Integrated Financial Training: Westchester NY

Practical Reality Seeps in...

Let's take a closer look at the implications as it unfolds in our lives. The returns and risk levels quoted are annual averages. If we look back historically at an equity chart (one is given in this article), you may note periods of 15-20 years where the stock markets move sideways and equal periods where they advance aggressively. Let's take a 35 year old who is expected to live to age 85 and puts $5,000/year (increasing with inflation every year) in a Roth IRA to fund their retirement. They invest 100% in stocks, to make this easy, and require $20,000/year from this vehicle in today's dollars to support themselves in retirement. With the stock market averaging 5.83%, if they invested until age 65, they would be able to buy TIPs at 5.05% at that time to produce $41,506 before inflation and $22,914 in today's dollars. Had they invested in TIPs from the beginning they would have been looking at $20,135 in today's dollars. So far, so good.

Suppose they actually get the 5.83%, but not at the same return each year. Say they did extremely well in the first 15 years, earning 10.89%, which was followed by a return of 1% for the next 15 years. The reason why the returns were so low in the latter 15 years is inflation jumped from 2% to 5%. Their pre-inflation annual income at retirement falls 20% to $33,357. However, their income in today's dollars fell 48% to $11,922. The next points are very important. Their inflation adjusted income fell 48% from when they received the 5.83% in stocks to when they received 5.83% in stocks. Imagine what would have happened if the returns fell below average as well! Even if you take out the effects of inflation, just the difference in timing of the returns cuts 26% off the potential income. The reason for these differences are because they earned high returns when their investments were comparatively lower and low returns when their investments were higher. Some Monte Carlo simulations might include these effects, but a naive analysis that only uses average returns will miss this key point.

Now we need to consider common sense. The return history we might use for a 25 year old should be 60 years or so. Prior to the past 60 years, the quality and quantity of data erodes, but in any case we do not have much more than two full 60 year periods of history to use. We don't really know what the future will bring and the past is only of limited value in figuring that out. So if we know our expenses are tied to inflation and there are no guarantees on what inflation will do, maintaining a certain level of inflation protection simply makes sense. The wealth maximization models and average return simulations do not give any consideration to these facets. In fact 88% of their allocation was not in TIPs, whereas the income protection portfolio had only 58% that were not in TIPs. Both portfolios supposedly have the same moderate risk level.

Conclusion

If we are not clear on what we are trying to do and do not look specifically at how our strategies will unfold, we can sabotage our efforts beyond repair. We have seen here where following the wrong objective can lead to the polar opposite of what we are really trying to do. We increased our risk when we wanted to decrease it and reduced our returns when we wanted to increase them. We did not make any effort to hedge our real risk exposures. Then when we declared victory and walked away simply because we had favorable returns, we suddenly found that the devil was in the details. Merely the timing of the annual returns with the constant inflow of new dollars to invest was enough to reduce our income 26%. If in addition inflation was the cause for the timing differences, we wound up losing about half of our income. As maintaining real income is our ultimate goal, these strategies were very ineffective. We need to be clear on our real objectives and then vigilant to be certain they are met.

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