11 Mar 2011 How Much Is Enough?

Do you ever wonder if you will have enough money to see you through the surprises and challenges ahead? Or, if you are blessed with abundance, do you ever think how nice it would be to quantify your surplus, find purposes for it, to enjoy the benefits today; rather than leaving it to the next generation to fight over? Truth is, most people have no idea whether their plans are over- or under-funded, or by how much. They spend most of their time worrying about return.

During the Internet and dot com booms of the late nineties, market returns were setting new records. People expected and largely saw every purchase they made quickly increase in value. It was not uncommon to hear people talking about early retirement, travelling the world, or starting their own businesses, many of them as day-traders. Without knowing any better, people innately believed they had more than enough wealth to accomplish all of their needs including some pretty silly want-to-haves. Thinking the rally would never end, people added to their stock allocations without concern for the bust that would surely come.

We see the opposite behavioral extreme demonstrated in the financial meltdown of 2008. With stock and corporate bond markets diving to new lows week after week, people became convinced that their plans would be forever under-funded. It was commonplace to hear folks bemoan the fates of their ‘201K’ plans and how they would be forced to work for the rest of their lives at McDonalds.

During extreme market conditions, good or bad, we worry over the question “how much is enough?” But our perspective at each extreme is remarkably different. During the horrific foxhole moments in our lives we focus squarely on our money. How much money do we need to see us through? We can’t quantify it, but we feel convinced that our plans have become perilously under-funded.

At the opposite extreme, when markets are rising and it seems they will continue almost indefinitely, we worry less about how much money and more about how much return. And as markets improve, we worry not just about return, but about getting the very best possible returns. And because achieving the very best possible returns constantly is impossible, we worry constantly.

The $1.1 trillion financial services industry is built on the very premise that we are drawn to the very best possible returns by our instinctive natures. And market cycles play directly into their hands. On average, stocks rise about four years for every year they fall. Marketers know you worry about returns four times longer than you worry about your money. Do you ever wonder how all the tall marble buildings get built? They get built with the money you ignore those four years while chasing returns.

Before people invest their money, they determine an investment strategy. There are indeed many. A few years ago I came across a fascinating paper written by my friend David Loeper of Wealthcare Capital Management, entitled Measuring Temperature with a Ruler. Better than anything I had ever seen, it laid out a remarkably objective and unbiased comparison of popular investment allocation strategies to his own wealth management methodology; the same one we use for our clients (the term allocation refers to the proportion of stocks, bonds and cash in an investment portfolio). In his analysis, David used 80 years of actual market return data for domestic equities and US Treasuries. Written for an audience of investment professionals, the paper is technical and lengthy, however the findings are so compelling, I felt it important to tell the story in a way that might appeal to a more important audience – you.

A Story of Return versus Wealth

Through the use of actual historical market returns, I will demonstrate how our wealth management strategy compares to popular alternatives for investment allocation strategies. Our story begins in 1926 with a 20-year old new mother who has just been widowed by the tragic death of her husband. She faces not only the painful reality of raising a daughter alone, but in her grief, she must choose how to invest $100,000 in life insurance proceeds (roughly $1 million today) on her husband’s death. All she really knows at this point is that she will need at least $5,000 (about $50,000 today) in annual income, rising with inflation, to support the two of them.

Zoom eighty years forward to meet our widows’ great grandson, David, a successful Wealth Manager. David has just learned that he has been afforded the incredible opportunity of going back into time to help someone with make better financial decisions based on his knowledge of the future. Having heard the sad story of his great grandmother and the hard times she endured, he chose the very moment in 1926 when his grandmother faced her most difficult investment decision. It was required that David leave immediately, with no time for preparation. The cramped space of the time machine allowed for only one carry-on bag into which he threw his laptop containing annualized stock and bond market returns since 1926.

Upon arrival David wasted no time seeking out his great grandmother. When he arrived at her home and knocked on the door, he found it difficult to compose himself when a beautiful young woman, half his age appeared. She was likewise stunned and amazed at the striking resemblance this stranger had to her father, and there was this unsettling feeling that they were somehow related. In a strange way, she found it easy to trust him as he told his incredible story which revealed how much he cared for her predicament.

When she handed him the list of options provided by her current-day financial advisor she broke down into tears, saying how terribly afraid she was of making the wrong decision. David consoled her and said he would do all he could to help her make the very best choice possible. Her list of options read as follows:

1. Long-Term Risk-Tolerance Allocation: A strategy spanning a long period of time, which considers a need for cash flow with a low level of risk. The strategy remains static over the client’s lifetime and consists of 38% stocks and 62% bonds. The portfolio will be re-balanced annually.
2. Age-Based Allocation (Target Date): This allocation strategy adjusts equity exposure annually according to a simple formula which starts at 100% and reduces that percentage by 1% each year over the client’s life. At 20 her exposure to equities would be 80%. At age 60 equities her equity exposure would be 40%, and so on.
3. Stocks for the Long Run according to Professor Jeremy  Siegel, “equity risk declines with time,” so the widow could  benefit from the superior returns of equities given the long-time span of her plan. This allocation consists of 100% stocks.
4. Superior Selection: This portfolio would  have the same allocation as #1 but assumes that through superior investment selection the portfolio would outperform the benchmark, net of expenses by  1.5% a year. In our example we also assume there is no timing risk of when superior and inferior returns occur as exists in the real world. We simply better the actual market returns by 1.5% annually.
5. Wealth Management Allocation: This allocation strategy consists of determining the funded status of our widow’s plan each year and adjusting the risk allocation if required to provide a confidence level of between 75% and 90% that she will exceed her simple spending goal of $5,000 annually, adjusted for inflation.

Upon receiving the information, David retired to a quiet and secluded place to begin his work, careful not to reveal his laptop to his 20-year old great grandmother. That would have been too much. It would be another 30 years before Steve Jobs and Steve Wozniak were even born.

Running each allocation strategy through his database of actual stock and bond returns for the past 80 years, David calculated the returns and dollar amounts each strategy would deliver according to actual market returns each year, without biasing the results due to his knowledge of the future.

For his own strategy David ran his Monte Carlo simulator for the first year, 1926 to determine what his great grandmother’s initial allocation should be to yield confidence between 75% and 90% in providing annual income of $5,000 (adj. for inflation). He determined it should be 80% equities and 20% US Treasuries. Using the annual return database on his laptop he determined the portfolio’s value at the end of each year, just as he had done for the other strategies. He then re-ran his Monte Carlo simulator on the new portfolio value to determine its funded status (confidence), making adjustments to allocation as indicated by his analysis. See page 28 of Measuring Temperature for a complete list of actual changes and portfolio values. David found that his great grandmother would need only 9 allocation changes, and all would occur in the next 20 years of her life.

David developed a series of tables to coach his great grandmother to the best choice. As soon as he laid the first one down, she impetuously pointed to the $265,707 ‘guaranteed’ Stocks for the Long Run all-stock strategy. Not so fast David said when he explained that there would be short periods of time when she would experience losses of forty, fifty or even sixty percent.

Wise for her years, she wanted to avoid risk, but felt she needed as much return as she could safely get, so she re-focused her attention on choice #4. It clearly offered the best return, 9.8% and had less than half of the risk of 9.55%.

When David suggested she consider the #5 Wealth Manager approach, she immediately feared that time travel had gone to his head. And when he presented the table below, her fears were all but confirmed. She implored him to look at all the years of superior returns offered by the other strategies compared to his Wealth Manager.

David gently assured her that he had not lost his head, but given his limited time with her it was imperative that he impress upon her the importance of keeping her own head in the difficult years to come. He knew that she would be bombarded by huge market swings, by sensational marketing claims from the growing financial services industry, by well-meaning friends, and by her advisor touting the latest and greatest variations of the other four strategies. David knew how easily any one of these influences might sway her from the plan that he was about to lay before her.

As he prepared to make his recommendation to his great grandmother, it was painful knowing that he would not be able to remain at her side through her life as he was with his present-day clients helping to guide her confidently to success. He would not be able to provide new advice as her life and goals would surely change. The best he could do was to assure her that she would have her $5,000 annual income, adjusted for inflation, for the rest of her life.

He presented his findings to his great grandmother in the table below. Step-by-step he showed her the weaknesses of each of the other approaches in generating what she would need at the grocery store – MONEY, not returns. For all their promise of returns, the first three strategies would leave her broke in her 50’s. And rarely would they produce more money than his Wealth approach would. Only Strategy #4 would take her successfully through life, but with considerably less money than the Wealth approach. What’s more, the #4 Superior Selection strategy (not available in the real world) would provide more money than our Wealth manager only three years out of 80.

With time growing short, his driver’s license photo fading, our Wealth Manager provided his great grandmother with a list indicating the years she would need to change her allocation and by what amounts. He kissed and hugged her goodbye, as he implored her to hold fast to her plan. He confidently assured her that if she did, she would achieve the outcome on the table above.

What if you could know with confidence the funded status of your plan at any time; in good markets, bad markets, and all in between? Would you worry less if you could be presented with the knowledge that you had an 82% probability that you would exceed all of your important goals during your lifetime?

As wealth managers we use similar tools to those of well-managed institutional pension funds to monitor our clients’ plans alerting us to those time they become over or under-funded. The plans of our clients are considerably richer in detail than our simplified widow’s plan. Hers considered only income and portfolio allocations on an annual basis. We consider EVERY aspect of our clients’ financial lives important to them, including dreams that might never be shared with those practicing Allocation Choices 1-4.

How much is enough for you?