How reducing exposure to a catastrophic event, such as running out of money during retirement, is a better strategy than trying to accurately predict a catastrophic event.
In this episode you’ll learn:
- How repeated exposures to low probability events can lead to ruin.
- How bonds have outperformed stocks over long stretches of time .
- How the success of retirement spending rules depend on the market environment and why a flexible approach to retirement spending makes the most sense given the wide variety of risk factors.
David takes listeners back to the root of an investment strategy with one simple investment rule in this exciting 250th episode of Money For the Rest Of Us! What truly matters when considering how to diversify your portfolio and save for retirement is avoiding what will ruin you. Author and investor, Nassim Nicholas Taleb, said that “I effectively have organized all my life around the point that sequence matters and the presence of ruin disqualifies cost-benefit analysis.” How does recognizing that life is lived along the sequence of time influence investment decisions?
Modifying your exposure to fit the risk and avoid ruin
David shares the story of a friend who was diagnosed with an aortic aneurysm. The big decision facing his friend was whether or not to endure an open-heart surgery to fix the aorta. When he considered the statistics, he was informed that he risked a 7% chance in any given year that the aorta would dissect. If it did, the risk of death is extremely high. Open heart surgery, on the other hand, carries a 1% risk of death during procedure, but the risk of dying after a successful surgery decreases. David explains that if you were to keep having the surgery every day, then you’d eventually die from it—just as you would from an untreated, dissected aorta. But life is lived out through time, and catastrophic events—such as a dissected aorta—must be avoided as much as possible, leaving the open-heart surgery as the better option.
Investing is much like the medical decision that David’s friend had to make. Modifying your exposure to unnecessary risk should be the driving force behind your investment decisions. While not all investment decisions will be lucrative—or even prove safe in the long-run—you have control over continued exposure. Just like a medical tragedy, there is no going back in time to fix poor exposure. The key is to fix negative exposure before it can cause further damage—or any damage to begin with.
Conditions to look for when deciding between bonds and stocks
David considers the history of trading in the U.S. with stocks and bonds. Referencing charts from 1926 that show the return on a dollar invested over time through both mediums, the results are rather surprising. In many scenarios, the bond outperformed the stock in short, 30-year periods—about the time we tend to save for retirement. In the long run, stocks outdid bonds, but in the short-term, the result varied depending on the period. Theoretically, stocks should always outperform bonds—but this is obviously not always the case. Why is this, and what can you look for when trying to decide which option will prove more profitable—without excessive risk?
It all depends on the conditions. The driving factors behind stocks are cash flow, how dividends perform over time, and the value that investors place upon the cash flow. Bonds, however, are simply driven by cash flow—and sometimes by interest rates. It’s important to understand where we are today in terms of dividend yield. The dividend yield on U.S. stock is below average at 2%, whereas global stocks are expected to have a higher return. With bonds, it’s currently the opposite, with higher yields in U.S. bonds than global. David encourages listeners to simply be aware of what is happening in the economy right now so that they can make the best, low-risk decisions to best prepare for the future.
Spending rules to consider when living off retirement
There are several investment rules when it comes to spending while on your retirement. David unpacks a few of them, following the experimentation of Michael McClung in his book, “Living Off Your Money.” While the traditional strategy is to spend 4% of your retirement nest egg and increase or decrease that amount based upon inflation in future years, there are other options. McClung recognizes that there are risks to living off retirement, and he takes different strategies and considers their historical performance.
What is the maximum withdrawal rate in any given strategy? In the best case scenario, you could spend 4.4% of your nest egg in the initial year and not run out over the next three decades. That wasn’t the case in all strategies, however. Some maximum withdrawal rates ran rather low at 2.2% in the UK. An important aspect of McClung’s work is that he then went on to consider what the maximum withdrawal rate could be without taking into consideration the 10% worst-case scenarios. The rate rose dramatically. David explores why this is perhaps not a wise way to approach retirement spending, however. What if one of those worst-case scenarios were to happen? The number one rule is to avoid ruin. A better way to approach retirement spending is to evaluate how your portfolio is performing every year and adjust when necessary to promote the longevity of your retirement savings. Be sure to listen to the entire episode for further insight into other spending rules and considerations.
Avoiding ruin should be the foundational investing rule of your investment strategy
David explains that while one can study case scenarios and try different strategies, there is only one shot that we have at life and retirement. We live along the sequence of time, and we cannot make financial decisions outside the space of time that will not in some way affect us and our future. Ways to help modify the risk are to keep your portfolio diverse, balance your investments, and create redundancy. Being flexible in your approach to your portfolio can help keep you from sticking with unnecessary exposure. Have buffers, and create a retirement plan that won’t lead you into potential ruin.
- [0:20] Celebrating 250 episodes – thank you for listening!
- [1:51] 3 individuals who have greatly influenced David’s passion for good investing.
- [2:37] The sequence of life – and how you are affected by it – matters.
- [9:21] Defining risk and modifying exposure.
- [9:53] Case study: bonds vs. stocks.
- [15:34] The conditions for premium dividend yield.
- [18:00] Spending rules for retirement.
- [23:04] Considering worst-case scenarios.
- [26:10] Best strategies for retirement planning.
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