Sunday, September 23, 2007

Risk and Return

A recent article in Barron's magazine was titled 'Weathering the Storm in Style' and it discussed what retirees could do if the market tanked in the years while they were living off their retirement savings. The article mentions people who planned to retire just prior to the 2002 market meltdown but whose portfolios went down significantly (25% - 40%) and they had to change their plans and keep working as a result.

Later the article mentions how many "good years" you need in the years following the meltdown in order to make up for the bad times. For example, if the market drops 25% in one year, you will need to gain 46.67% in the following year to recoup the gain plus make 10% more (i.e. if you have a base expectation that the market will make you 10% in a year, you don't just need to recover the drop, you need to make up for the 'lost year'.

I covered a similar conceptual issue in a post titled "Percentage Returns... and other Lies" about how the portfolio managers could have a series of good looking years after a debacle like 2002 and yet investors still hadn't recovered their initial investment (let alone make 10% / year to boot). I used a bit of my own portfolio for color commentary in that post, to "humanize" it, like a good journalist should.

Retirees in particular are susceptible to big one-time crashes in stock because 1) they have to live off their assets, not their salary or working income 2) they have less time to make up for the losses because their time horizons are shorter. The basic theory is that you put a higher percentage of your investments in bonds and fixed income investments when you are older because you don't have the time to make up for losses in the higher performing but riskier stock sectors.

Not mentioned in the article but conceptually linked is the fact that people often behave irrationally in a down turn. If the market goes down, people generally "bail out" at a low point rather than holding until the assets turn around. Even worse, people generally "chase" high cost options on the way up (like today's real estate market) and then sell at the worst possible time, which compounds their woes.

But none of these related, and important, concepts is really what this post is all about. The REAL issue is the assumed rate of return.

I see articles everywhere that list a long term return assumption of 8-10%. By this I mean that people have an expectation that, including all downturns (and the fact that you have to "make up" for those lost years, not just recover to get back to where you were) that there is a net expectation that you are going to earn this return annually over time.

I don't think that an assumed long term return of 8-10% is viable for most people. It is true that the stock market has a relatively high long term return for US equities looking back at historical data, but this assumes that people were rational, reinvested dividends, invested steadily and didn't "freak out" and sell during a crisis, and didn't chase high-performing stocks (which typically subsequently plummet). Most investors have a much lower return than the average return of all investors because they fell prey to these and many other linked pathologies on investing.

If you have anything in debt you need a much lower rate. Interest rates on debt instruments have fallen over the last few decades, since the "stagflation" era in the late 70's and early 80's. It is true that there are higher yielding debt instruments out there, but these instruments carry higher risk that (theoretically) negates their higher return. Generally a long term treasury bond gives about 4-5% BEFORE TAXES. This equates to about a 3% return AFTER TAXES. 3% is a long way from 8%, and this has to make up a big chunk of your total portfolio over the course of your life.

For your TOTAL return assumption to be near 8-10%, then you have to make a lot on the stock portion of your portfolio, given that it is assumed to represent 30% - 70% of your total portfolio depending on age (with the rest being bonds). It is unlikely that the average person is going to earn anywhere near this return over their life horizon unless they are a disciplined investor and don't have to liquidate during a market debacle.

A more realistic return assumption would be something closer to 6%-7%. This return assumption would be closer to what a typical investor might receive, across their entire portfolio of debt and equity investments, if they stayed rational during times of exuberance and market downturns.

What does the difference between 6-7% and 8-10% matter? Quite a lot, actually. It means a lot more years of work before retirement and a much higher percentage set aside for retirement and not immediate consumption along the way.

This is a second "nail in the coffin" of the retirement myth out there - I hit the other side of retirement in this post called "You'll Never Retire" which says that the concept of a middle-class retirement is new and probably doomed anyways - the rich never stop working (although their concept of working is more akin to what we think of in terms of investing) and the poor never do, either.

I really think that retirement advisers are selling a bill of goods with these high rates of returns on peoples' investments. It isn't practical advice and it can lead to incorrect conclusions that can't be fixed later (if you are close to retirement you'll never be able to make up the lost years).

If you really want a nice retirement go work for the government. They are the only institution that doesn't have any market discipline. After all, they can make up for their current mistakes by taxing the heck out of all of us a few decades from now.

Cross posted at Chicago Boyz

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