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May 31, 2005

Indexing - Would you bet your retirement on one hand of Texas Hold 'Em?

Last week, I posted an investment scenario and listed six mutually exclusive alternatives for investing your money. I asked which you would pick at different ages. Quite a lot of people left their picks, and their reasons, in the comments section.

 

Just to remind you, the scenario was that you had accumulated $100K in retirement funds. We have a crystal ball that tells us twenty years from today, the S&P 500 will be either 20% higher or lower than it is today but it doesn't tell us which way it will go, only that the odds are 50/50. No other outcomes are possible.

 

The choices were:

 

A. Buy and hold a market basket of stocks and hope that it goes up 20% instead of down 20%

B. Try to time the market - get in when it is going up and out when it is going down

C. Try to pick stocks using historical data, company fundamentals, technical analysis, sector analysis or some other stock-picking methodology

D. Put your money in bonds which will return on average about 5% but have a small risk of loss

E. Put your money in a principal protected cash equivalent like CDs paying 2%

F. Put your money in an investment that will lose significant value if the market declines but will generate a consistent cash flow of approximately $1000 per month over the ten year period.

 

I asked which of these investments you would choose at age 35 and at age 55, if you had to pick only one and were locked in for the entire twenty year period.

 

Turns out that my quiz was more of a loaded question than I had intended. The readers of this blog have to be somewhat biased towards cash flow or they probably wouldn't stay readers for all that long. I also realize, in retrospect, that I didn't do a very good job of making D and F an apples to apples to comparison.

 

Even though I put F at a disadvantage because of the way my choices were worded, an overwhelming majority of the people who left their comments chose F. That would, of course, be my answer as well, which was the whole point of the quiz. Let's look at why I think the higher yielding cash flow investment is the better choice.

 

This is going to take some doing to explain, so you'll have to stick with me here for awhile. Let's take them one at a time, and just to make the scenario more realistic, let's assume the starting number is $1 million instead of $100K:

 

Buy and hold the indexes - This is a lousy choice. Mathematically, my expected rate of return is 0%. Some people pointed out that in reality, there is probably a greater chance that the market will go up than down. Over long periods of time, I would agree, but in the short run, who knows? As the famous economist, John Maynard Keynes said, "In the long run, we're all dead!"

 

What I do know is the possibility exists that there could be a 20 year bear market in my life time. It has happened in the past. It will happen again. And I have no way of knowing when or if it is coming. But as someone who must someday support myself from my portfolio, maybe for as long as 30 years, I believe the only reasonable thing to do is to plan as if it will - because if I don't and I am wrong … well, how does cat food for dinner sound?

 

Let's look at this from the two different age perspectives:

 

Let's say I am 35 and I am trying to achieve growth in my portfolio. If 20 years from now, the market is 20% higher, I am now 55 years old and my principal has only grown to $1.22M. Not great!

 

Worst case, my principal has shrunk to $800K - an unacceptable outcome for someone who will someday very soon have to live off this money.

 

Now let's say I am 55 and I will retire at age 65 and begin to withdraw money at the rate of 4% per year. Best case scenario, the market goes up 20% over the twenty year period. At the end of ten years, my principal has risen to almost $1.1 million but now I start taking retirement distributions of 4% of the previous year's ending value to live on.

 

Because my distributions are greater than the increase in the market, two things are happening: my principal is declining and, as a result, so is my income - even though the market is going up. At age 75, I only have $786K in principal generating only $32K a year in taxable income with presumably, a good number of years left until I die.

 

 

Worst case scenario is, well … worse. Much worse. Assume I am 55 and the market declines 1% per year for twenty years. Now my principal shrinks even faster, as does my income. Twenty years later, I have only $490K and my income has shrunk to only $20,848 per year, before taxes.

 

And just to throw more fuel on the flames, these little back of the napkin scenarios don't take into account the fact that inflation rises, on average, at a rate of 2% - 3% per year. So in terms, of purchasing power, this scenario is just devastating.

 

 

Is this a reasonable scenario? Absolutely it is. Has it happened before? Yes. Is it likely to happen again? Dunno! But you wouldn't bet your retirement on one hand of Texas Hold 'Em would you? Why would you bet it on one hand in the stock market?

 

Next, we'll tackle scenarios B and C - stock picking and/or market timing. We can dispatch with both of these relatively quickly I think, so stay tuned. In the meantime, your comments are welcome. Post them below.

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make 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. 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. All investments are subject to risk including possible loss of principal.

Posted by Kim Snider on May 31, 2005 | Permalink

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