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rc17057Our previous post explored a model of the cost of the promise you make to yourself to fund your retirement, but that model omitted a very important real-world risk: volatile equity markets.

Most recently, the 2008 stock market crash changed many retirement plans for the worse. A 2009 study by the Urban Institute, “What the 2008 Stock Market Crash Means for Retirement Security,” provided a quantitative forecast of the crash’s effects. When the study was published in 2009, it included three scenarios for the stock market: no recovery, a partial recovery, and a full recovery.

With the benefit of six years’ hindsight, we see (happily) that the full recovery scenario they modeled is the one most closely describing the retirement effects of the 2008 crash.

The Urban Institute study quantifies some important (and perhaps obvious) insights:

Higher earners are more exposed to stock market volatility, because they save more, and more of their savings tend to be allocated to equities.

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What Is the Funding Status of Your Personal Pension?

c019718Pause and reflect on what a pension is: income for life after you retire, intended to replace part of all of your employment income.

For retirees in the “Greatest Generation,” pensions were common. For a host of reasons (presented well by Jacob Hacker in his 2006 book The Great Risk Shift) structural changes in the American economy since 1980 have driven traditional defined benefit pensions almost extinct for private sector workers.

Instead, during your years in the workforce, you must build your own “Personal Pension.”

Your Personal Pension payment for each and every year of your retirement is a promise you’re making to yourself, and you want those promises to be fully funded. How much will that cost?

There are several issues to keep in mind as you consider Personal Pension funding levels: longevity, target annual income, and projected investment returns.

I built a model to expRetirement Liabilities Worksheet Resultslore these issues, and the results are summarized in the chart below.

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Belushi RetirementMost people know (at least in the abstract) that choices have consequences. Choices you make to manage your behavioral tendencies (or not) and about your investment costs may have tremendous consequences for when you can retire.

I built a model to explore the tradeoffs between retirement age, investment costs, and behavioral tendencies. Like any model, it makes necessary simplifying assumptions. Nonetheless, I think its results (summarized in the table below) are directionally useful for your own planning and decision-making.

Delayed Retirement Effects of Investment Costs and Behavioral Tendencies

To make this walk through the model a bit more fun, let’s frame it as a story of four college roommates: Leo, Mike, Henry, and Bill. Through age 22, they’ve made really good, really similar choices. All four have studied engineering at a moderately priced state school and obtain great jobs prior to graduation.

To keep our model simple, we assume all of them remain in the workforce until retirement without interruption: that’s right – assumptions contrary to observed reality in the American workplace – no layoffs, no disability, no mid-life crises, no leakage of retirement assets upon divorce, etc.

For fun, let’s further assume that their university had an economics distribution requirement for engineers, and that all the roommates chose a personal finance class with lecture times that allowed them to sleep in on Friday mornings after all-night lab or coding sessions (or the occasional kegger).

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What Is Your Investor Personality Profile?

monopoly1Successful investing presents practical and emotional difficulties. Reducing those difficulties as much as possible turns on your answers to two questions:

Do you believe markets are efficient?

Can you manage your behavioral tendencies?

After you have thoughtful answers to those two questions, it’s easier to make good decisions for you about choosing an investment style and the type of advisor you’ll work with best (if any).

The first key question is what you think about market efficiency.

The “markets are efficient” argument has been made well by many academics (notably Burton Malkiel at Princeton in his A Random Walk Down Wall Street). Generally speaking, proponents of market efficiency are very skeptical that market timing is feasible, and that beating the market on average over long periods of time is possible. They focus on obtaining access to long-term market performance as cheaply as possible, often through low-cost index funds.

Proponents of the “markets are not efficient” argument point to events like the 1987 U.S. stock market crash (down 25% in one day) and the more recent “flash crash” in 2010. They believe security selection done right can permit market-beating returns over time, and point to individuals like Warren Buffett and Seth Klarman as examples.

Still other market participants seem to take a hybrid approach that markets may be efficient in many ways over long time periods, but present near to mid-term inefficiencies that can be exploited for advantage. John Hussman and other tactical asset allocation funds are example of the hybrid approach, which focuses a lot of energy on trying to call the tops of bubbles early, and finding the right time to reenter markets after a downturn. As shown by experiences in recent memory from 2007 through 2011, rewards to making these calls correctly are very large, but the costs (including opportunity costs) of being wrong are also quite high.

The second key question is whether you can manage your own behavioral tendencies. continue reading

wolf-of-wallstreet-dicaprio-mcconaugheyWe live in a world of nearly infinite, nearly free information. That includes financial information, commentary, journalism, and forecasts. Among this clutter, it can be very hard to decide what deserves attention, what’s worthwhile, and what to believe.

Print, television, and Internet journalism thrives on readers and viewers. In a media landscape that is so crowded, being sensible, useful, and accurate is often boring. Boring is bad for traffic, and bad for revenue. Strong incentives exist to make content (including financial content) exciting and entertaining, rather than valuable.

Similarly, in a marketplace that offers thousands of mutual funds, ETFs, hedge funds, private equity funds, and asset managers competing for “share of balance sheet,” their most urgent competition is for your attention.

Boring doesn’t grab attention.

So, strong incentives exist for all the competitors for your balance sheet to tell you a compelling story. Acknowledging that the future is uncertain is boring. Forecasting near-term massive upside in a particular asset class or near-term macroeconomic doom with an unwarranted degree of certainty is much more entertaining.

Discounting information written for the primary purpose of grabbing attention can help you manage the behavioral tendencies we all have, and make better decisions about your financial planning (and related aspects of estate planning).

The investment return forecasts made in a piece of financial commentary are a “tell” you can use to filter out information created to grab attention.

How might we think reasonably about forecasting investment returns, so as to distinguish reasonable forecasts from unreasonable ones? continue reading