The Most Influential Decision You Must Make
When your employment income “faucet” turns off, the stakes go up, and your entire investment mindset and process has to drastically change.
It must begin by first identifying your level of Retirement Bucket Dependence™ (the amount you must withdraw to support your desired lifestyle), and then calculating the investment rate of return you must earn in order to have your Retirement Bucket™ provide the lifestyle sustaining cashflow you want without running dry.
Once you’ve arrived at your number, the next question we ask in developing The Relaxing Retirement Formula™ is where do you position your Retirement Bucket™ holdings to generate that real long term rate of return you need while experiencing acceptable levels of volatility and paying less taxes to the government?
To help you determine the correct answer for yourself, there are several principles and guidelines I recommend for you.
Last week, we tackled the first one which was knowing what NOT to invest, i.e. funds you will be spending soon, and thus don’t want to subject to short-term market price volatility.
Let’s take a look at the next principle today.
Risk vs. Expected Return
As we have touched on many times in the past, one of the biggest reasons why most investors fail to earn market rates of return is their lack of understanding of the relationship between risk and return.
The easiest way to think about this is that every investment has its own expected return. When evaluating any individual investment, the risk of that investment is quantified by the degree to which its short-term returns deviate from its long-term expected return.
Higher risk (or more volatile) investments carry a wider range of short-term outcomes, but also carry higher expected long-term returns which compensate investors for withstanding short-term volatility.
In contrast, investments that have had a narrow range of outcomes over long periods of time are expected to provide more consistent returns with the trade-off of lower returns.
Another way to look at this is higher expected returns are the reward for an investor’s willingness to accept higher volatility. Risk is ultimately the source of returns, and should be embraced in appropriate doses.
The two key words there are “appropriate doses” because not all risks are rewarded the same as Nobel prize winner William Sharpe outlined in his famous Capital Asset Pricing Model which explained about 70% of all stock portfolio returns.
With his famous model, he was able to demonstrate that by subjecting themselves to the systematic risk of the total U.S. stock market, investors were rewarded with a return that was 7.9% above the risk-free return of treasury bills since 1928.
The key ingredient is your strategy for accepting and managing the higher level of volatility so you can capture the substantial risk premium of owning stocks vs. treasury bills.
Your Most Influential Decision
Without going any further today into the other sources of returns which have been uncovered through extensive academic research, the biggest influence over your expected future returns comes down to your answer to one binary question:
Once you have set aside funds to support multiple years of your anticipated future withdrawals in money markets and short-term fixed income 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)?
Your answer to this binary question will have the greatest impact on your ability to generate the investment returns you need.
Historically, the higher the percentage of your Retirement Bucket you can position in the long-term equity ownership of a globally diversified mix of stocks, the higher the probability of protecting your long-term purchasing power.
The reason for this is simple: inflation!
While money market, CD, and bond returns have barely kept pace with historical inflation, thus doing a poor job of preserving your purchasing power over your anticipated lifetime, equity returns (ownership shares of great companies) have far surpassed inflation, thus doing a spectacular job of protecting your ability to produce lifestyle sustaining cashflow you need.
Large cap company share returns have averaged more than 6% above inflation historically. Small cap stocks have returned even more.
So, before jumping into all of the other factors, the single biggest influence on earning the investment returns you must earn is the percentage of your Retirement Bucket™ you allocate to long-term equity ownership of a globally diversified mix of stocks.
The larger the percentage, the higher the probability of protecting your long-term purchasing power.
Assuming for a moment that this one critical factor registers with you, the next question is where? Where will you allocate the equity (stock) portion of your Retirement Bucket™?
We will dive into that in the next edition.