You can read anywhere and everywhere about how so and so lost x amount of money in their 401k or retirement accounts. How much did you lose? Is it done 10s of thousands? 100s of thousands of dollars? I wonder, if someone came to you and said I can give you a safety net on your investment but it will cost you a percentage of your return, what percentage would you pay for that, if any? Would you give up 1% per year to guarantee a safety net of 6%? What if that safety net only cost you 0.5% per year?
No one can predict the future of the market. They will always try and someone will guess right but no one knows for sure. I find that as people get closer and closer to retirement they become more and more cautious of their investment losses. Makes sense right? Would they sleep better knowing that they had a safety net?
You might say why not just invest in safe investments. My response to that is opportunity cost. How much do you give up over the long term by moving to safe investments. In todays environment you’re lucky to get a 2% rate of return from your 1-year CD. According to the AllFinancialMatters the 20-year return for the S&P 500 from 1989-2008 is 8.41% That gives an opportunity cost between the two of about 6%. This gap is as big now as it has ever been due to interest rates being at historic lows.
What if you can have your cake and eat it to? Let’s say your 55 or so years old. You are very likely to live another 20 years if not 30 or more. You plan on retiring in about 10 years and you’re a bit nervous about being invested in the market yet you need some returns on your money to retire comfortably. You might even have a financial planner that showed you a nice compound interest curve. Maybe you even realized that as your asset allocation gets more conservative you just might be Destroying Your Compound Interest. What if someone offered a safety net? Now it’s not free. You get a guarantee that your account won’t earn less than 6%. Meanwhile the account still stays fully (or as much as you choose) in the market. The cost is that your fee comes out of your return. So that if you earn 9% you would only see an 8 or 8.5% rate of return depending on your fee for this safety net.
There’s a lot more details to this obviously but I’m just wondering what fee would you be willing to pay. Would you pay 1%? Would you pay less? I also understand that your answer might be different today than it would have been in 1999 or even in 2007. That’s why I’m asking you today. If you want clarification or you have questions, e-mail me.
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Hey, found your site through one of your comments at WealthPilgrim. You had an interesting comment so I followed. I think 1% is nothing compared to that safety net, and virtually everyone would do it. At 3%, it’s a harder decisious but I would still do it. What % of your car do you pay for auto insurance? This sounds like a deductible, so I think you should get some actuaries to do some of these calculations. Very interesting, though.
No one can predict the future of the market.
I hear this sort of statement frequently. I have never been able to find anyone who could offer support for it. I now view it as a marketing slogan for The Stock-Selling Industry, nothing more.
If you buy a broad index fund, you are buying a share in the productivity of the U.S. economy. The U.S. economy has been sufficiently productive for many, many years now to support a 6.5 percent average annual return for stocks. What’s so unpredictable about that? You know what you are going to get going in and then you get it.
What throws people is their belief in Passive Investing. The Stock Selling Industry has been telling us for years that it is not necessary to look at price when buying stocks. This is of course nonsense (effective from a marketing standpoint, but nonsense all the same). You obviously can’t get 6.5 percent in the long term if you pay double or triple for the stocks you buy. But what would you expect?
We have historical data going back to 1870. If you look at the record, you will see that the return on a stock investment has been largely predictable for that entire time-period for those willing to look at valuations before putting money on the table. It is only the marketing benefits that go to The Stock Selling Industry for telling us that we don’t need to look at price that makes long-term stock returns unpredictable. (I agree that short-term returns are unpredictable, but who cares?)
Rob
In that situation, would you pay an extra fee, not for the stock purchase, but for a safety net of to limit the losses of your money?
I wouldn’t, Evolution.
I think the insurance idea is too complicated and too costly and not necessary.
Stock returns are to a large extent predictable at 10 years. They are highly predictable at 15 years. Yes, there are some circumstances in which unpredictability becomes an issue. But circumstances in which there is no way to deal with the unpredictability at least somewhat effectively (and the insurance idea does no better than that) are rare.
At low valuations all possible outcomes are good even at five years out. There is unpredictability in the sense that it could be that your five-year return is going to be amazing and it could be that it is only going to be solid. So long as you are not counting on anything more than solid, you are set.
At moderate valuations, this is not entirely so. But you still can plan for a worst-case scenario and thereby protect yourself from unpredictability. The worst-case scenario for the five-year return for a purchase of an index fund made at moderate valuations would be a negative number. But so long as you go with a low enough stock allocation so that that negative short-term return does not wipe you out, you are okay buying some stocks (those with time-frames of 10 years or more could of course go with higher allocations — we are here discussing only those who can not afford even five years of negative returns). The key is getting the stock allocation down to where the worst-case scenario is not a killer for you.
At high valuations, the possibility of an extreme negative outcome are sky high. The sensible choice here is not to go with a high stock allocation and then pay for insurance. The sensible choice (in my view!) is to go with a very low stock allocation. When super-safe asset classes are offering better returns than stocks, why not just invest in them rather than pay fees for protection from the mistake of buying overpriced stocks? Avoid the mistake and you avoid the need to pay for the protection!
80 percent of what determines success for the typical investor is getting the stock allocation right. The biggest factor determining what allocation you should be going with is the price at which stock are being sold at the time you are thinking of buying. Once we all get in the habit of never, never, never buying stocks without looking at price (that is, never investing passively), most of the risks of stock investing go “poof!”
At the top of the bubble, the most likely 10-year return on stocks was a negative 1 percent real annualized . The guaranteed 10-year return on inflation-protected bonds was 4 percent real annualized. That’s a differential of 5 percent per year for 10 years. Do the math and you see that the Passive Investor loses 50 percent of his starting-point portfolio value because of his unwillingness to consider price when setting his stock allocation. There is no insurance that you can buy that is going to come even close to making up for the loss you suffer from investing passively.
Risk is Passive Investing. If you don’t like risk, just don’t invest passively. Sometimes the most simple and obvious solution is the best solution.
That’s my take, in any event.
Rob
Well thank you for coming over and reading my post. I hope you enjoy it. What if I told you you could get that safety net for less than 1% extra? It was a hot selling up till 2009 and unfortunately the cost were too low, usually around 0.5%, for the market losses of 2008. Even the actuaries didn’t account for that big of a loss. I’m sure they will be back on the market. Well actually some variations still are. There are more things involved and I’ll do more posts on it in the future. Stay tuned.
I definitely agree with a lot of what you are saying. The purpose of the post was to get people talking and it seemed to work for you. I appreciate your comments.
I wrote the post focused on the last thing you said, “short-term returns are unpredictable”. Sooner or later that matters. At some point in your life you just might feel that time is running out. Maybe it’s not even that extreme but instead you become more aware of the fluctuations in your account. At the very least if you are drawing income from your investments you need to be aware of the short-term fluctuations because you might not be able to recover from them when money is withdrawn. In that situation, would you pay an extra fee, not for the stock purchase, but for a safety net of to limit the losses of your money?
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