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Paul Winkler: Okay. So one of the things that I think we don’t talk about quite enough, and this is getting down to the nuts and bolts of financial planning, one of the really, really super important things about financial planning is that you’re trying to protect for the future. You’re trying to get an idea of, am I going to have enough? Do I have enough? Have I accumulated enough money? Am I putting enough away? Is my retirement date feasible? Am I going to be able to live off of my investment portfolio without moving into a box under a bridge someplace?
Financial planning in the past
And you know, the reality of it is it can be a tricky process. And what I want to talk about is a little bit about how that process takes place. Now, back in the old days, when you did projections for retirement accounts. That’s where you’re projecting what the account values might look like in the future. In the past, we basically did linear projections. So let’s talk a little bit about linear projections for retirement and what that is and how it works.
Well, linear projections just means you take a static amount that you expect to make every year, whether the number is 4% or 5% %6, whatever that number is. And you’ll see balances steadily grow by that number. The problem of course, with that is that has nothing to do with reality. Yeah. And, and a lot of times you’re not really taking into account inflation as part of it because your income goes up, therefore your savings amount goes up every year is another thing that you gotta be considering in that process.
And the issue is you pointed out. Well, the biggest issue though, is this order of returns doesn’t come in that way. If we look at large US stocks, for example, large US stocks, average annual return, going back to 1926 is about 10%. You know? So that’s been the average annual return.
One year in 1993 was one year that it was close and it was 10.1%. If we look at five-year returns, I went and looked at five-year returns for the S&P 500. Now that range is going to be a bit narrower, but, you know, and we had a few more 10% approximately. Not exactly, but approximately 10% average annual returns over five years where, where it was around 10, if we look at what the ranges were, it was at the, at the bottom end, there was a five year period in history where it was negative 12% per year, negative 12% per year, average annual return.
And then the very on the top end, it was 28%. So that was a huge jump. And I think we can both guess which, or I, I know already know, but I’m sure you can guess which five-year period had a 28% return.
Jim Wood: Late nineties.
Paul Winkler: Yep. You got it. Yeah, exactly. And the downwind I’m guessing was probably 2004 to 2008. It was the depression.It was actually a great one back then. And that’s a really good point we’re making right here is that academics like as much data as possible. They don’t want to look at just 5, 10-year periods or even 15 years, because that’s just not enough data, you know, there’s you, you’d like to have 70, 80, 90 years of data. If you’ve got it, that’s much, much better in planning. So that’s one of the problems you run into is that when you’re doing static planning, you’re saying 10%, 10%, 10%, 10%, but that’s not the way returns come in. So if you’re looking at your financial plan over a 5-year period or a 10-year period, and you’ve just done it with linear planning, you may look at it, you know, especially after a period of poor performance and say, Oh my goodness, it’s not getting done. Something’s wrong. I’ve got to change. I got to do something different. And you’ll go into a panic mode because of the fact that you expected the 10, 10, 10, 10, 10, 10, 10, 10.
But the reality of it is that’s not the way it happens. So how do we do this? Well, you know, in the old days, you know, you didn’t. When you didn’t have really great computer technology there, wasn’t a great way of doing it. Now you have computer technology, you can do this. Now, one of the things that you have to be super, super careful about our retirement calculators and where the numbers come from.
The problem with financial planning calculators
So I’m just gonna address that really quickly and then talk about how it should be done. Retirement calculators use numbers that may or may not at all reflect your actual returns in your investment portfolio. Why? Well, it comes down to asset mix. So talk just a little bit about how asset mix.
Jim Wood: Well, asset mix really makes all the difference in what you’re looking at. Whether you’re looking at a portfolio that is a hundred percent stocks has some fixed income, and then what type of fixed income and what type of stocks, you know, if it’s all large, US that’s going to give you very different results than something that’s globally diversified, same thing on the fixed income level. If you’re looking at short term, high quality bonds versus high yield, or sometimes called junk bonds, that’s going to give you very different results.
Paul Winkler: Yeah. So, you know, if we look at, for example, small companies, and we look at what, if we put a dollar in small companies in the 1920s, you know, versus what if we put a dollar in large companies and we’re talking about tens of thousands of dollars of difference. Yeah. Yeah. I mean, it just seems insane that it’s that big of a difference.
So we look at that and go, Whoa, wait a minute. The difference in the asset mix can make a huge difference. You know, risk can make a huge difference over time horizons. You know, when I look at a portfolio that has a lower risk number, and we’ll get into measuring that in just a second, because it’s important, I could have hugely different results. Let’s say if I’m putting money away. And the results that I get in my portfolio are what we saw from 1995 through like 2005 or something like that.
Even though my average annual return may have been very similar to let’s say, 1973 to the mid to early 1980s, even though my average annual return may have been similar, my outcome would be totally different. Why? Well, because in the first example from the mid nineties, until the mid two thousands, we had great returns in the beginning followed by lousy returns. And then the second example I gave you had lousy returns in the beginning, followed by great returns.
Well, if I’m putting money away, what’s happening in the first scenario is I keep paying a higher and higher and higher and higher price. And then all of a sudden, when I’ve got the most amount of money, the market drops off in the first scenario, I keep paying progressively lower and lower prices because the market went down in the early years. So every time I put a deposit in, I paid a lower price, I paid a lower price. I paid a lower price. Then when the market recovered, I had more shares that I owned and I had bought more shares in the early years because I kept progressively paying a lower price for the same deposit.
And then all of a sudden want to recover it. And I’m like, yeah, this is really, really great. So that’s why that’s so important to understand that. Now, when we look at how the planning is done, number one, you’ve probably figured it out. It can be garbage in, garbage out with retirement calculators. If you don’t really know what asset categories are held, what areas of the market, large, small, large value, small value international, and how they interact with each other.
Diversification in financial planning
That’s another key. Yeah. You can’t just know your asset categories. You’ve got to know how they interact with each other, because what happens is when you put a portfolio together of two things, let’s say one asset category has an expected return of 10%. And the other asset category has an expected return of 12%. You would say, and I got half of my money and one half of my money and another, am I going to get exactly an 11% return out of my portfolio?
Not likely. Well, because, because what happens is if they move dissimilarly enough and we have a good period of time where the one that has historically had a return of 10% and it just does really, really, really well. And then the other areas kind of stinking the joint, right? And what would I be doing if I managed the portfolio? Well, I would be rebalancing. I would be selling off some of what was historically at a 10% return, but outperformed it, you know, maybe it went up 30% instead of just 10%, which is the historic norm.
And I would go, you know, what’s taken up more than 50% of my portfolio. I should probably sell some of it and buy some of the other one because it’s not going to go up forever. And when I do that, I’m systematically buying low, selling high. That’s the idea. I’m buying relatively low and I’m selling relatively high in the other asset category. And that’s why when the portfolio return actually comes out, it very well may likely be even though one asset category, half the money is at 10% return, the other one half of the money is at 12%.
You would think 11%, well, no, because of this other process, which is the management of the portfolio, it may very well be over 11% and maybe significantly over that, just depending on what the period is.
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Financial planning requires flexibility
Jim Wood: And another thing about that too, is people say, well, why don’t I just invest it all in the thing that gets 12%, that seems to make more sense. But of course, in terms of diversification, that’s why you do that. Those dissimilar price movements of having both of them, it’s going to make your ride a lot smoother. If you have maybe an expected return of 12% and you have a hundred years, and there’s a lot of data backing that up, then maybe that might make sense. But in the real world, that diversification is, you know, really is one of the most important things in terms of your success.
I think a lot of people miss this about building a portfolio, that is, looking at the different asset classes. All this stuff has good returns. That’s what I want, but it really comes down to what are the expected returns longterm of the individual asset classes, as well as how do they interact? Do they have similar or dissimilar price movements? Because things in the short term have great returns, but long term poor returns. And sometimes people say it makes a good diversifier, but it doesn’t belong in the portfolio because it either moves together or at the wrong time, or it might be something that has completely dissimilar price movements.
But long term has allowed the expected return. Now you can look at the past several years.
Paul Winkler: So large US stocks, wow, what great returns they’ve had, but we could look back through history and go, well, no return in 20-year periods where there are no returns whatsoever. And you know, you’re sitting there going well. Oh, well, I invested based on the past performance. And it was really, really good. Then all of a sudden, now I go 20 years without a return, you better have some of those areas that don’t move with large US stocks.
Jim Wood: Yeah. And then looking at things too, people get excited about things like commodities sometimes, or, you know, certainly precious metals when they’re having a big run up and in the news, their long term expected return is very, very low. The volatility is very, very high. The exact opposite of what you want, but it comes down to people speculating that: No, I think it’s going to keep going higher now because something, something I read in the news. Yeah.
Financial planning using software
Paul Winkler: Yeah, exactly. So when you’re doing probability analysis, in essence, what happens is this you got to look at, I look at, okay, so where is the person in the retirement cycle? Are they just getting going? Are they just starting to accumulate money for retirement? Now that tells us we can put more money in stocks, right? Are they getting nearer retirement? Are they 10 years to retirement? Are they 15 years to retirement? Are they in a position?
Period. End of sentence. Are they extremely rigid in their goal? And that is when they’re going to retire and bottom line and it, you know, I don’t have any flexibility. Well, if I don’t have any flexibility than I might have to back off on the risk of the portfolio, I might have to have a lower stock allocation and just put up with that. I’m not going to have as high an expected return. So as one of the things that we look at, okay, how long are they in retirement? You know, so you look at those types of things, you devise the portfolio based on their time horizon, how flexible or how rigid they are in the period of time before they’re going to retire.
What level of income am I going to take? Am I going to need to take a 2% income off my portfolio? Do I need 3%? Do I need to try and get more out of the portfolio than that? How much income am I going to have to take? Once you come up with your asset mix, then what happens is, and we know what that is. Then you have to determine how the mix is going to change over time. So I may start with one asset mix and then little by little as I approach retirement, change it. So your investment portfolio, the financial plan needs to actually show how the risk return trade off changes as time goes on.
Making financial planning projections
So that’s another reason that these calculators can be really, really problematic. Then what you do is this is you take the return and once you’ve gotten the return expectations and as much data as you can possibly get, that’s what I want. I want 70, 80, 90 years. If I can, when I’m using international, I have to just put up with it. I’m going to get 50 years of return data that I can work with. Then when you do this, then you go and have the computer actually give us iterations based on what the expected return is and how that return may vary around the mean.
Jim Wood: An I wanted to say, too, that in terms of what people will look at, “I have that rigid date of retirement,” and they think that they have, you know, they have to make all kinds of changes on that day. They think that, okay, the day I retire, everything changes and that might be a time to address and maybe adjust some things, but it doesn’t mean you completely, okay. Now I have to do everything. I have everything in cash because I’m retired. I can’t take any risk anymore because you can still have a 30 years plus life expectancy with increasing prices.
So I think sometimes people just think like, okay, well I’m going to do this. I’m going to retire in five years. And then, Oh, I’m going to move everything to cash or something like that.
Paul Winkler: Yeah, that is so right. So you’re, you’re looking at that. And then you’re going to be making changes as time goes on as you approach that date. So you might be, maybe let’s just put numbers on it. You might be at 75% stocks now. And then when you start to take that income, you’re at 60%, well, you don’t just go from 75% down to 60% of stocks. You might go 75% then down to 73% and then at 71% and 69%. And you’re going to back off little by little until you get to that 60% number when we’re projecting, how is it likely to look? Are we likely to be okay?
That’s where it gets tricky. So what you’ll do is you’ll say, okay, here’s the expected return on the portfolio. Let’s say, let’s just use a nice round number. It’s like 10%. And based on the full way the portfolio is set up, it’s got a risk number of 14%. So what I would do is I would actually have a computer project out 68% of returns, two thirds of the returns that the computer spits out year by year are going to fall between 10% plus or minus 14%. So, you know, one year it might be 24%.
That’s just 10% plus 14%. Another year. It might be 18% another year. It might kick out 16% and then it might go the other direction, 10% minus 14%. So -4% may be kicked out one year as a return of the portfolio and the negative two, and then positive three. And you know, 68% of the returns are going to be between those two numbers, 10% plus 14%, which is 24%, 10% minus 14%, -4%. Then you say, well, that means 32% of the returns fall outside of that.
You know, if I, if I look at that and go, well, you know, some that means I’ve got to go higher than that sometimes in lower than that. So what we’ll do is we’ll say, okay, so 68%, 95%. Okay. So in effect, what we gotta do is we’ve gotta say, well, could 27% of returns are going to be, you know, split that in half 27% and, you know, split that in half and go, okay, 13.5%. So 13.5% of returns are going to be this, and you literally, you have a computer spit out where the returns might fall based on history.
It’s really stinking complicated.
I just want you to get that, that idea that it’s really, really complicated and a good computer program will give you a thousand different outcomes. And then you need someone who has the education and understanding to interpret those outcomes. So it’s both. You need a sophisticated software program and you need a knowledgeable advisor.
And then what you’re doing and the purpose behind it is this is you’re looking at the numbers and going, okay, based on what I’ve got based on what I’m putting away, based on when I’m going to retire based on what my social security is going to be based on how much of a pension I have, or I don’t have based on life expectancies.
Financial planning at its finest
This folks is financial planning at its finest. This is what it ought to be. It shouldn’t be, “Hey, you need to buy this annuity or this real estate investment trust to drive, get income,” or “You need to get this dividend bank stock fund.” It ought to have some complexity in it. And it ought to take into account taxes. It ought to take into account how Medicare is actually, Medicare premiums are affected by income from portfolios.
Paul Winkler: Are you doing pre-tax or post-tax tax deferral on the investment portfolio? You know, what order do you take income from the various portfolios? Lots of complexity. So I just hope that this segment has given you an idea of just when you are really doing financial planning. There ought to be so much more to it than just spitting out a bunch of numbers and saying, here’s how much money I’m putting away. And here’s how much I got. And yeah, I’ll have enough money, because it’s a lot more complicated than that.
I’m Paul Winkler and you are listening to the Investor Coaching Show.
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