Good Morning Relaxing Retirement Member,
Last week, we discussed the one binary question you face which will have the greatest impact on your ability to earn the investment rate of return you need to earn in order for your Retirement Bucket™ to remain full for the remainder of your life while providing you with the lifestyle sustaining cashflow you need:
Once you have set aside funds to support multiple years of your anticipated future withdrawals in money markets and short-term instruments, what percentage of your Retirement Bucket™ will you invest in ownership shares of quality companies (stocks) vs. fixed income investments (bonds, money markets, CDs, and fixed annuities)?
As Nobel prize winner William Sharpe outlined in his famous Capital Asset Pricing Model (CAPM), investors who subjected themselves to the systematic risk of the total U.S. stock market were rewarded with a return that was 7.9% above the risk-free return of treasury bills since 1928.
Given this, and assuming that you want a large portion of your Retirement Bucket™ in equities, where will you allocate the equity (stock) portion of your Retirement Bucket™, i.e.
- In ONE company, i.e. Amazon vs. Johnson & Johnson?
- In ONE idea, i.e. solar vs. electric?
- In ONE industry, i.e. technology vs. health care?
- In ONE region, i.e. U.S. vs. China?
- In ONE asset class, i.e. small cap value vs. large cap growth?
- In ONE investing style, i.e. value vs. growth?
If you’re going to invest your life savings in just ONE of these, you better be right as you are subjecting yourself to far more risk than the total U.S. stock market in Sharpe’s model!
If you chose Apple when nobody else wanted it, you hit a home run. However, if you chose Polaroid or Enron, you’re bankrupt today!
The challenge going into any given year is who can predict with absolute certainty what company or asset class will be the big winner.
And, if someone did have the confidence to make a bold prediction as to who this year’s winner will be, are you willing to place your entire Retirement Bucket™, that now has to support you for the rest of your life, 100% into their predicted winning asset class?
I believe I know your answer already.
This is why we believe in strategic diversification vs. tying 100% of your future to any ONE thing.
Substantial academic research has demonstrated that you can achieve greater returns and experience less volatility through diversification.
An Intelligent Question to Ask
Let’s assume for a moment that you have carefully forecasted your level of Retirement Bucket Dependence™ into the future, and assuming a 5% inflation rate per year, you’ve calculated that you need to earn 2% above inflation, or a 7% nominal rate of return on your money in this example in order to make your Retirement Blueprint™ work, i.e. to have your Retirement Bucket™ remain intact year after year while still providing you with the lifestyle sustaining income that you want.
If you need to earn 7% (or 2% above inflation), can you afford to have all of our money in money markets and CDs earning 1%?
Certainly not. Money markets and CDs have no volatility, but they also don’t provide you with a reasonable opportunity to earn the 7% you need (or 2% above inflation) to make your numbers work. Alone, they will not get the job done for you.
Conversely, if you only need to earn 2% above inflation (or a 7% nominal rate of return), do you need to have all your money in small cap stocks?
Certainly not again! Why subject yourself to the higher level of volatility that comes with owing all small cap stocks if you don’t want or “need” to.
So, the intelligent question to ask isn’t “what’s the best investment or asset class?”
The intelligent question is “how much of your money do you need to allocate to various asset classes in order to generate the overall long term rate of return you need to earn while subjecting yourself to an appropriate and acceptable level of volatility”?
To accomplish this, you’re going to ask different classes of investments to do different things.
And, because of this, you can expect them all to behave differently in the short run. The key word is to “expect” it and not be surprised when it does.
In the short run, there will be asset classes that will perform better than others. That doesn’t necessarily make them better in the long run. It just means they were in favor during that period of time.
Next week, we’re going to explore Eugene Fama and Kenneth French’s famous work into the other critical factors which have the greatest impact on your returns.
Committed To Your Relaxing Retirement,
The Retirement Coach
P.S. Arm yourself with the questions you must ask to determine if your financial advisor has a legal obligation to work in your best interest at all times vs. the best interest of the company they represent. To receive a free copy of the Consumer Guide titled: “The 13 Questions You Must Ask Your Retirement Advisor (or Any Financial Advisor You’re Thinking of Working With) Before You Hire Them”, simply click this link: http://www.theretirementcoach.com/free-consumer-guide-how-to-protect-yourself
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I appreciate the trust you place in us. Thank you!
(The content of this letter does not constitute a tax opinion. Always consult with a competent tax professional service provider for advice on tax matters specific to your situation.)