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October 17, 2007

Loss of principal may be the wrong dragon

A man is lying in his hospital bed, surrounded by friends and family, reflecting on his recent near death experience. "I always thought it'd be the ulcer that killed me. I did everything the doctors told me. I drank the cream, ate the butter, drank the milk. And now I have a heart attack!" This was a scene from a new original series on AMC, called "Mad Men", set on Madison Avenue in 1960.

 

It is also a scene playing itself out in the portfolios of millions of Americans. Like Don Draper's boss in Mad Men, many of us are fighting the wrong dragon - and killing ourselves in the process.

 

At each speaking engagement I do, I ask my audience, "When thinking about your investments, what worries you most?" One of the first answers offered is always losing money. Capital preservation is our ulcer. Inflation is our heart attack.

 

Think about the average Baby Boomer - someone born around 1952. For many of you, that won't be too tough. You are the average Baby Boomer. Assuming your parents were 25 when you were born, your parents would have been born right around 1927. How do you think that shaped the messages you got about money, and in particular about investing? How do those messages affect you today?

 

The dominant financial experience in the lives of most of our parents, and certainly our parents' parents, was the Stock Market Crash and ensuing Great Depression. As a result, Baby Boomers were imprinted with certain ideas about money, almost from birth: Don't put your money at risk, pay off your home, stock market losses are ruinous.

 

It is not just investors who are indoctrinated with this belief system. The ranks of financial advisors, financial journalists and government regulators are populated by this same demographic cohort, with the same belief system, stemming from the same seminal event.

 

As a result, as we accumulate assets, we become focused - obsessed in some cases - on avoiding capital losses. So, as we age, we put more and more of our money into fixed income securities like bonds. If capital preservation is the ulcer, fixed income portfolios paying 5% or 6% are the cream.

 

"How so", you ask? The first thing you have to understand is the fact from which all your investment decisions must emanate, assuming your objective is to someday be able to live off the proceeds of your portfolio, is your life expectancy.

 

The average retirement age for all Americans retiring in the year 2007 is 62. So let's consider the case of the average couple retiring this year. They are both 62 years old and non-smokers. I want you to take a guess as to the age at which the second death will occur. In other words, both are 62 years old today. According to the actuarial mortality tables, how old will the latter to die be, when he or she passes away?

 

Jot the number down or just fix it in your mind. Got it?

 

If you would like to dig for the answer, or verify the answer I am about to give, go to your insurance agent and ask to see the mortality tables for the joint life expectancy of a 62 year old man and a 62 year old woman who don't smoke. They will confirm for you the answer is 92 years old. Their joint life expectancy is 30 years.

 

This is the good news bad news joke. We are living longer, but that longevity is also one of our greatest risks.

 

Now I want you to consider this. In 1988, I was fresh out of college and I made $18,000 a year. I was single. I had my own one bedroom apartment in a reasonably nice apartment complex. I had a new Ford Probe Turbo, on which I made monthly payments. I paid my insurance and gas. I could afford to eat out, go out at night with friends and take a couple of vacations a year. I could do all that on $18,000 a year. Granted, I didn't save anything, but my lifestyle was pretty comfortable.

 

So imagine one of my grade school teachers who retired, in 1977, with a pension of $20,000 a year. They were probably able to live pretty comfortably too - for awhile. After all, the median income in 1977 was $13,572. In 1977, a gallon of regular gas cost $0.62. You could buy a Porsche 924 for $9395! The median price for a new home was $54,200.

 

But fast forward thirty years to 2007. How well do you think my grade school teacher is doing on that $20,000 a year pension now? Even with a Social Security check and a paid for house, I can promise you, her monthly income doesn't go far enough.

 

So here is where our inherited belief system clashes with our reality. The cost of living rises, in the United States, an average of 3.5% per year. That does not take into account health care, which is rising at least twice that rate. If you hold a portfolio which returns 6% a year, for example, your real rate of return, or the return left after inflation, is only 2.5%. This is not enough to sustain any reasonable standard of living over a period which will likely span 30 years of retirement.

 

The only way to sustain a reasonable standard of living over that long of a time period is to earn a real rate of return significantly higher than that paid by bonds. In short, your long-term standard of living is directly correlated to the percentage of your assets you place in what has traditionally been thought of as the riskier asset classes, like stocks.

 

And therein lies the conundrum. In order to live comfortably, you must do the thing that you fear, which is put your capital at risk - because profit is the reward for risk. Without risk, there is no risk premium. And you must earn the risk premium in order to be able to live when you no longer have a paycheck.

 

That is the bad news. Here is the good news. In spite of what you may think, in spite of what your gut might tell you, and in spite of the belief system passed on to you by your parents, there is, effectively, zero risk in the stock market for the long term investor holding a diversified portfolio. Market risk only exists in the short term.

 

To that end, we have to stop thinking of our investment time horizon as our retirement date. Our investment time horizon is as long as we will live. For almost everyone reading this, we are talking a minimum of twenty years. For most of you, much longer.

 

I am 44. For planning purposes, I assume my investment time horizon, for example, stretches to the age of 102. In other words, my investment time horizon is 58 years. If I plan to hold an equity based portfolio for that long, what risk do I have? Not much.

 

Will I experience temporary declines in my portfolio value? Of course. Markets are cyclical. They go up and down. But at the end of 58 years, how likely is it that my investment will not have grown at a rate that exceeds the total return on bonds? As my grandmother used to say, "Nothing's impossible, just highly improbable."

 

Therefore, your choices are really quite simple. In order that you not run out of money, or at least purchasing power, you must commit a substantial portion of your assets to equities and keep them there for the long term - through the ups and downs - all of the panic buying and selling. The only way to make the required return is to always be in the stock market. Not market timing. Not stock picking. Holding a portfolio of America's greatest companies over long periods of time.

 

For most of you, that is not easy. It will never be easy. It goes against programming imparted to you almost at birth. But you have to do it anyway. To do otherwise is to guarantee a heart attack by treating the ulcer.

 

Kim Snider Financial Communications makes no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Diversification does not ensure a profit or protect against loss of in a declining market. All investments are subject to risk, including possible loss of principal. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing.

Posted by Kim Snider on October 17, 2007 | Permalink