Change is inevitable. Usually change is incremental and sometimes monumental. Eventually, even incremental change crosses over into monumental territory. However we got to where we are today, the current economic environment is monumentally different from the setting that most retirement planning has been built upon.
The past year has seen the simultaneous collapse of the stock, housing and credit markets -- followed by an economy that relied too much on all of the above. So how do you adjust? Begin by thinking hard about the risks you face, because they may be significantly different from anything you've ever seen. This can change how you save, invest, borrow and plan. In this article, we'll examine some of the flaws in the conventional wisdom about money management and propose some new ideas for these changing times. Please read the four old thinking concepts below as well as the new ideas that should be implemented instead.
No. 1. -- If you manage risk through diversification, you'll be rewarded.
New idea: Diversification isn't as helpful as we once thought, so you should guarantee results whenever possible or risk missing a crucial goal.
We all consider risk when we make decisions. But how is risk defined today? Financial analysts have generally equated risk with volatility. They understood, correctly, that Las Vegas real estate and penny stocks could change value rapidly. But for many years, the general assumption has been that if you are patient with the market, you will be handsomely rewarded. As long as you had the stomach to see the occasional "paper" loss and didn't panic, superior returns over time would be your reward.
However, despite "historical analysis" and sophisticated "modeling," these alleged experts failed to consider the possibility of "black swans" (what statisticians call "fat tails"). This idea, which comes from the book, The Black Swan by Nassim Nicholas Taleb, refers to large-impact, hard-to-predict, and rare events beyond the realm of normal expectations. In any endeavor susceptible to notable, unpredictable exceptions (like the financial markets), no amount of examining the past will enable us to foresee the future.
More to the point, if you hit a slump in returns at the moment you need extra cash or while taking income from your portfolio early in your client's retirement, even the eventual upside of volatility won't do you much good. Consider the analysis from T. Rowe Price, which shows the impact of a weak market in the first five years after you retire if you are funding cash flow out of an investment portfolio. Because you have to sell falling assets for income in your early retirement years, your portfolio may be so small by the time the rebound comes that you still run out of money, even if you thought yourself well prepared for retirement. Unfortunately, many Americans were (and are) particularly vulnerable to today's downturn. According to the Employee Benefit Research Institute, more than 30 percent of near retirees had 80 percent or more of their 401(k)s invested in stocks.
So what? One of this bear market's lessons is this: How much risk you can take is a matter of how much you can lose and still meet your basic goals. At a minimum, that means using products with guarantees to make sure that a future black swan won't cripple your retirement, even if you may not get the level of return that you'd like. Moreover, nearly all retirees ought to fund cash flow needs with an annuity, thereby protecting against running out of money or living "too long."
No. 2 -- A diversified portfolio lowers your risk.
New idea: Diversification won't always save you, and you need more of it and more types of it than you think.
Diversification hasn't stopped you from getting hurt in this downturn. Both U.S. and foreign stocks are deep in the red. Holding bonds did cushion your losses, but most kinds of bonds have still declined. What happened? As Jeremy Grantham has observed, we have a bubble not just in one or two kinds of assets, but in risk. Investors around the world were so confident and anxious for an extra basis point of return, they were indiscriminate in their risk-taking. Moreover, really smart people (who ought to have known better) were monumentally stupid and claimed that all sorts of risks were adequately hedged when clearly they were not. The risk bubble has now burst. Diversification doesn't help much beyond mitigating some of the loss if everything is trading down.
Even though diversification isn't the panacea some thought it was, it still helps, since nobody is right all the time and the markets are incredibly hard (impossible?) to time. Stocks are down over the past 10 years but, on average, U.S. corporate bonds earned 4.6 percent per year throughout that same period, for example. And, according to Jack Marrion, indexed annuities have done even better.
So what? You also ought to manage your return expectations downward and plan accordingly. If you planned your retirement based upon an expected 8 percent to 10 percent annual return, you'll want to rethink that (and redo your numbers using the present as the starting point).
Most people also ought to have foundational assets -- rest-of-your-life money -- that are protected from the vagaries of the markets. For younger people, it should include emergency funds and shorter-term savings (for things like a new car). As you age, the percentage of your overall holdings deemed foundational ought to grow and, as retirement approaches, it ought to grow more quickly. Investment involves risk. You shouldn't invest money you can't afford to lose because, as recent events amply demonstrate, you can lose.
No. 3 -- The longer your time horizon, the more stocks you should own.
New idea: Time isn't everything. You must also consider your earnings potential as well as your intermediate and long-term goals.
It's one of the traditional basics of retirement planning: The more years you have to recoup losses, the more aggressive you can be. Unfortunately, the math isn't so clear-cut. Zvi Bodie, a finance professor at Boston University, has repeatedly explained that while the odds of losing money shrink as the years pass, the worst-case scenario -- in which you lose substantial value early in the income phase -- is virtually impossible to remedy.
If holding stocks for the long run really did make investing safe, mutual fund companies would gladly guarantee your investments. None do. The past decade's returns are a vivid reminder of why.
There's another way to think about how aggressive your portfolio should be. Consider your human capital -- meaning your ability to earn income by working. In most cases, your human capital will be your primary asset for much of your life. The safer this asset is, the more chances you can afford to take with other assets. When you're young, the value of your earnings potential far outweighs the balances in your investment accounts. As you age, the value of your human capital declines and you'll need to secure more of your savings. So the conventional advice to hold a lot in stocks when you are young and then scale back as you age can still make sense.
But that advice is not for everyone. The nature of your career may make your human capital more secure or more risky. Some professions have human capital that resembles a triple-A rated bond with a high coupon, especially when they have a solid pension plan. Those lucky souls can pretty much do what they want with their money. The human capital of a commission-based mortgage broker, on the other hand, is pretty clearly high risk. That person should own a fair amount of principal-protected savings vehicles -- even when young.
So what? Assess your human capital. Use that analysis as a baseline and then think about how long you'll be working, the stability of your current job and your ability to change careers if you have to. You've probably realized in the past few months that your human capital is not as secure as you once thought. If you've been an aggressive investor to this point, that alone may be a reason to shift more of your assets to safer ground.
Moreover, once your various retirement savings goals have been met, consider taking the money you need to meet those goals "off the table," and save via a principal-protected asset such as a fixed or fixed index annuity. That way, you're insuring that the goals will be met, irrespective of market performance or personal situation.
No. 4 -- Borrowing sensibly is a good way to build wealth.
New idea: Borrow cautiously and judiciously. You have a lot to worry about.
The quarter-century leading up to 2007 wasn't simply a golden age for stocks. It was also a bull market for leverage. When my wife and I bought our first home in 1983, we obtained a three-year ARM with an initial rate of 11.75 percent, fixed for three years -- 30-year fixed rates were 15 percent or more. As of year-end 2008, 30-year fixed rate mortgages averaged around 5 percent. Student loan rates had dropped to around 3 percent. Credit standards were lowered too, almost across the board. Americans responded to easy and cheap credit in a predictable way. The personal savings rate fell from more than 12 percent to essentially nothing, and household debt payments as a percentage of disposable income rose by a third as families increasingly "charged it" via credit cards and home equity loans.
In hindsight, this borrowing binge didn't make much sense, but few realized it at the time. Even the chairman of the Federal Reserve didn't see it as a problem. "The household sector seems to be in good shape," said Alan Greenspan in a 2004 speech, "and much of the apparent increase in the household sector's debt ratios over the past decade reflects factors that do not suggest increasing household financial stress."
Neither Greenspan nor the banking and credit card industries understood how much families were leaning on housing wealth, or how shaky that wealth was. Apparent experts like Ken Fisher (in his book, The Only Three Questions That Count) even went so far as to say that the non-existent savings rate wasn't significant because the wealth held in real estate (home equity) and securities was a ready substitute. In the end, much of the real estate and related booms were the byproducts of ever-loosening lending rules made possible by Wall Street wizards who thought that they had found a way around the risk. Indeed, we experienced a reckless environment of lending where a laborer with income of $50,000 (claimed but unverified) would default on a $500,000 home loan for his third property. Sounds silly now, doesn't it?
The obvious moral here is to be conservative. There are always good reasons to borrow, even today. You need a mortgage to buy a house, and a college education provides enough of a lifetime payoff to justify a loan. On the other hand, borrowing money for a depreciating asset should always be a concern, even when necessary (as with a car, for most people). You ought to stretch less.
There's a more subtle lesson here too: You probably have more exposure to leverage than you think, especially now that everyone is trying to unload debt. Perhaps your employer borrowed a lot throughout the past decade and now needs to conserve cash, and, as a result layoffs are looming. Suddenly, that HELOC you used to build a new barbeque deck doesn't look like such a good idea. You can't lean on your investment portfolio for help because many of the companies whose stock you own used leverage to pump up profits, and now they can't borrow, so their earnings and stock prices are falling. And it's harder to shore up your own balance sheet by selling your house when banks are cutting back on lending and potential buyers are scared to borrow for an asset that may decline further.
So what? Be conservative about debt. Make that really conservative, especially when your neighbors aren't. Find a mortgage you can afford for the life of the loan, and make sure you put at least 20 percent down if you buy a home now. If you expect to stay in the house for the long haul, obtain a fixed rate mortgage and don't assume you'll necessarily be looking to trade-up anytime soon, either. If you really aren't very likely to stay in the house for more than five-years or so, consider an ARM. But, again, consider the terms carefully and make sure you can afford it if, or when, the rate-lock period ends.
Similarly, get rid of consumer debt and its high interest rates as quickly as you can, but beware of quick-fixes via HELs. The lower rates they offer are attractive, but many consumers use the cash made available thereby and don't pay down the debt quickly enough, while charging up the credit cards again. Common sense is a good thing. Be sure to apply this facet.
Keep an eye out for part two of this series, in which we will discuss old thinking concepts No.'s 5, 6 and 7.
*For further information, or to contact this author, please leave a comment and your e-mail address in the forum below.