Great Investors Know the “Real Risks”

By |2018-12-20T16:24:33-05:00May 29th, 2018|Blog, Great Investors Series|

“Futurists say the first person to reach 150 years of age has already been born, and some project that people alive today will live 300 years or even longer.”
-Ric Edelman

In last month’s article, we shared a new way to think about “asset allocation”. This week we shine a light on the two large “elephants in the room” for most Americans planning their financial futures.

Announcing Clarity

Before we get to the topic of discussion, I am proud to announce the publication of my new book, “Clarity: How Popular Culture is Misleading You About Successful Wealth Planning and What to Do About It.”  Order your complimentary copy here.

What is Risk?

If you ask most people to define “risk” when it comes to their investing and financial planning, you will likely get a consistent answer: Most people have a great fear that they will lose money in the stock market. Many Americans spend a great deal of time, energy, and emotional stress obsessing over the possibility that they might lose money, trying to devise strategies to avoid this fearful outcome. However, as we have written many times in the past, the risk of a permanent loss of investment capital has actually never happened in the stock market for investors with the patience and emotional control to ride out the temporary volatility inherent in stock prices. Every Bear Market in history has faded with time and eventually yielded to much higher stock prices.

So, what are the real risks we need to watch out for in our long-term financial planning? In my experience, there are two major “elephants in the room” that Americans are systematically and consistently ignoring when they think about their wealth planning.

The Definition of “Money”

The first “elephant in the room” is that most people have a complete misunderstanding of the basic definition of the word “money.” In the long run, the only true definition of money is purchasing power.

Most people have a hard time understanding this reality, and they often confuse “money” with “currency.” They mistakenly think that their “money” is reflected by the amount of currency they own, and they obsess over their stash of little green pieces of paper with pictures of dead presidents. What matters is “purchasing power,” which is the number of goods and services we can purchase with each piece of currency at a given time. A little green piece of paper with Ben Franklin’s picture on it has no intrinsic value. It is only valuable to the extent that you can walk into a restaurant and use it to obtain a nice meal and bottle of wine.

Currency isn’t the same thing as purchasing power, as it loses some of its value every day due to inflation. Although most Americans underestimate their life expectancy, statistics tell us that most of us will live through a 30-year retirement. Over that period, at a three percent rate of inflation, your cost of living will rise by about 250 percent.

Imagine the first year of your retirement. Your morning routine includes a daily trip to your local convenience store to purchase a large coffee for $1. By the end of your retirement, your beloved cup of coffee will now cost you $2.50. Of course, you could change your habit and buy a small coffee, as your $1 will now purchase about 40 percent as much coffee, but if you really enjoy the large size, you will need to come up with $2.50. This same thing will happen to the cost of your housing, food, clothing, golf balls, and vacations!

Making matters worse, the impact of inflation may hit hardest on the cost of medical care. As it is today, healthcare costs are accelerating far more rapidly than the overall rate of inflation, a trend we might expect in the future. We might also expect that as we age, the proportion of our household budget that we will spend on healthcare is likely to increase as well, which will have the effect of exposing our household more and more to higher and higher rates of inflation as we age.

An investor who focuses their investment plan only on preserving the amount of currency they own, at the expense of growing the purchasing power of their assets, will be forced to make these difficult decisions over time. Those who ignore the impact of inflation are doomed to endure a deteriorating standard of living, as their “currency units” slowly but surely lose their purchasing power over time.

Your 100-Year Plan

The second “elephant in the room” is the fact that Americans consistently and systematically underestimate their longevity. In doing so, they risk dramatically underestimating the number of years their nest egg will need to provide for them, in this environment of continually rising consumer prices.

I have found that our greatest mistakes usually happen when our expectations are most disconnected from reality. So, let’s begin with the reality. For most of human history, life expectancies changed very little – but in the last 100 years or so, they have begun to show signs of increasing rapidly. When my grandfather Herb Strid was born in 1904, his life expectancy was 46.2 years. Luckily, he outlived that by a lot and lived to be 69. By the time my father was born in 1943, his life expectancy was 62.4 years. He also has outlived that expectancy by a lot – today he is 75 and still going strong, with a current life expectancy of 86.3 years. My son Carter was born in 2001 and his life expectancy was 75 at birth, and I am confident that he will vastly outlive that like the generations before him.

A related reality is that joint life expectancies are longer than single life expectancies. In other words, the life expectancy of the last spouse in a couple to die is longer than the individual life expectancies of each of the spouses alone. At age 75, my father’s current life expectancy is 11.3 years; however, my parents’ joint life expectancy is 19.9 years.

Now let’s examine the expectation. When we ask most clients how long they think they will live, they immediately think about how long their parents lived and make a ballpark estimate based on that age. Usually, this number comes in right around the low 80’s. When we suggest to a client couple that we should create their financial plan based upon a joint life expectancy that could be age 95-100, the reaction is almost always laughter at the idea that they might live that long.

Most baby boomer couples understand that life expectancies have expanded significantly during their lives, but they usually attribute that to significant medical advances that they consider to be one-off miracles. They remember that in 1918 twenty-five million people died of the flu, but today we all get a flu shot every year. They remember their childhood, when people routinely died of tuberculosis and polio, which are diseases my kids will probably never even know existed. However, most baby boomers believe that these amazing discoveries and revolutionary cures aren’t repeatable – they believe that everything that is to be discovered in the world of medicine already has been discovered.

Today, doctors are executing organ transplant surgeries by “printing” new organs with 3-D printers. Cancer is being cured with gene cell therapy, and blindness is being reversed with stem cell treatments. The reality is that science is only now just getting started on extending our life expectancies.

I wrote a blog about this topic, which I encourage you to read for further discussion: What is Your 100 Year Plan?

A Risky Combination

Investors who define “risk” as the temporary volatility in stock prices may be seriously miscalculating the real risks they face in their wealth planning. The baby boomers represent a generation of people who are likely to live to age 90, 95, 100, or even longer, but who generally believe that they will die by age 85. Not only are they underestimating the time horizon they need to prepare their portfolios to endure, but they are also dramatically underestimating the impact inflation will have on the income stream required to afford them an independent and dignified lifestyle in their later years.

Ironically, while most Americans fear the risk of the stock market, historically, equity ownership has been the most reliable way to achieve the investment returns necessary to keep up with, and even exceed, inflation. Since World War 2, stocks have produced an annualized return of roughly 10 percent and a stream of dividend income that has risen by about 5 percent per year. Not a bad way to combat a 3 percent rate of inflation over time.

Conventional wisdom has it that the best way to prepare for retirement is to dramatically reduce your stock market exposure and load up on fixed income investments like bonds and CDs. In our view, it is “financial suicide” to enter a retirement of 30 years or longer of relentlessly rising costs of living, armed only with investments that produce a fixed rate of return.

Having a Plan

The very best investors have a disciplined approach to making portfolio decisions and always stick to their plan, no matter what the rest of the world is doing. They are able to live through the peaks of euphoria, as well as the depths of terror, with a healthy understanding that a well-designed written investment and financial plan will get them through both.

No predictions. No witch doctor investment sorcery or magic investing formulas. Just hard work, patience, and discipline.

By |2018-12-20T16:24:33-05:00May 29th, 2018|Blog, Great Investors Series|

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