and the other like Goldilocks from three bear fame, wants it “just right.”

We should give them a name, design some type of unimaginable situation, develop a hypothesis and see what happens. Let’s call the first family The Risk-Lovers, the second The Risk-Haters and the third The Just-Rights. Let’s assume they are neighbors, each raise a child that enters the workforce in 1970, and invests $2,000 per year in accordance with their nature. They do this every year at the start of the year and do it for 30 years in the hope of creating a nest egg for retirement.

Three Approaches

Jerry Risk-Lover invests all his money in an aggressive stock index fund every year. He chooses to invest in the S&P500 since he hears that stocks are a great way to save for retirement. He’s heard somewhere that if you “buy and hold” stocks they will give you an average return of about 10% per year and that it’s the best thing to do because you know “you can’t time the stock market.” He doesn’t have time for a lot of research because he is too busy living life and so he settles on his course and executes the plan to perfection. For 30 years, Jerry Risk-Lover invests $2,000 per year into an S&P500 index fund.

Jerry Risk-Hater invests all his money in conservative Treasury Bills every year. He hears that stocks are too risky and that people can lose money that way. He’s heard somewhere that “you can’t go wrong collecting interest on a daily basis.” He also doesn’t have time for a lot of research because he is too busy living life and so he settles on his course and executes the plan to perfection. For 30 years, Jerry Risk-Hater invests $2,000 per year into Treasury Bills backed by the full faith and credit of The United States of America. Jerry Risk-Hater has a touch of patriotism as well.

This leaves us with Jerry Just-Right. True to his nature, he wants everything “just right.” Like Goldilocks, he wants it not too hot or cold, not too big or small and not too hard or soft. Jerry wants it “just right.” This presents a problem however. In order to get things “just right” you can’t just pick a strategy true to your nature when there is no “just right” strategy. You have to come up with one. So, after much reading, Jerry Just-Right comes up with the answer. It’s what academia calls Modern Portfolio Theory, it’s what the financial planning industry advocates, it takes about 15 minutes to learn if you look in the right place and it seems “just right.” Jerry will invest 60% of his $2000 in the same S&P500 stock index fund as Jerry Risk-Lover and 40% of his $2,000 in the same Treasury Bills as Jerry Risk-Hater. But, that’s not all. Nothing is simple in the world of Jerry Just-Right. In addition to his annual investment of $2,000, he will rebalance his portfolio annually so that every year the portfolio begins with the same 60% allocation to stocks and 40% allocation to Treasury Bills.

I’m sure by now you either know what happens or want to know what happens. You may have even read or heard this type of tale or analysis before. Let me assure you, it is not what you think. Here is the customary ending to this tale.

By the end of 1999, Jerry Risk-Lover is still the same risk-seeking person he always was and has amassed the tidy sum of $1,125,360. Jerry Risk-Hater is still cautious and has $183,427. Jerry Just-Right is as always, happy with what he’s accomplished, as types like him seem to be and he has $572,657. The moral of the story, what the financial industry wants you to believe because it is in their best interest is clear. You should buy and hold stocks for the long run, not spend a lot of time researching because it is futile since you can’t time the stock market and you are short-changing yourself if you are cautious. I think I’ve covered all the bases right. So, let’s proceed.

So How SHould I plan?

If you have an ounce of curiosity and can think more than one move ahead, you know this couldn’t possibly be the end. You may want to know what the three Jerry’s do with their money when they retire. If you do, then A Tale of Withdrawal is for you. You may want to know what the three Jerry’s do when it is time to put money aside for their children’s college education. If you do, then A College Planning Tale is for you. You may also want to know, what happens if the author of these tales doesn’t cherry-pick the starting date of 1970 to begin his analysis. Lastly, you may want to learn about alternative solutions other than risk-on, risk-off or “just right.”

The rest of this tale will focus on two things, 1) what happens if you vary the starting dates and 2) providing you with a viable alternative solution.

Not the End

Once again, if the story ended here, it might lead you to believe something silly like stocks are always the best way to save for retirement and they are a better investment than Treasury Bills by a 6 to 1 margin or some other nonsense. You may even incorrectly draw the conclusion that you must be aggressive and that you must follow a buy and hold strategy. However, you need to read a little more so that you can understand why the subtitle of this tale is “How Should I Plan For My Retirement.” You see the three Jerry’s have three siblings each. In a tribute to a famous 1970 University of Maryland graduate, we will call the siblings, George, Elaine and Kramer.

Varying The Starting Dates

I like to use the age differential of my four children whenever I pick dates for illustrations. They were in fact born in 1985, 1987, 1991 and 1994, so they are two, four and three years apart. Since the Jerry’s started in 1970, I will have the George’s start in 1972, the Elaine’s in 1976 and the Kramer’s in 1979. How do the siblings fare? The following table gives us the answer.

  1970-1999 1972-2001 1976-2005 1979-2008
         
The Risk-Lovers        
Jerry $1,125,360      
George   $760,090    
Elaine     $591,142  
Kramer       $315,532
         
The Risk-Haters        
Jerry $183,427      
George   $181,303    
Elaine     $143,998  
Kramer       $130,484
         
The Just-Rights        
Jerry $572,657      
George   $442,818    
Elaine     $348,872  
Kramer       $233,258

 

Now we are getting somewhere. Let’s examine the most glaring thing in the table above. Look at the difference between Jerry and Kramer Risk-Lover. Remember, they did the exact same thing for 30 years. Jerry retired at the peak of a bull market with $1,125,360. He had more than 3 times what Kramer had since he retired at the very bottom of a bear market. The following is one of my favorite sayings and this tale is the best illustration of why I believe it to my core.

They say “you can’t time the market,” but it can certainly “time you.”

In my opinion, this level of unpredictable outcomes within the same family is unacceptable. Let me repeat this one more time, the level of unpredictable outcomes associated with an aggressive buy and hold strategy is unacceptable. I/we/you need predictable outcomes. Can you imagine the dinner conversation when Jerry looks at Kramer and says, “I don’t know what’s wrong with you, I retired with over a million dollars and you barely have $300,000, you must have done something wrong.” Soon thereafter, George chimes in, “yeah, I retired with twice as much as you. You must have done something wrong.” Of course, Elaine is keeping quiet because although she followed Jerry and George’s advice, she suspects they didn’t tell her the whole truth. She isn’t a math wizard, can’t believe that luck plays such an important role in a retirement account and assumes the two older brothers are holding out on her and Kramer. They didn’t tell them the full secret on how to grow their money.

There is a bright spot to Kramer Risk-Lover’s situation however. You would rather have Kramer Risk-Lover’s lousy outcome within his family than the best outcome from the Risk-Hater family. What is clear is the Risk-Lovers are going to have a higher dispersion of results than the Risk-Haters but the results justify the dispersion. Dispersion is a fancy word for unpredictability, uncertainty or volatility. Furthermore, the Risk-Haters got exactly what they expected. They got very predictable, very similarly lousy outcomes. This is here I agree with the traditional story about risk-on vs. risk-off. It doesn’t pay to be a Risk-Hater. These returns are also unacceptable.

This leaves us with the last family. What can we glean from the Just-Right family? As expected, they have less dispersion than the Risk-Lovers but more than the Risk-Haters. There returns are better than the Risk-Haters but nowhere near as good as the Risk-Lovers. However, if you look at the range of outcomes, my conclusion is Modern Portfolio Management isn’t very comforting to me. The Just-Right approach seems more like a Just-Wrong outcome and is not something I personally would pursue nor recommend to those that might listen to me. When accumulating wealth, I would rather take my chances and be a Risk-Lover. I say this because, if a balanced portfolio with annual rebalancing still produces these types of disparate results, if this is the best academia can come up with, and I am still subject to the market “timing me” I don’t know if I want to play this game.

A Viable Alternative Solution

Is there an alternative or alternatives? This is the problem any investor or investment manager must solve if they are to produce predictable outcomes with a higher reward to risk ratio than what is readily available. Fortunately, we’ve devoted our lives to coming up with this type of solution and we will share our solution with you over the course of many tales. Our solution is…. and combines two technical trading techniques. These two combined techniques produce one disciplined way of trading the markets such that we think we know the best time to own stocks as well as the best times to avoid them. After all, we do not want to be the victims of market timing.

The following results are, as the above results, hypothetical but about what we would expect if our cast of characters had some new neighbors move into the neighborhood back in 1970 that subscribed to the use of a simple 12-month moving average. We will call the family The Simples and they only own the SP500 when it is trading above its 12-month moving average and when it isn’t they own Treasury Bills. Some call this market timing, we call it disciplined investing. Granted, the rule couldn’t possibly be simpler and requires a minute of month of work, regardless, it is a valid strategy because it transforms the rates of return of the stock market to something more predictable and less volatile. As we’ve already learned, you must try to time the market before it times you.

How did the Simple siblings fare? Jerry Simple’s portfolio grows to $824,545 in 30 years at the end of 1999. George Simple’s portfolio grows to $685,422 in 30 years at the end of 2001. Elaine Simple’s portfolio grows to $625,503 and Kramer Simple’s portfolio grows to $544,483. To me, these outcomes seem “more right” than the alternatives. You may agree. If you do, you may want to adopt a more disciplined approach to investing.

This is A Retirement Tale and if you are reading it, perhaps you’ve already made some decisions that will help you. We hope so. We highly encourage you to learn more as well as adopt a disciplined approach to investing, but recognize this tale will be a distant memory for most in the near future. To those we offer the following observations;

  • If you are early in the retirement planning process of your life, an aggressive posture is better than a conservative posture.
  • Stocks are a tool, no different than, a hammer, blender or phone. They are not a religion. They are not a way of life. If you’ve been fortunate enough to take an aggressive posture with your portfolio and if you ever look at the value of your portfolio and say to yourself “wow, that’s a good chunk of change, I could probably retire on what I have,” it is probably a good time to reduce the risk in your portfolio. There is no need to take risk just for the sake of risk-taking. Folks that found themselves with temporarily overinflated portfolios in 1971-1972, 1987, 1998-1999, 2006-2007 and perhaps even today 2015would have been wise to reduce the risk of their portfolio. If the objective is to build up the value of your portfolio so that you can retire, and you’ve done it, then why overstay your welcome.
  • It is better to be lucky than good.
  • It is better to be disciplined than good.
  • You can control your investment strategy. Time the market before it times you.

Appendix

The following table is the basis for the analysis of this tale. The first column is The Risk-Lovers and they are 100% risk-on. The second is The Risk-Haters and they are 100% risk-off. The third is The Just-Rights and they are a 60/40% mix of risk-on and risk-off with annual rebalancing. The last is The Simples and they use of a 12-month simple moving average. The first two column numbers are from The Stern School, the third is a simple algebraic calculation based on columns 1 and 2 and the last column assumes The Simples collect dividends when they own the SP500 and receive T-bill interest when they don’t. If you would like access to the derivation of The Simple model, contact us.

  The Risk-Takers The Risk-Haters The Just-Rights The Simples
   

 

(SP500)

 

 

(T-Bills)

 

 

(60/40 Mix)

12 Month Moving Average
         
1970 3.56% 6.69% 4.81% 11.83%
1971 14.22% 4.54% 10.35% 5.87%
1972 18.76% 3.95% 12.83% 18.76%
1973 -14.31% 6.73% -5.89% 0.59%
1974 -25.90% 7.78% -12.43% 7.78%
1975 37.00% 5.99% 24.59% 16.03%
1976 23.83% 4.97% 16.29% 23.83%
1977 -6.98% 5.13% -2.14% 0.08%
1978 6.51% 6.93% 6.68% 2.26%
1979 18.52% 9.94% 15.09% 12.96%
1980 31.74% 11.22% 23.53% 22.27%
1981 -4.70% 14.30% 2.90% 6.10%
1982 20.42% 11.01% 16.66% 26.46%
1983 22.34% 8.45% 16.78% 22.33%
1984 6.15% 9.61% 7.53% 2.73%
1985 31.24% 7.49% 21.74% 31.24%
1986 18.49% 6.04% 13.51% 18.50%
1987 5.81% 5.72% 5.78% 8.24%
1988 16.54% 6.45% 12.50% 2.96%
1989 31.48% 8.11% 22.13% 31.47%
1990 -3.06% 7.55% 1.18% -12.53%
1991 30.23% 5.61% 20.38% 25.20%
1992 7.49% 3.41% 5.86% 7.49%
1993 9.97% 2.98% 7.17% 9.97%
1994 1.33% 3.99% 2.39% -5.29%
1995 37.20% 5.52% 24.52% 34.02%
1996 22.68% 5.02% 15.62% 22.68%
1997 33.10% 5.05% 21.88% 33.10%
1998 28.34% 4.73% 18.89% 12.55%
1999 20.89% 4.51% 14.34% 20.89%
2000 -9.03% 5.76% -3.11% -0.44%
2001 -11.85% 3.67% -5.64% 3.67%
2002 -21.97% 1.66% -12.52% 1.66%
2003 28.36% 1.03% 17.43% 23.01%
2004 10.74% 1.23% 6.94% 10.74%
2005 4.83% 3.01% 4.10% 4.83%
2006 15.61% 4.68% 11.24% 15.61%
2007 5.48% 4.64% 5.15% 5.71%
2008 -36.55% 1.59% -21.30% 1.59%

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Topics: Retirement Tales

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