We’ve been talking about why investment risk matters most right at retirement. First, that’s typically when you have the most invested and, therefore, the most to lose. And, that’s when your ability to recover from a financial setback becomes increasingly limited due to the shortening length of time before you need the money, and your gradual consumption of your financial assets, leaving less and less to provide future growth and income.
How do you manage this risk? Diversification is the usual answer, and this definitely is important for the longer-term portion of your investment portfolio. But, at times like we saw earlier this month, nearly all asset classes can plummet in price at the same time in response to a market shock.
So, the only sure way to avoid suffering losses at the wrong time is . . . by not taking price risk with the money you will need to live on as you await the market recovery.
Are those “duhs” I’m hearing?
We all wish there were an easier answer, but the only sure way to eliminate this risk is with the classic rainy day fund – a cushion of liquid reserves invested in price-stable investments. These include share savings accounts, time deposits, money market mutual funds, and short-term bonds. (They could also include stocks and long-term bonds protected by some kind of options or futures hedge, but this effectively turns them into short-term, lower return assets and is a complex undertaking not suitable for most investors.)
The goal is to have cash reserves sufficient to never have to sell long-term investments when they are at depressed prices. This, of course, raises two more questions: How much do you need in liquid reserves? And, how do you know when prices are “depressed?” Tough questions. Any suggestions?
Larry Halverson: I've Been Thinking
Larry Halverson, CFA, Managing Director of MEMBERS Capital Advisors, Inc., is a veteran of more than 35 years in the financial services industry. Links: SUBSCRIBE TO: I've Been Thinking | 
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Friday, March 30, 2007
Wednesday, March 28, 2007
Subprime Outlook
One more comment on the subprime mortgage issue. I believe it will have a broader and more negative impact on the economy than is currently reflected in the stock and bond markets. Federal Reserve efforts to soothe the wounded with lower interest rates won’t help because, thanks to tighter real estate lending policies (from the lenders and their regulators) and the growing risk of further defaults, the problem will be the availability of credit, not the price of credit -- it will be cheap to borrow, but only strong borrowers will qualify.
Will this be bad for investors? For those who have to sell assets at depressed prices, yes. But, this kind of risk can be minimized. I’ll share some thoughts on that later in the week.
Will this be bad for investors? For those who have to sell assets at depressed prices, yes. But, this kind of risk can be minimized. I’ll share some thoughts on that later in the week.
Friday, March 23, 2007
With Age Comes Wisdumb?
Interesting article in The Wall Street Journal yesterday. Under the title, “Why Middle Age May Be Healthy for Your Wallet,” it describes the findings of a study to determine the age at which people make the fewest financial mistakes. It defines mistakes as things like not getting the lowest available interest rate on a loan or getting stuck with readily avoidable credit card fees.
The optimum age, it turns out, is just over 53. People younger or older make more mistakes than do 53-year-olds, and the mistakes increase as you move away from 53 in either direction.
The researchers attribute this to the crossover between declining mental abilities (which begins at about age 20) and accumulating experience (which begins as soon as we start paying attention – sometimes well after 20). They also acknowledge, though, that some of this may be attributable simply to the different eras in which each generation grew up.
Both explanations sound reasonable. But, I think there is also another one. As we move through middle age, our focus on maximizing our wealth peaks. Prior to that, we’re distracted by thoughts of building relationships, a family, a home, a self-image, a career, and all the other aspects of life and legacy. After that, most of us start to mellow out, realizing that it’s often more important to deal with the best people than to get the best deal. And, we’re more willing to sacrifice the attainment of “optimum” for simplicity.
Some may view this as getting soft, or even soft in the head. And, our brains may, indeed, be shriveling in size and assuming the texture and conductivity of Swiss cheese. At the same time, the pace at which we are experiencing new things (thereby enhancing our judgment) may be slowing as we settle more and more into our preferred routines (aka ruts). But, we are also usually becoming less internally focused. And less demanding of ourselves and of those around us.
You might even say that, as we become less financially rigorous, we become better people. Or, maybe it’s the other way around.
Either way, for most of us it’s probably a good trade.
The optimum age, it turns out, is just over 53. People younger or older make more mistakes than do 53-year-olds, and the mistakes increase as you move away from 53 in either direction.
The researchers attribute this to the crossover between declining mental abilities (which begins at about age 20) and accumulating experience (which begins as soon as we start paying attention – sometimes well after 20). They also acknowledge, though, that some of this may be attributable simply to the different eras in which each generation grew up.
Both explanations sound reasonable. But, I think there is also another one. As we move through middle age, our focus on maximizing our wealth peaks. Prior to that, we’re distracted by thoughts of building relationships, a family, a home, a self-image, a career, and all the other aspects of life and legacy. After that, most of us start to mellow out, realizing that it’s often more important to deal with the best people than to get the best deal. And, we’re more willing to sacrifice the attainment of “optimum” for simplicity.
Some may view this as getting soft, or even soft in the head. And, our brains may, indeed, be shriveling in size and assuming the texture and conductivity of Swiss cheese. At the same time, the pace at which we are experiencing new things (thereby enhancing our judgment) may be slowing as we settle more and more into our preferred routines (aka ruts). But, we are also usually becoming less internally focused. And less demanding of ourselves and of those around us.
You might even say that, as we become less financially rigorous, we become better people. Or, maybe it’s the other way around.
Either way, for most of us it’s probably a good trade.
Friday, March 16, 2007
Timing of Retirement Investing Losses
Continuing with the saga of the timing of retirement investing losses . . .
The first question posed earlier related to the timing of losses to any one lump sum investment over its lifetime. There, timing didn’t make any difference. But, timing does matter to a pool of such individual investments that grows over time with new investment dollars, and then shrinks as the money is withdrawn and spent. There, you want to have your losses early. You don’t want them right when you retire. Timing of losses does affect the value of your nest egg in this scenario.
The reason is much more logical than the answer to question one. It is easily envisioned by considering the first few days of building your anticipated pool of retirement investments – when it might have consisted of a small initial investment into a mutual fund. Any loss that happened to it then could change its terminal value a lot, but it wouldn’t affect the values of subsequent lump sum investments. A loss 40 years from now, however, will whack every investment you ever made into this pool, at least all that are still in there.
Most of us gradually build up our retirement investment assets over our working years. The total reaches its largest amount virtually at retirement, and then we draw it down gradually over our years in retirement. So, the most important time to avoid significant losses is right at retirement. From then on, of course, avoiding losses remains important for the reasons cited earlier – limited if any earned income coming in, and the difficulty of reducing your standard of living at that stage of life.
Patently obvious to the most casual observer, you say? Maybe so. Question one was the tricky one, not question two. But, we all know of people devastated by a market downturn right when they were retiring, or planning to retire, but then couldn’t. And, not just former Enron employees.
So, how do you keep your investment risk down while still going after good returns? Some thought on that next time.
The first question posed earlier related to the timing of losses to any one lump sum investment over its lifetime. There, timing didn’t make any difference. But, timing does matter to a pool of such individual investments that grows over time with new investment dollars, and then shrinks as the money is withdrawn and spent. There, you want to have your losses early. You don’t want them right when you retire. Timing of losses does affect the value of your nest egg in this scenario.
The reason is much more logical than the answer to question one. It is easily envisioned by considering the first few days of building your anticipated pool of retirement investments – when it might have consisted of a small initial investment into a mutual fund. Any loss that happened to it then could change its terminal value a lot, but it wouldn’t affect the values of subsequent lump sum investments. A loss 40 years from now, however, will whack every investment you ever made into this pool, at least all that are still in there.
Most of us gradually build up our retirement investment assets over our working years. The total reaches its largest amount virtually at retirement, and then we draw it down gradually over our years in retirement. So, the most important time to avoid significant losses is right at retirement. From then on, of course, avoiding losses remains important for the reasons cited earlier – limited if any earned income coming in, and the difficulty of reducing your standard of living at that stage of life.
Patently obvious to the most casual observer, you say? Maybe so. Question one was the tricky one, not question two. But, we all know of people devastated by a market downturn right when they were retiring, or planning to retire, but then couldn’t. And, not just former Enron employees.
So, how do you keep your investment risk down while still going after good returns? Some thought on that next time.
Subprime Mortgage Meltdown
I’m compelled to interrupt the “investing in retirement” theme momentarily to outline how I see the “subprime mortgage meltdown.”
1. Government lowers interest rates to 1% to spur economy
2. World is already awash in liquidity seeking investment
3. People start to borrow (against home equity, etc.) to buy nice things
4. Lenders are increasingly eager to lend
5. People borrow more to invest in higher return investments and pocket the difference
6. Lenders further relax lending standards (but still within government regs -- mostly)
7. People borrow even more to invest in real estate (nothing down, floating rate, minimal
payments)
8. Demand for loans finally pushes interest rates up a notch
9. Fear of even higher rates means less borrowing to buy real estate and some selling
10. Less buying and more selling means real estate prices quit rising and start falling
11. Declining real estate prices take down weaker borrowers (“subprime”) and their lenders, as
well as investors in bonds backed by loans generated by those lenders
12. Government steps in to save the day by tightening lending regulations, which takes down
the remaining weak borrowers, lenders, and bond holders.
All three parties – borrowers, lenders, and government – contributed to this situation essentially in the order listed. But, I’m most disappointed in the government. Just as it did with the S&L crisis of the 1980s, it created a situation that naturally leads to “war” (this is ONLY AN ANOLOGY), stood silently behind the lines as the battle raged, then combed the battlefield after it was over to identify the dead, shoot the wounded, and send the survivors off to fight the next war.
1. Government lowers interest rates to 1% to spur economy
2. World is already awash in liquidity seeking investment
3. People start to borrow (against home equity, etc.) to buy nice things
4. Lenders are increasingly eager to lend
5. People borrow more to invest in higher return investments and pocket the difference
6. Lenders further relax lending standards (but still within government regs -- mostly)
7. People borrow even more to invest in real estate (nothing down, floating rate, minimal
payments)
8. Demand for loans finally pushes interest rates up a notch
9. Fear of even higher rates means less borrowing to buy real estate and some selling
10. Less buying and more selling means real estate prices quit rising and start falling
11. Declining real estate prices take down weaker borrowers (“subprime”) and their lenders, as
well as investors in bonds backed by loans generated by those lenders
12. Government steps in to save the day by tightening lending regulations, which takes down
the remaining weak borrowers, lenders, and bond holders.
All three parties – borrowers, lenders, and government – contributed to this situation essentially in the order listed. But, I’m most disappointed in the government. Just as it did with the S&L crisis of the 1980s, it created a situation that naturally leads to “war” (this is ONLY AN ANOLOGY), stood silently behind the lines as the battle raged, then combed the battlefield after it was over to identify the dead, shoot the wounded, and send the survivors off to fight the next war.
Tuesday, March 13, 2007
Okay, where were we?
Okay, where were we?
Wednesday’s scenario: You’re 30 years old and you invest $10,000 for your retirement at age 65. You don’t know it yet, but your returns are going to be exactly 8% in every year except one. In that one year, you will lose 30%.
Wednesday’s first question: Assuming your goal is to have the most possible assets at the time you retire, is it better for that loss year to be early in this 35-year period or late?
Friday’s answer: It doesn’t matter, even if it happens at the end of the period when the 30% loss will cost you in excess of $41,000, dropping your then nearly $137,000 nest egg to less than $96,000. In the first year, it would have cost only $3,000 (30% of $10,000), but that is $3,000 that would no longer available to grow for 34 years at 8% compounded annually, ending with a value of (guess what) about $41,000. You would end up with the same amount no matter when the loss occurs.
Wednesday’s second question: In your actual retirement investing, do you care when the inevitable losses come – before, at, or even after your retirement?
Yes, you do care. At least, you should care. As most retirement experts will tell you, you have to invest more prudently in retirement because your ability to recover from a financial set-back is increasingly limited. Your earned income has slowed significantly or stopped, so you can’t double-up your saving rate to catch back up. And, you probably have been tailoring your life style to the anticipated size of your nest egg, so a sudden drop in value just before retirement can be particularly difficult to adjust to.
But, there’s another aspect. The losses (and gains) that matter the most are those that happen when you have the most money invested.
Wait. Isn’t this what we just disproved with our answer to the first question?
Nope, this is different. Think about it. We’ll pick this up again later.
Wednesday’s scenario: You’re 30 years old and you invest $10,000 for your retirement at age 65. You don’t know it yet, but your returns are going to be exactly 8% in every year except one. In that one year, you will lose 30%.
Wednesday’s first question: Assuming your goal is to have the most possible assets at the time you retire, is it better for that loss year to be early in this 35-year period or late?
Friday’s answer: It doesn’t matter, even if it happens at the end of the period when the 30% loss will cost you in excess of $41,000, dropping your then nearly $137,000 nest egg to less than $96,000. In the first year, it would have cost only $3,000 (30% of $10,000), but that is $3,000 that would no longer available to grow for 34 years at 8% compounded annually, ending with a value of (guess what) about $41,000. You would end up with the same amount no matter when the loss occurs.
Wednesday’s second question: In your actual retirement investing, do you care when the inevitable losses come – before, at, or even after your retirement?
Yes, you do care. At least, you should care. As most retirement experts will tell you, you have to invest more prudently in retirement because your ability to recover from a financial set-back is increasingly limited. Your earned income has slowed significantly or stopped, so you can’t double-up your saving rate to catch back up. And, you probably have been tailoring your life style to the anticipated size of your nest egg, so a sudden drop in value just before retirement can be particularly difficult to adjust to.
But, there’s another aspect. The losses (and gains) that matter the most are those that happen when you have the most money invested.
Wait. Isn’t this what we just disproved with our answer to the first question?
Nope, this is different. Think about it. We’ll pick this up again later.
Friday, March 9, 2007
Something to Chew on Part 2
(Note: Our “comments” button is acting up again, so I apologize to those who tried to send in a response to Wednesday’s questions and couldn’t get through. It’s supposed to be fixed soon. All I can say is please try again sometime.)
Wednesday’s scenario: You’re 30 years old and you invest $10,000 for your retirement at age 65. You don’t know it yet, of course, but your returns are going to be exactly 8% in every year except one. In that one year, you will lose 30%.
Wednesday’s first question: Assuming your goal is to have the most possible assets at the time you retire, is it better for that loss year to be early in this 35-year period or late?
The answer: Mathematically, it doesn’t matter. To illustrate the extremes, if the loss were to occur in the first year, the calculation would be $10,000 times 0.70 (to reflect the 30% first year loss) times 1.08 (to book the second year’s return) times 1.08 (to book the third year’s return) etc., continuing 34 times. The formula would be:
($10,000)(0.70)(1.08 to the 34th power)
If, instead, the loss occurred in the last year, the formula would be:
($10,000)(1.08 to the 34th power 34)(0.70)
We all know that A x B x C is the same as A x C x B, right? So, either way, you’ll end up with the same amount – that $10,000 investment will have grown to $95,831.
This is also true, of course, with any subsequent retirement investments. If you invest $15,000 a few months later and it has some good return years and some bad loss years, the sequence of gains and losses again won’t matter – it won’t have any effect on the ending value of this investment. So, this leads us to . . .
Wednesday’s second question: In your actual retirement investing (that’s you, for real), do you care when the inevitable losses come – before, at, or even after your retirement?
Ponder that a bit (if you’re so inclined). If you have some thoughts, please try sending in a comment (if you’re not too frustrated from prior unsuccessful attempts). I’ll give you my views on this next week.
Enjoy the weekend!
Wednesday’s scenario: You’re 30 years old and you invest $10,000 for your retirement at age 65. You don’t know it yet, of course, but your returns are going to be exactly 8% in every year except one. In that one year, you will lose 30%.
Wednesday’s first question: Assuming your goal is to have the most possible assets at the time you retire, is it better for that loss year to be early in this 35-year period or late?
The answer: Mathematically, it doesn’t matter. To illustrate the extremes, if the loss were to occur in the first year, the calculation would be $10,000 times 0.70 (to reflect the 30% first year loss) times 1.08 (to book the second year’s return) times 1.08 (to book the third year’s return) etc., continuing 34 times. The formula would be:
($10,000)(0.70)(1.08 to the 34th power)
If, instead, the loss occurred in the last year, the formula would be:
($10,000)(1.08 to the 34th power 34)(0.70)
We all know that A x B x C is the same as A x C x B, right? So, either way, you’ll end up with the same amount – that $10,000 investment will have grown to $95,831.
This is also true, of course, with any subsequent retirement investments. If you invest $15,000 a few months later and it has some good return years and some bad loss years, the sequence of gains and losses again won’t matter – it won’t have any effect on the ending value of this investment. So, this leads us to . . .
Wednesday’s second question: In your actual retirement investing (that’s you, for real), do you care when the inevitable losses come – before, at, or even after your retirement?
Ponder that a bit (if you’re so inclined). If you have some thoughts, please try sending in a comment (if you’re not too frustrated from prior unsuccessful attempts). I’ll give you my views on this next week.
Enjoy the weekend!
Wednesday, March 7, 2007
Here’s something to chew on. It will take a few paragraphs, so I’ll split it between today and Friday.
This is the scenario. You’re 30 years old and you invest $10,000 for your retirement at age 65. You don’t know it yet, of course, but your returns are going to be exactly 8% in every year except one. In that one year, you will lose 30%.
First question: Assuming your goal is to have the most possible assets at the time you retire, is it better for that loss year to be early in this 35-year period or late?
Second question (begged by the first): In your actual retirement investing, do you care when the inevitable losses come – before, at, or after your retirement?
Give it some thought, share your views with me if you wish (click on “Comments” immediately below), and check back on Friday.
This is the scenario. You’re 30 years old and you invest $10,000 for your retirement at age 65. You don’t know it yet, of course, but your returns are going to be exactly 8% in every year except one. In that one year, you will lose 30%.
First question: Assuming your goal is to have the most possible assets at the time you retire, is it better for that loss year to be early in this 35-year period or late?
Second question (begged by the first): In your actual retirement investing, do you care when the inevitable losses come – before, at, or after your retirement?
Give it some thought, share your views with me if you wish (click on “Comments” immediately below), and check back on Friday.
Friday, March 2, 2007
Interesting week in the markets, huh? Tuesday’s stock market downdraft was triggered by one of those impossible-to-predict but inevitable “external shocks” – this one being a nearly 10% drop in mainland China’s stock market in response to fears of increased government attempts to slow their economy. That shouldn’t have been that big of a shock, but add the uncertainty in the U. S. housing market, utterance of the “R” word by former Fed Chairman Greenspan, and some very mixed economic reports and you have the stuff of a market correction. In fact, it produced the biggest point drop in the Dow since the day the markets reopened after 9/11/2001.
I was traveling when this latest sell-off occurred – presenting our economic and market outlook to various groups of credit union boards, managers and members in the Gulf Coast area (which, by the way, is coming back very strongly in most areas, but still bears many highly visible scars from the 2005 hurricanes). The conclusions in my presentation:
- The U. S. is overdue for setback/consolidation (or at least volatility) in our economy, bond markets, and stock markets
- An economic “hard landing” (recession) appears highly unlikely (barring a significant external shock)
- Our interest rates are attractive to foreign investors (as long as the dollar’s decline is only moderate)
- Our stock valuations are reasonable (as long as earnings hold up)
- The global liquidity glut has to go somewhere, and although more and more will go to other nations, we do capitalism best and our markets will continue to get support from foreign investors.
My recommendations ended with:
- Be prepared to see a modest U. S. and global slowdown, increased investment market volatility, but about historically average investment returns.
It appears we’re getting the first two – a modest economic slowdown and increased market volatility. We’ll have to wait awhile to see if we get the third – decent returns – over the next several quarters. And this, of course, will depend on the impact of the next unexpected event, and the next one, and . . . you get the point. But, that’s just part of investing, and of life in general, right?
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