Tuesday, December 09, 2008

The Limits of Financial Planning

If you're like anyone who's invested in the stock market over the last few years, the past 12 months must have been sobering --- we're seeing drops of close to 40% over market peaks. What's worse, nothing seems to be safe --- gold is down, international markets are down (so much for decoupling), and even Berkshire Hathaway, king of all value stocks is down.

In these times of uncertainty, we should take a moment to reflect on how we know so little about what the future will hold. As Bernstein says, history has not been kind for those seeking stability --- over a 40 year period, the chances of us being caught in some kind of catastrophe is approximately 20% --- and we're talking about war, potential global warming nightmare scenarios, and other such that would cause you to think that your portfolio dropping 40% is the least of your problems. So even though all the retirement calculators might show that your portfolio will survive no matter what, there's always that 20% chance of failure no matter what.

I asked Bernstein about FireCalc and other such tools last year, and this was his response:
as you hinted at, and as paul samuelson famously said, we only have 200 years of history to go on, and the experience of the rest of the world, as well as current expected returns suggest, going by those 200 years are overly optimistic.

forget all the sophisticated methodologies: GIGO, and what goes into these black boxes is most assuredly G.

here are 2 simple ways of looking at it:

1) start with 3.5% real for stocks, and 2.5% for bonds. that's about 3% for a mixed portfolio. if you're going to retire at 50, your time horizon is for all practical purposes "forever," so you can only withdraw your real return, or about 3%. but it's worse than that, since you have to adjust for uncertainty and a bad initial draw. so figure 2%.

2) even simpler: since in the long term, to stay hedonically adjusted you don't just have to keep up merely with inflation, but with the living standard of your non retired peers, which increases at the productivity growth rate, or 2%. add in a soupcon of uncertainty and your hedonically adjusted rate of return is zero. so . . .you have to save one year's living expenses for every year you plan to live, or 50 years, "worst case," or . . .2%

2% is grim, but that's only if you want to be bullet proof. in the real world, if you need 3% or 4%, you're trading off safety for a reasonable standard of living, which is OK, as long as you understand the tradeoff.

In the mean time, I plan to enjoy myself, stick to my asset allocation strategy, and not worry too much about it --- if you or I have to work a few years longer, that's hardly the world's biggest disaster. Even now, I am much more worried about global warming causing us to have an uninhabitable Earth (for humans that is --- cockroaches will survive everything) than about a second great depression.
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