15 Oct 2010 Confidence

While officially the recession is over, that view is a tough sale for real estate people, furniture reps, car dealers, travel agents, city employees, waiters, barbers, or you fill-in-the-blank. The severity of pain varies, but even those with sufficient means to maintain lifestyle have curtailed their spending for reasons ranging from prudence to appearances. The result is an economy struggling to maintain enough forward progress to avoid tumbling back down the hill.

Every day the starving real estate agent hears words like; ‘I’ve decided to rent for a year or two because I cannot be certain of keeping my job.’ I’m told that Raleigh, which continues to be one of the fastest growing cities in the country currently, has a ten-year supply of homes in the mid to high-end range. The government crackdown on foreclosure practices of banks, while well-intentioned, will likely have unintended consequences of reducing the flow of mortgage money to qualified homebuyers. 

Retirees investing largely in bonds have seen their incomes plummet, wiping out any discretionary income they might have enjoyed pre-recession. Yields on 3-5 year CDs and Treasuries have fallen from 5% to 1.5% in the last three years. Talk to almost anyone in commission sales, outside of the health sector and you will hear a sad story. Because we are personally affected by the recession or know people who are, we reduce our spending and increase our savings. Our economy grew dependent on over-spending and will likely take years more to wring out the excess.

Once again, the ‘Baby Boomer’ generation plays a huge role in the direction of our economy. The influence of this huge post-WWII population bubble has stretched the fabric of the US economy since it began. The station wagon, interstate highways, and motels were built in the 50’s to get ‘the family’ out of the house and onto the road. The huge inflation of the 70’s occurred when the boomers began buying their first cars, houses, and all the stuff that went into them. The economy simply wasn’t large enough to fill the huge demand the boomers placed upon it. Nor has it adapted well to the inevitable vacuums that occurred when the boomers moved on. Think of all those empty Mac Mansions. What are they going to be good for? 

A large chunk of boomers have gone into economic bomb shelters. They have abandoned stocks for bonds and gold and other precious metals sending prices to record highs. While boomers are unlikely to retire as early as their parents did, they are hyper-focused on the savings they plan to use eventually for retirement. They are badly bruised by a seemingly relentless series of wallops just when they had grown huge. As a result, many boomers are losing confidence.

 As the economic malaise drags on it threatens more than incomes, savings and reserves. Yesterday’s concerns give way to today’s doubts, which ultimately result in tomorrow’s wholesale withdrawal from risk-taking. For individuals this might mean anything from cancelling an anniversary cruise or adding a sun porch, to taking everything out of stocks and going to gold, cash, and Treasuries. Small businesses might shelve expansion plans indefinitely. If they are owned by boomers, they might simply sell out or bleed the business as they coast to retirement. Big businesses address risk by letting employees go while expecting more work from those who remain. The common threads are falling confidence and lost jobs.

Most people invest their money, not for the fun of it, but to accomplish important goals in their lives. They plan for when and where they would like to retire and any number of other goals they want to accomplish. But inexplicably, they leave the how completely to investment performance, or more precisely, to managers of mutual funds and managed accounts. As a result they have no CONFIDENCE in meeting their goals, particularly in light of the past decade’s significant market drops. When large losses occur people leave stocks (often for good). Alternatively when large gains become in vogue, people are drawn to stocks like politicians to a fiscal stimulus bills. The result is that at any given time, people are generally taking too much risk or not enough risk. 

Take two examples of inappropriate risk. First consider a 70-year old couple living on social security and CD income. Four years ago they received $20,800 in Social Security income and $10,000 from their $200,000 CD portfolio with rates at 5%. Today’s lower rates have dropped their income to $25,500 from $30,800 four years ago. Is it any wonder they can’t sleep at night for worrying whether their savings will be enough? 

Our Wealthcare analysis showed that if the couple wanted to return to spending $30,800 a year on their portfolio of CD’s, they would have only a 71% confidence of success, so we developed a plan for them. By increasing their risk modestly they could significantly increase their spending level, hence their lifestyle, and their confidence. By moving their portfolio into 30% equities and 70% 7-10 year US Treasuries we could improve their confidence to 83% (well within our comfort zone) and provide annual income of $37,000! The improvement represented an $11,500 (45%) increase over their current spending and a $6,200 (20%) increase over the level with which they had been ‘comfortable’ before. At the news the couple tearfully considered all their new possibilities; of perhaps giving more or travelling again or . . . 

In a second example, let’s consider the possibility of taking too much risk. We have found that the vast majority of people investing for retirement take more risk than is required to meet their goals. The unfortunate result of the extra risk-taking is that after extreme market drops, these people are more likely to bail out of risk than they might be if invested in less volatile portfolios. 

Consider a couple, Roy and Dale Risktaker. They are 50 and 52 years old, the make $200,000 a year combined, save $16,500 a year, and have an investment portfolio of $1 million. They enjoy their work and can work until ages 70 and 72, but ideally they would like to retire at 65. In retirement they would like to spend $150,000 including travel and other goals. Their portfolio had been invested 90% in stocks and 10% in bonds. When we modeled the Risktakers we found that they had an 83% confidence in meeting their goals as presented, but they were sacrificing needlessly. 

With a quick check of our model we found that we could reduce our clients’ risk exposure to stocks by a full 10% and still maintain a confidence level of 83%. Further, we knew that our clients enjoyed their work and were willing extend their careers and reduce their estate if it meant they could materially reduce their investment risk. They had painfully watched their portfolio drop from a high of $1.5 million in October 2007 and hoped to avoid that likelihood in the future. Further adjustments showed that if we could extend their working/saving term by one year and reduce their estate by half of their ideal level, we could drop equity exposure from 80% to 60%. As you can see on the last line of the table on the following page, their portfolio risk would fall from 17.2% to 11.6% and the risk of loss from 13.5% to 7.8%, all by using less important goals to achieve more important ones.

In our everyday practice of Wealthcare, we talk to our clients about all kinds of things; sometimes about their money and the markets, but mostly about many other things truly more important to them. We discuss the possibility of retiring much sooner than they might think possible, about educating not only their children but perhaps their grandchildren. We listen to their dreams that range from cooking school in the south of France to full-time ministry in Ethiopia, or South Raleigh. We consider the cost to their goals wrought by months or years of reduced or lost commissions, or mounting business losses, or a home that will not sell. In essence we help our clients vanquish the monster of uncertainty with confidence provided by a plan that considers their important goals and priorities. We continually stress-test their plans for circumstances as bad or worse than those we currently face. We do not know nor do we attempt to guess when market disruptions of the magnitude of 2008/2009 (and greater) will occur. But we know they will, just as we know that 70% market rallies like the one of 2009/2010 (and greater) will occur. We can’t make the recession go away, but we can bring confidence back into the lives we touch with Wealthcare.