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Real Objective

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Our Real Objective

So let’s take a look at exactly what all this means for us. When you are investing for retirement, you need to ask the question of why you are investing. Do you want to maximize your wealth before inflation erodes it, maximize your wealth after taking out inflation, be able to live on a steady dollar amount during retirement or maintain a certain lifestyle in retirement? These four objectives are all met through different means. First we will throw out two of the objectives. The fact is inflation matters. It's not the dollar amount we have, but what we can buy with it. So we need to maintain the same purchasing power, not the same dollar amount. Now we are down to two objectives: maximize wealth after inflation or maintain a steady lifestyle in terms of purchasing power.

So what is it you really want to do? Say you invest 100% of your assets in stocks, but we have a long period of high inflation. Stocks do poorly in such circumstances. So say you really got the highest return you could, but then you needed to go on welfare in retirement because inflation eroded your assets beyond repair. If this scenario causes you little trouble, then wealth maximization is your objective. But what if you had the ability to give your wealth away to someone who would guaranty your ability to pay your bills for life at a reasonable level? Would you take it? Which is more important to you, your wealth or your lifestyle? Most of us think about our income first so we can take care of ourselves and then wealth for the balance to give to our heirs. So when we focus on the income protection portion of our problem, we need to have income protection for the objective. Wealth maximization can be used later for any excesses, but this article will focus on the first.

Dr Robert Merton gave an interesting webinar for the CFA Institute in early 2013 which highlighted a few relevant points. The first point was that if we solve the problem with the wrong objective in mind, we are likely to get the wrong answer. Applied here, if we measure our risk in terms of wealth maximization rather than income (lifestyle) protection, then we will see products that meet our needs precisely as very risky and avoid them. Instead we will pursue products that don’t meet our needs. He constructed a series of Treasury Inflation Protected securities (TIPs) strips that begin in 20 years and are designed to last through someone’s retirement years. He showed a chart of how volatile the prices are, being +/- 5 to 10% during some periods. Then he showed how risky it was in maintaining inflation adjusted income. The volatility was a flat line at zero. Then he showed 3 month Treasury Bills (TB) in the same way. The wealth risk was about as close to a flat line as you can get. But the risk in income protection was extremely volatile.

What is happening here is the risk of market value fluctuations does not reflect income protection, but opportunity risk. That means it tells us if we waited another month we could have protected an income level that was a bit higher than we did or vice versa. This component of the problem really falls into the decision of whether to manage our portfolio actively or simply buy when we have money to invest. While it should be considered, we need to maintain an investment position designed to achieve our goals. To make market fluctuations the final say in how we make investment decisions is highly speculative if our goal is to protect our lifestyle.

Next Article in series: Wrong Objective

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