Home

What the Rich Know and the Poor Don’t

This seems sooo simple. Just two questions? Actually, the rich don’t ask these questions, or they wouldn’t be rich either. But here are the questions.

  1. For those who are still saving for retirement the question is “How much money do I need to save this month to cover my longer-term financial needs?” If you are already retired, the question is “How much money can I spend this month so that I don’t run out of money during my lifetime?”
     
  2. “What return on investment did your assets earn last year?”

The article goes on to explain why knowing the answers to both questions is essential. As SO points out these are stupid and dangerous questions. You can’t know the answer to these questions.

Darn. I like simple. I was hoping this produced some reasonable approximation.

Predicting the future is a bad idea. Those retirement planning calculators are a hazard to your health and financial wellbeing. Plug in the numbers and poof – you will live in comfort until you drop dead at age 92 years 4 months and 7 days. Sorry, it is never that easy. What about all the assumptions that you and/or the calculator made about inflation, return on assets, cost of living, changes in lifestyle over the 40 year planning period? Are those reasonable expectations? How do you know? You can’t.

For the last several years housing has been appreciating at 20% per year in many areas. Retirement calculations that assumed even a portion of that for future returns are starting to look shaky. Houses around us are already down for the year. Oops, I’ll run out of money at lot sooner.

Better questions

  • What is your current annual spending?
    Like most people, our expenses vary considerably month to month, so basing planning on annual rather than “this month” spending will yield more realistic results. This may seem obvious, but it could be important.
     
  • What is the value of your current assets? What income are you entitled to in the future?
     
  • What are your investment strategies? What risks are associated with each strategy?
    Yes, strategies (plural). Any strategy has risks and returns. Government Treasuries are risk-free but they don’t return much either. (If this isn’t true, there are much bigger problems beyond the scope of this discussion.) Other strategies have higher risks and returns. This is where it gets more complicated – are the returns appropriate for the risk? For example, for many formerly investment-grade, now-junk bonds based on sub-prime mortgages, the promised returns were not nearly high enough for the huge risk of the investment being wiped out.

    Another potential problem is dealing with normal economic cycles – perhaps 30+ years long. Taking money out of assets during periods of downturn may significantly reduce the returns long-term. A return of 10% of nothing is zero. Retaining assets through good and bad times is essential to the overall strategy.
     
  • What is the likely range of real return based on that strategy for those assets?
    Real returns – inflation adjusted. So if the Consumer Price Index (CPI) goes up 3%, it takes an 8% return to get a 5% “real return” so those Treasuries with 4% yield are making about 1% real return.

    Putting money in an ETF is cheaper than mutual funds or individual stocks, and much cheaper than paying to have money “professionally” managed. The usual measure of success is beating the Dow or “the market” or some other relative measure. But if the market is down 20% and my ETF is only down 19% I’m still in deep trouble. I need a real return of 5% for my money to last a lifetime.
     
  • Given the spending rate, the assets, the strategies, and the range of returns, does the income cover the outflow?
    This is the hard part. Protect the principal. Those Treasuries are looking good. However, figuring out how to get a better real return is more difficult.

There are those who’s measure of success is beating Warren Buffett. The problem with that is, short-term, he isn’t even playing. He invests in companies that he believes will be profitable over time. When he buys in, these companies are “bargains” – good companies in businesses he understands that have the potential to perform better than their current stock price suggests.

In theory, anyone can do this. Understanding a company’s business and making an informed decision about the future performance of the company relative to its current stock price is hard work. Determining value and deciding when the price is low is not something one gets from the latest issue of Money magazine.

The discussion has been informative, but there is much still to do.

http://www.savingadvice.com/blog/2007/11/19/101913_what-the-rich-know-and-the-poor-dont.html

Advertisements