As any engineer can tell you, sensitivity and stress testing are important tools in determining how a system can fail and therefore, determining the safe usage for that system. When it comes to your financial life, it should be no different. Stress testing your financial plan is an important exercise in determining the health of your wealth. While this a natural inclination for engineers, it can be unclear where to start. Let’s look at the key variables and the impact they have on a financial plan.
Next week we will be hosting a webinar titled Accelerate Your Journey to Financial Independence where we expand on recent blog topic that proved to be quite popular (see How To Reduce Your Target Number and Retire Earlier). In the webinar, we'll look at the tremendous value of using supplemental income in retirement to create a shorter path to achieving financial independence.
With baby boomers more healthy and living longer than ever before, these "encore" or second careers are becoming increasingly common. In fact, a 65-year-old can now expect a lifespan of nearly twenty additional years—over five years longer than a 65-year-old in 1950.
These increases in health coupled with the shifts in the U.S. economy to service work and white color jobs and away from manufacturing jobs add up to an attractive opportunity for anyone nearing the traditional retirement age to bring in some supplemental income and, ultimately, get to financial independence earlier. Consider that:
If it bleeds, it leads. ~Joe Loder in Nightcrawler
Margin debt recently hit an all-time high—$528 billion as of February month end. But, by another measure, margin debt divided by underlying assets, it’s actually at a lower level than it was in February 2009—the start of the market recovery from the global financial crises.
So, how concerned should you be about margin debt? What does it tell us about the market going forward and how much attention should you pay to these attention-grabbing headlines?
In the 2014 film Nightcrawler, Lou Bloom (played by Jake Gyllenhaal) is a down and out thief turned “Stringer” (a freelance photojournalists) through whom the movie explores what Wikipedia calls “the symbiotic relationship between unethical journalism and consumer demand” or, better known as, “If it bleeds, it leads.”
The demand for gloomy or sensational headlines can be explained by our negativity bias, something the media is very adept at exploiting to their advantage.
Over the last three calendar years, Global stocks (MSCI All Country World Index - ACWI) have returned a meager 3.7% annualized leading some to question their investment approach. Large market moves up are obviously fun, and even big moves down are often easier to ride out (at least you can see something happening) than a sideways markets. It’s extended periods of low returns which test patience and one’s ability to stick with a strategy and let it work over time.
These periods can be frustrating, causing investors to wrestle with questions like: am I doing the right things to succeed? Is there somewhere else I should be focusing? Are there changes I should make? The pain of patience triggers the question: is my strategy broken?
In his fantastic biography, legendary mathematician, successful gambler, and hedge fund manager, Ed Thorp reveals how he answers this question.
We received a couple of questions on our recent post “How to Increase Retirement Wealth With the Right Withdrawal Order” and will address the first one here. (Note: as we mentioned earlier this year, we will be making an effort to address more reader questions on the blog this year, so, if you have questions send them in.)
The question has to do with the issue of taxes. Specifically, is taking IRA distributions before you are required smart given a potential increase in taxes paid on Social Security income or is it better to delay Social Security in the first place. Here’s the question:
What about the effect of taxable income on SS taxes? Or delay SS with additional withdraws from retirement accounts to cover delay in SS?
This question breaks down into a couple of parts: First, how social security income is taxed and second when to start taking it.
Last week I enjoyed dinner with a group of people, one of which happened to be a hedge fund manager and fellow CFA charterholder. As us finance-types are wont to do, we quickly made our way to a discussion of every investment nerd’s favorite question: what is risk?
Warren Buffett, in his 2014 Berkshire Hathaway annual letter (page 18), shared his views on the topic:
That lesson [that stocks are less risky than cash-equivalent holdings over the long-term] has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk.
Buffett is pointing out that over the long-term stocks are an attractive way to grow capital while cash and their equivalents (i.e., treasury bills) do little more than keep pace with inflation, as can be seen in the chart below. He’s obviously correct on this point, investing in stocks has historically been one of the best things you can do to compound your wealth.
Now then, does this mean people should ignore volatility and only own stocks? I’d say no. Buffett aside, most of us don’t live in the long-term; we live in the present and volatility is a risk that must be managed in the present.
So, despite my better judgment, I'm going to a disagree with one of, if not the greatest investor of all time and my new friend, the hedge fund manager with the NYU law degree and Stanford MBA to his credit—in other words, two very bright people.
In a recent article, Michael Kitces points out the dual benefits in staying off of the hedonic treadmill as it relates to income increases throughout your career—higher savings today and a lower required replacement income (meaning a lower portfolio balance is needed) when you retire. These two factors make a powerful combination in moving anyone towards their retirement number much quicker than someone who’s lifestyle quickly adjusts to any increases in income. While this concept is absolutely true and should be required reading for anyone with a significant amount time to retirement, my fear is that making radical changes to your level of spending, and therefore lifestyle, near retirement is simply unpalatable for most.
So, might there be another solution? Is there another tactic which allows you to hit your target retirement number quicker but without making drastic changes to your lifestyle?
There is, and it's already gaining traction due to the changing demographics of retirees and the shifting nature of work in modern society.
1. We believe in being intentional
What do you want to accomplish? Why do you want to accomplish it? Gaining this clarity by answering these “big questions” leads to better outcomes and a higher chance of success.
When you get clear on your objectives, only then can the best strategy be put in place to accomplish them. Being intentional about the results you seek will keep you focused on the goal and prevent opportunistic decision-making that can derail you, your investment strategy and your financial plan.
As Stephen Covey says, “Begin with the end in mind.”
2. We believe the best advice is tailored advice to you
All clients have different visions about what financial success looks like for them. No two people have an identical balance sheet, risk constraints, spending profile and investment objectives.
It’s for this reasons that our process is designed to begin with a discovery process so that we truly understand who you are and what you are trying to accomplish with your wealth. It’s only after this deep level of understanding is achieved can tailored advice, which leads to the best results, be delivered.
All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident. ~Arthur Schopenhauer
19th-century German philosopher, Arthur Schopenhauer thought truth (and in this case, we'll extrapolate to include “new ideas”) passed through three stages: ridicule, opposition, then acceptance. While the index fund, which turned 40 last year, is a new idea no longer, based on the massive shift in assets that are moving from active to passive, one could argue their “truth” is now self-evident.
According to Michael Mauboussin and others at Credit Suisse, “Since the end of 2006, investors have withdrawn nearly $1.2 trillion from actively managed U.S. equity mutual funds and have allocated roughly $1.4 trillion to U.S. equity index funds and exchange-traded funds (ETFs).”
This shift from active to passive funds has driven total assets invested in index mutual funds to around $2 trillion with another $2 trillion invested in ETFs.
Clearly, index investing is an idea that is catching on and gaining momentum.
But sometimes it feels like people are disappointed to have to “settle” for indexing. No one wants to be passive or merely average. It can feel to many like settling for meatloaf because you can’t afford the prime rib.
Recently, legendary investor Charlie Ellis was interviewed by Barry Ritholtz on his Bloomberg Masters in Business podcast. The whole interview is worth your time, but here I wanted to focus on just one of the topics they covered: The danger in using rules of thumb.
Here is the exchange:
Ritholtz: As an investor, how do you aim in the right direction?
Ellis: Well, I can’t give you a straight answer except in generalities because each of us is unique. But start with: how much money do you have? Are you saving money or spending money? How many years do you have before you need to cover your retirement or cover you kids going to college, or whatever is your objective? How much wealth do you have? How much income are you creating? Take all those things you can work out an investment strategy that makes good sense.
Let me give you an example; I'm 79. Most people would say, ‘At that age, you must have a lot of bonds.' I have no bonds. …First, I'm still working, and I have enough to cover my operating costs. And second, who am I investing for? I'm investing for my grandkids with an average age of ten.
To sum up his point on investing being all about aiming in the direction of your unique goals and avoiding rules of thumb when they don't match your aim, Ellis uses the following metaphor. Imagine a road trip to Chicago with the rule of thumb being the higher your average speed, the quicker you’ll reach your destination. Ellis instead says:
I don’t care how fast you drive to Chicago, just be sure you aren’t heading to Miami.
Investopedia lists several of these financial rules of thumb to be aware of and suggests taking them with a grain of salt as well:
While rules of thumbs are useful to people as general guidelines, they may be too oversimplified in many situations, leading to underestimating or overestimating an individual’s needs. Rules of thumb do not account for specific circumstances or factors occurring at a particular time or that could change over time, which should be considered for making sound financial decisions.
So, what can you do to account for your specific circumstances when it comes to managing your finances? Well, we have some ideas.