The longer that I’ve been a practicing financial planner, the more I realize that the most important measurement in investing is not the average returns in the U.S. or international stock markets nor the federal funds rate set by the Federal Reserve. Sure, these are important data points to understand to be an astute investor. But they are outweighed many times over by this key metric: the six inches between your ears. Our ability to formulate and adhere to a wise investment strategy is absolutely critical to our ability to provide for ourselves in the future when we’re no longer willing, able, or inclined to work to generate income.
For better or worse, investors are mostly left to their own devices and resources to manage and calibrate a lifetime of savings and then somehow convert that sum into a stream of cash flow that will support them for the rest of their days. Yes, Social Security is important and pensions can help those who are fortunate enough to have them. But for the most part we’re on our own. What catches many investors by surprise is that our perspective can change dramatically over our investing lives. The same person who at one point has an iron gut for market volatility may morph into a retiree who checks on their portfolio multiple times a day, observing daily swings in their portfolio that exceed the highest monthly pay they’ve ever had. Your risk appetite as an investor will probably change. The more you can anticipate and adjust for changes in your own mentality, the better you can navigate past temptations that could crush your portfolio.
The first is what I call the law of large numbers. The financial press and advisory industry largely focuses on percentages. Want some examples? The S&P 500 index was down 19 percent last year. The 12-month US Treasury bill currently pays 5.3 percent. Some financial gurus advocate that you should use your age as the recommended percent allocation of bonds in your portfolio. All of that is useful information, but the issue to consider here is that many of us think in dollars instead of percentages when it comes to our portfolio. For example, when we’re in our thirties and are just getting started in our investing journey, with a $50,000 balance in a 401(k) we may lose $10,000 in a bear market. That’s a lot of money to be sure, but you may be earning ten times that much every year in your job.
Now imagine someone in their sixties about to retire. They’ve been able to save $750,000 in their investment accounts. If they use the same market and investment strategy as the person in their thirties, then their portfolio could decline $150,000 – more than most people ever earn in a year. You could point out that their investments had only declined 20 percent, but in my experience that’s little consolation to a person who loses a six figure (or worse) sum in the market. I would anticipate that your Spock-like detachment to the ups and downs of the market will likely degrade as the numbers at risk grow larger.
The second factor is the change in mentality of one who is building their portfolio versus one who is regularly withdrawing from it. The point of saving for retirement (or financial independence if you like) is clear. You regularly put money away while you work so it’s there to support you later in life. It’s an obvious point and a change that every investor intellectually understands but few anticipate is how it will feel. I’ve seen people flip from almost not caring if their portfolio goes down while they’re working to tracking its daily value and losing sleep during market corrections in retirement. There are steps you can take such as a bond ladder or short-term cash cushion that can help lessen your need to check your portfolio daily in retirement.
Finally, it’s a mathematical certainty that our remaining life expectancy decreases as we get older. When we suffer through a poor year or two in the market, it helps to reason that we have many years left to make up for our losses. We can also console ourselves that while working that we are buying into the stock market at a good price. But as we get into our sixties, seventies, and beyond, we become more aware of the time we have left. Our confidence that the market will recover in time to help us can be shaken. This is a legitimate phenomenon as one of the worst things investors can experience is a series of poor market years at the beginning of retirement.
Among the worst investment strategies is one that you may abandon at times of market volatility. Consider your current and future appetite for risk when building a portfolio that makes sense for you.
David Gardner is a Certified Financial Planner