We might do all the right things in investing – keep expenses low, not chase performance, stick to the plan even when markets are terrible – and still get low returns just because our investing career coincided with a time period in which market returns were much lower than we expected at the outset. In his book, The Intelligent Portfolio (review), Christopher Jones makes this point:
Even for this conservative allocation [90% fixed income and 10% equities], the range of potential outcomes (in today’s dollars) is relatively wide, especially as the horizon increases. At 30 years out, you could expect to see portfolio values [of a $10,000 initial investment] fall in the range of $13,000 to $31,000 about 90 percent of the time. That is not a trivial spread of potential outcomes.
How does an investor insure against such an eventuality? Unfortunately, not much because any cure (such as investing in low return assets such as bonds) might be worse than the disease as we’ll be exchanging the low probability of a poor outcome for a near certainty of (perhaps) a slightly better one.
If equity returns does turn out to be much lower than we expected ex-ante, we simply have to adapt to it. We may have to:
Save more: Instead of saving, say 10% of our income, we might find that we need to save 12% to make up for crummy markets. Granted, it means we should save 20% more that we planned to but saving money is under our control, market returns aren’t. Or we may opt to save the same as before and revise our plan and spend less in retirement.
Retire later: There is no law requiring that we retire on the exact date that we planned. If markets did not co-operate, we can opt to remain in the workforce for a couple more years, which would give us the opportunity to add more to the portfolio and allow it to grow at the same time. If the thought of retiring later depresses you, remember that a favourable outcome is just as likely with stocks: our returns might be better than our reasonable expectations.
Ease into retirement: Another option is to work part-time, which would allow us to delay tapping the portfolio or at least withdraw less in the initial years. As an added bonus, it would let us test drive retirement on an installment basis.
In other words, when investing, like life, hands us lemons, we can turn it into lemonade.
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13 responses so far ↓
1 Michael James // Aug 18, 2008 at 1:14 am
Thanks for the link. I agree with you about adapting to outcomes. Taking calculated risks with retirement savings means that you can either retire 5 years earlier if things go well, or retire 2 years later if they don’t go well. I’m always happy to take on some risk if the odds are in my favour.
2 Rob // Aug 18, 2008 at 10:08 am
The different outcomes are most dramatic with one purchase and one redemption. One cash flow in and out makes the differences very profound.
When you invest regularly (and eventually divest regulary), there are several cash flows, and the range of possible outcomes become much more narrow.
3 NN // Aug 18, 2008 at 10:23 am
It is very easy to incorporate the historical ‘worst-case’ scenario over your investment horizon in your retirement plan. Of course, future ‘worst case’ scenarios may turn out to be worse! In any event, this should give one a good idea of the saving required to be ~95% sure of the outcome.
Most people won’t be able to save enough under the ‘worst-case’ scenario, which means they either have to revise their plan, or accept a higher probability of not reaching their goals.
4 Richard // Aug 18, 2008 at 10:43 am
It’s hard to believe the outcomes fall in the same range if you actually invest over the whole time period, but no one does that study. Maybe it’s just not as dramatic. Even in the worst case scenario (1/3 of the best case) things might not be that bad. If the years following your planned retirement date have average returns it might only take 5-7 years to get back to the plan (which has to be a bit less than the best case). As Michael said, if the best case is earlier than expected the worst case should only be a bit later than expected.
My solution to this uncertainty is overkill. I’m simply trying to generate cashflow independent of my work as soon as I can rather than having a set retirement date. Even when I do retire I know that I’ll want to do things that are interesting to me and useful to others at least occasionally, but I’m not counting that in my plans yet.
5 Canadian Capitalist // Aug 18, 2008 at 4:01 pm
Rob: I agree that it seems intuitive that over a lifetime of saving, the expected outcomes are a lot narrower. Even that is likely to be a wide range. The good news is that our investing time frames are very long. A 45 year old investor’s time horizon could be as long as 40 to 45 years and the longer the time period, the less likely that the expected returns don’t pan out.
MJ, NN, Richard: Thanks for your comments. We can always be flexible and tweak our plans.
6 pessimist // Aug 18, 2008 at 6:11 pm
I keep hearing people say they’ll ‘just retire later’ as a solution but I have seen up close the immense difficulties faced by job seekers who are 50+ (to say nothing of people in their mid 60s). Any job in their field of choice becomes difficult to get (positions of responsibility especially). Yes, they can bag groceries but that kind of income will not solve anything more than immediate survival needs.
7 Phil S // Aug 18, 2008 at 7:26 pm
To the pessimist. I’m 40 and am already almost at the point where my investment income can cover my basic living expenses. However, even I cannot foresee a time when I will be completely “retired”. I think that my work life will shift over to doing things that I really enjoy doing - but for all of my life I had to work to pay the bills…
For example, after my employer boots me out the door, I plan to spend my time doing things like inventing stuff, writing music (or generally just kicking off a music career), coaching or managing sports teams, fixing up houses, I’d even thought about tending bar somewhere, etc. Some of them may be for money, others may be for capital gains or investment returns, yet more still being volunteer work for no pay.
That is my goal, to have the financial freedom to be able to do whatever I want - but I’m also not the personality type who will “do nothing” for very long. I’ll always have some kind of hobby or extra-curricular activity that I’ll be busy away at…
8 Steve Heath // Aug 18, 2008 at 8:55 pm
I wonder why everyone mentions saving more and working longer, and they keep forgetting the third option…. die younger. I figure when I run out of money, I’ll just call Chuck Norris a pansy to his face and it’ll be over faster than I can blink
9 Michael James // Aug 18, 2008 at 9:58 pm
Steve: Sure, leave it to the last minute. Forward thinkers start smoking early
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11 Dividend Growth Investor // Aug 21, 2008 at 10:27 am
I agree that one has to be flexible in order to withstand the effects of market forces on their portfolios. In my opinion if you do have a diversified portfolio of income producing assets, you can still retire at the age you originally planned to..The trade-off is that you might have to start withdrawing a lower initial percentage than previously expected. (Say 3% instead of 4%).
You might not be able to control your investment returns ( unless you are a skilled day trader) but you can certainly control your spending (to acertain degree)..
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