Are You Saving Enough For Retirement? Use These 4 Simple Rules Of Thumb And Find Out Now.

by Millionaire Mommy Next Door on September 18, 2009

in Calculators,Guest Post,Resources,Retirement

This is a guest post written by Todd Tresidder.

How do you know if you are saving enough so you can afford to retire? And more importantly, are you saving enough to retire with confidence so that you can support your present lifestyle without running out of money early?

2615289324_685aa07107To answer these questions, you might consider using one of the many online retirement calculators available. Unfortunately, these “simple” retirement calculators are often complicated and require you to assume many things about your future retirement that may or may not work out to be true. It’s the old “garbage in equals garbage out” rule, and nowhere is that rule more true than with retirement calculations.

One alternative to sophisticated retirement calculators is to apply simple rules-of-thumb that allow you to quickly and easily estimate the sufficiency of your nest egg and savings plans. While these simple formulas lack the “rocket science” sophistication of Monte Carlo theory and other financial planning innovations, they do provide a reasonable ballpark approximation that is easy enough to do yourself – without a computer, software, calculator or financial planner. Usually, a pencil and the back of a cocktail napkin are sufficient.

The advantage of this simplicity is you will actually complete the exercise – which is essential to successful retirement planning. You must know the retirement savings goal you are aiming for in order to plan constructive actions to reach the goal. You are far better served by knowing a rough approximation of your retirement planning needs than to have no estimate at all.

The truth is perfection in retirement planning is impossible anyway because accuracy depends on assumptions about your future which can never be made with certainty. Therefore, it’s better to at least work with ballpark estimates than to risk being thwarted by complication that might keep you from playing the game altogether.

Below are four simple rules-of-thumb for retirement planning that will at least get you in the ballpark until you have the time and inclination to sharpen your pencil…

The Ten Percent Rule

Some old-wives-tales are true, and the importance of saving 10% of your income happens to be one of these truths. This retirement savings strategy was popularized in the bestselling book The Richest Man in Babylon. In general terms, the way the math works is if you save 10% and invest it with long term returns around 10%, your investment portfolio will grow to the point that it can support your lifestyle from earnings in roughly 35-40 years. That means you could retire and live on the investment earnings alone, never touching the principal. Your life expectancy doesn’t even matter in this situation because you would never run out of money since it doesn’t require you to spend principal. The biggest risk to this simple formula is inflation, although even with that limitation it still provides a good working approximation for how much you should be saving.

What’s fun about this formula is how easy it is to understand, easy to implement, and easily adapted to your situation. For example, if you have less than 40 years until retirement then you should obviously be saving significantly more than 10%. The sooner you start saving, the longer you have for your interest to compound to build your retirement fund. If your average investment return exceeds 10%, you won’t need to save as much. If it is less than 10%, you need to save more.

One big benefit to using this simple rule-of-thumb is you don’t need to pay for a fancy financial plan that sits in the binder on your shelf collecting dust to get started. It is a rough approximation that points a clear direction so you can get started immediately – and starting immediately is a critical factor to your retirement savings success.

The “Millionaire Next Door”

Now that we have a reasonable approximation for how much you should be saving each month, lets examine a different approach that provides an approximation for how successful your savings efforts have been to date.

According to The Millionaire Next Door, authors Stanley and Danko provide a simple yet reasonably accurate formula for assessing your wealth accumulation skills:

Multiply your age times your realized pretax annual household income from all sources except inheritances. Divide by ten. This, less any inherited wealth, is what your net worth should be.

For example, if you are 35 years old and earn $100,000 per year with no inheritances, then your net worth should be $350,000: 35 times 100,000 divided by 10 equals 350,000. If you meet this standard, consider yourself to be “on track” for moderate wealth accumulation and a successful retirement fund. You aren’t a super achiever, but you aren’t behind either.

Go ahead and do the math for yourself. How do you measure up? This formula is really just another twist on the 10% savings rule cited earlier. It is based on sound mathematics and seems to provide a conservative but realistic figure for a broad range of scenarios.

Although it does not consider inflation, taxes and varying interest rates, this simple formula does yield a useful estimate of your retirement savings goal. It gives you a fast and easy way to see how well you are progressing toward financial freedom.

Stanley and Danko go one step further, creating two additional benchmarks based on their basic formula. “Prodigious accumulators of wealth,” or PAWs, have accumulated twice the savings indicated by the formula. “Under-accumulators of wealth,” or UAWs, have accumulated half the expected total. If you are a PAW then you are reasonably on track to knowing if you can afford to retire. If you are a UAW, now is the time to step up your financial management skills and start saving more.

12 Times Income

Jonathan Clements, former columnist for theWall Street Journal and author of The Little Book of Main Street Money: 21 Simple Truths that Help Real People Make Real Money, offered another alternative to the “How Much Money Do I Need To Retire?” question by claiming a reasonable retirement nest egg should be 12 times your income. To reach this goal, the amount you need to set aside each month depends on how much time you have before your target retirement age and your current savings-to-income ratio. This premise makes a few assumptions:

  1. your income increases to match inflation,
  2. you draw 5% of your savings as income the first few years of retirement, and
  3. you achieve an investment return of 5% after inflation.

The numbers purport to yield 60% of your pre-retirement income. Combined with Social Security and other income, you might end up with 80%, a figure that most retirement calculators assume is enough. Alternatively, if your own calculations show that you need a higher percentage, then you need to amass more than 12 times your income.

Rule of 25

One of my favorite rules for simplifying how much is enough to retire is to multiply your expected annual spending for your first year of retirement by 25 to determine your total savings required. This is just a mathematical simplification of the famous 4% rule where you are allowed to spend 4% of your savings each year during retirement.

This rule is on firm empirical grounds because the sophisticated retirement planning models including Monte Carlo optimizations will generally result in spending rules ranging from 3-5% depending on assumptions and confidence interval required. Now you can get roughly the same result without a computer, software or arcane mathematics. Just take your first year of retirement spending, multiple it by 25, and presto – you are right in the same ballpark.

Summary

These quick and dirty rules of thumb are far from perfect. But the ugly truth about retirement planning is there is no such thing as perfect. In the end it is all a rough approximation anyway. For those readers wanting more explanation and detail, the ebook “How Much Is Enough To Retire” will help you understand exactly when you can afford to retire.

The future is unpredictable and conventional retirement planning requires you to predict the future in order to apply their models – this is a serious flaw. The truth is many unknowable factors will determine your financial needs during retirement, and those will only be known in the fullness of time. There are alternative models to retirement planning that don’t require you to see into the future and for those readers who don’t have the time or inclination to learn those models, this article provides some simple rules that will get you close enough for basic planning.

The important thing is to develop a concrete retirement savings goal to work toward – regardless of the model used. An inaccurate goal is better than no goal at all. You can use these simple rules of thumb to get started today and sharpen your pencil later when accuracy becomes more important.

About the Author

Todd R. Tresidder is a financial coach who retired comfortably when he was just 35 years young. His ebook, How Much is Enough to Retire? is based on his own experiences and explains how you, too, can afford to retire. Check out his web site for more retirement planning books, educational articles, and try his free retirement income calculators.

photo credit: ted.sali

{ 36 comments… read them below or add one }

Beth September 18, 2009 at 2:59 pm

I’m confused by this line: “For example, if you have less than 40 years until retirement then you should obviously be saving significantly more than 10%. ”

So anyone over the age of 25 who plans to retire at 65 should be saving “significantly more than 10%”? Doesn’t that defeat the purpose of the 10% rule if most people should be saving more anyways?

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Millionaire Mommy Next Door September 18, 2009 at 3:22 pm

Todd, the author of this post, just left for a camping trip with his family this weekend. He will be back on Monday to respond to questions and comments here.

@Beth, I have a comment to make on this but am running out the door right now. I’ll respond soon.

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Anonymous September 18, 2009 at 4:03 pm

Ummmm…….when is a person who’s retired really considered ‘retired’? I went to Todd’s website and he’s selling books, charging fees for financial coaching etc. etc. I wouldn’t exactly consider him retired, because he still is working, paying taxes on his income and well, he’s working!

Retired means RETIRED period-not working, just living off your investments, using up your saved money and not working to generate more money. At least, that’s what it means to me.

Just saying, IMHO.

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Jen September 18, 2009 at 5:54 pm

I don’t know, we’ve been saving (just in retirement) roughly 20% a year. So definitely a lot more than option 1. But given option 2, we’ve only got about 1/3 of what we should have in savings based on our income*age/10.

I think the issue here is the market. Lots of these calculators depend upon 10% growth. We entered the job force in 2003 after school and we have seen virtually NO growth in those 6 years on our portfolio – in fact we may be negative cumulatively after last year. Obviously we’re in a better position than our parents who are entering retirement age, but I think we are much worse off than people in their late 30′s and 40′s who had time for growth in their portfolios. Compound appreciation breaks down if you aren’t making any gains at the beginning. :(

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traineeinvestor September 19, 2009 at 2:13 am

While the four rules of thumb may provide some useful guidance, in both theory and in practice each has significant flaws:

1. the 10% rule assumes that people will be saving for 35-40 years. That may (or may not) have been the norm for earlier generations. I very much doubt if too many people can confidently assume that they will be employed for that long or that they will be able to save 10% pa for each of those years. That said, if you do manage to put away 10% of your incime each year for a long period of time, you will be a lot better off than most people

2. the millionaire next door formula does not work very well for people at the early stages of their career, those with rising or variable incomes or people who are still paying down student debt etc rather than accumulating investments – for people in either position it can be a bit demoralising to be classed as an under accumulator of wealth. It works better for people who have been earning and saving for quite a few years. Also, it fails to link expenditure with net worth (other than in a very indirect manner)

3. 12x income is the weakest of the four. Why income and not expenses? And a draw down rate of 5% is just too risky for anyone planning anything other than a relatively short retirement. Quite frankly, this is a pretty dangerous rule of thumb

4. the rule of 25 is much better than the 12x income – not only is it based on expenses rather than income, but it assumes a lower withdrawl rate. That said, if you are planning on a long retirement, even 4% may end up being too much. Still it is a much better rule than the other three.

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Little House September 19, 2009 at 9:57 am

I’m afraid that by definition of both these rules, I’m really behind! Based on rule #2, I’m so far behind, I don’t know where to start. If I look at rule #1, I think I’d have to start putting 20-30% of my variable income towards retirement.

I also have to agree with the comment by trainee investor, I have a variable income and it’s very hard to stash away this much money. Any suggestions for these types of income?

-Little House

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Nick Pfennigwerth September 21, 2009 at 9:40 am

hmmmmm, interesting article. A lot of key tools to use to see if you’re on track for financial success.

However, is there ever retirement? I mean, if you’re doing what you love would you ever want to retire? I think “retirement” is faulty logic. A lot of people pursue retirement thinking that they will be on a beach all day, sipping pina coldas, and have no worries. No amount of money is going to make you feel secure. Eventually you’ll get bored and want to do something or be something. I’m aware that our physical bodies have a time limit, but if your work is physical and once your physical work comes to an end, there is always alternatives to stay on purpose and be involved.

Look at what most sport stars do. Most of them have more than enough money to “retire” and do nothing. However, after their sports career, they get involved in other sports alternatives (such as broadcasting, charities, business, etc) because they still want to be someone and do something.

I agree, it’s important to have a wise saving plan, but if you want to prepare for retirement, do so by finding your purpose and pursuing your dreams because life is an ever unfolding process. Not a stop point when we hit retirement.

Peace and love,
Nick

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Beth September 21, 2009 at 10:46 am

Nick has an interesting point. Part of my career planning has included work that is flexible enough I can do it part time on a freelance basis when my kids are small so I won’t lose income or career momentum. I’ve recently started thinking about how I can manage my career to keep working once I “retire” from full time — like consulting, free lance, etc — so I can earn a decent wage and not end up working a minimum wage retail job or something.

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Millionaire Mommy Next Door September 21, 2009 at 11:21 am

@Beth: Last time I did the math, the following rule of thumb worked pretty well as long as you start saving before your early thirties: 10% to cover the basics, 15% for comfort, 20% to retire lavishly or early. The longer you wait to start saving, the more you’ll need to increase these percentages. For instance, if you wait another decade to start, you’ll need about 15% for basics, 20% for comfort. Time is the greatest asset when it comes to the power of compounding.

@anonymous, Nick and Beth: I think retirement is defined by each individual. I’m sure Todd will have his own take on retirement. For me, retirement means that I have enough money to take care of my basic needs without the need to work. Perhaps “financial freedom” is a better term to use for this purpose. Now I work when I want to, doing something I want to do so much that I don’t care whether I get paid for it or not (take this blog as an example).

We get paid for other things we do which means we can afford to live more comfortably. Surprisingly, my husband and I have simplified our lifestyle so much — and our expenses have pared down accordingly — that we haven’t dipped into our savings portfolio yet!

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Todd R. Tresidder September 21, 2009 at 11:24 am

Hi Jen, I’m back from camping. Here are some replies to comments by your readers. Hope they help…

@ Beth – These are just guidelines designed to point a direction – they are not failsafe rules. The fact that most people don’t start saving at age 25 does not defeat the rule as it is written(IMHO). Instead, your comment points toward an entirely new article about How To Catch-Up On Savings For Late Starters and Procrastinators which I have provided on my site. In other words, yes, it is unfortunate that many don’t begin saving at a young age. Jen and I are two notable exceptions, and believe me, starting early makes a big difference. The later you start the harder it is because you have less time for the money to grow. In the example cited, for every 7 years at the theoretical 10% growth rate you miss one doubling period. What that means is you have half as much savings compared to starting just 7 years earlier. This is important stuff to understand. It can be a big motivator to get started today.

@Anonymous – The implied assumption behind your comment is that people who don’t need to work shouldn’t. I disagree. I write extensively on my site that “retirement” is a word that should be retired. We think of retirement as playing endless golf, travel, pro-leisure circuit, whatever, but in my usage of the term it is more accurately about not being bound by a job. Retirement in my world is reserved for when my health is gone and I am confined to bed rest. Work is not a four letter word (well it is actually, but you know what I mean). In my case, I work 8-9 months out of the year building my educational web site while my kids are in school. I have tried full time liesure and full time work and found 8-9 months of work per year with 3-4 months vacation about ideal. The vacations are more fun when contrasted with meaningful work. Life feels more satisfying when I apply myself to creative pursuits I am passionate about. In this case, I am hopelessly fascinated about investing and personal finance. If I had to rely on the money from this business to support my family I would have closed the doors long ago. It is a creative passion (although I hope to make it a viable business model in the foreseeable future).

@ traineeinvestor – Yes, you are right. All the rules have flaws. They are just helpful guidelines, yet, they are far from perfect. I also agree with you that the rule of 25 is one of the better choices although there are many valid issues with that one as well if you really want to dig deep into the subject. The truth is there is no perfection in retirement planning. That point is developed extensively in the ebook referenced in the author resource box above. Each model is predicated upon assumptions and forecasts for the future which by definition is impossible to do accurately. You are working with a world of imperfection when planning retirement and anyone who tells you otherwise is either a liar or self-deceived.

@ Little House – regarding variable income issues, it really doesn’t change the main principles being taught here. You could try a five year average of income if that helps to get you in the ballpark, or you could just model it based on a target income. Whatever works for you to fairly represent your income situation is what matters.

@Nick Pfenningwerth – thanks for the feedback, and, yes, I agree with your thoughts on retirement. See the discussion above on that issue. My experience is consistent with your beliefs.

Hope that helps, Todd

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Beth September 21, 2009 at 3:25 pm

@Todd: Thanks for the response, but you’re preaching to the converted ;) I understand the power of compound interest, getting in early, etc, etc. I started saving/investing well before the 40 year time frame and followed the 10% rule of thumb, but then the recession hit… I’m breaking even, but 10 % rate of return? Doubling period? Those are laughable concepts right now.

I’m looking forward to reading Jim Otar’s “Unveiling the Retirement Myth” when it comes out because I think he’s got a better sense of what’s going on. I can’t help but feel that these rules of thumb were meant for (and formed during) a period of history that we’re no longer living in.

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Todd R. Tresidder September 21, 2009 at 5:12 pm

Hi Beth,

There appears to be a miscommunication…

This article is designed to provide some simple rules of thumb to help people set a savings goal that is somewhere in the ballpark so that they can get started today working toward the goal. The key point is to help people get started – the earlier the better. It is not designed to be a replacement for more sophisticated retirement planning tools.

The ideas in this article are deliberately over-simplified because many (“most” according to Employee Benefit Research Institute) people are either not taking action or are taking inadequate action for retirement savings. This article attempts to remove some of the barriers to action by simplifying the process.

You appear to be more sophisticated and deeper into this process than most given your interest in Otar’s work; however, it appears you are also making some very common mistakes.

For example, one of the most common mistake when planning retirement is the assumption used for “return on investment”. For example, you referred to “laughable” doubling rates and for many readers that will ring true. However, there is a well documented relationship between long-term investment holding period returns on a diversified portfolio of equities and the valuations at the time you begin your holding period. The returns you experienced in the last decade were completely expected. Not only did I publish material back at the turn of the decade under my old web site (pre-blog newsletters) stating this, but other authors including John Hussman have documented the expected returns very clearly in real time. You could easily do the same. I will provide the formula in a future article. It is easy to apply and statistically robust. In fact, there are some retirement calculators based on this expected return model that are quite useful.

Just so you don’t think I’m playing Monday morning quarterback, I have walked the talk with my own portfolio using these principles where I have held no (zero) assets in a traditional asset allocation (diversified equities) since the very end of the 1990′s because the mathematical expectation was unfavorable. Instead I focused on real estate and commodities selling all my investment real estate in 2006. None of this was forecasting but instead solid investment risk management. I don’t consider the ideas of doubling rates laughable, but instead I consider them necessary given the likely outcome of serious inflation after this deflation has run its course (not done yet).

This segways to your last comment about Otar’s work. While I have great respect for Jim Otar, his writings, and the education he provides, it is fundamentally flawed and will mislead you in the end because it is based on “backcasting” as he states himself. His work is vastly superior to the simple rules of thumb I provide above, but don’t let the apparent science of the process mislead you into believing it can be relied upon. The map is not the territory.

I spent a decade of my life testing and developing “backcasting” computerized trading systems for the financial markets. I am intimately familiar with the promises and problems of the methodology. I have real time experience applying actual models into the future. In a nutshell, the best it can provide is a vague guideline – superior to these simple rules of thumb and way more sophisticated and scientific – but in the end it has flaws as well.

I state all this to help you see that retirement planning is both art and science and you would be served to not be deluded by the apparent accuracy at the “science”. There are many valuable scientific tools, but they are all limited by the undeniable fact that your retirement is in the unknown and unknowable future, but the tools you will use to plan it are predicated upon assumptions about the past. This is a fatal flaw.

Be careful. Monte Carlo has its limits and uses, Otar’s work has its limits and uses, as do some of the more conventional tools – not to mention the simple rules of thumb in this article.

For my own personal planning, I have used all the above and more because each has shown me a different piece of the puzzle. In the end, my favorite is to drop all asset based assumptions (Monte Carlo, Otar, rule of thumb – basically all of them) and build a cashflow based model. It has the advantage of eliminating nearly all the assumptions required by the asset based models and increases the flexibility to include other streams of income like my blogging, book sales, etc..

Anyway, this is a long winded reply but I wanted to be as helpful and clear as possible. Beth, I’m trying to make two points: this article is targeted to help people who are not using the existing, more sophisticated tools already. If you are already using those tools then you might find these simple rules of thumb provide a helpful additional perspective. Also, when using more sophisticated tools don’t be deluded by the apparent science and believe the output will even remotely model your future retirement. If it does it is random luck, and I wouldn’t want to base my future future on random luck. All asset based models require a number of assumptions about the future (Otar’s included) which make them prone to failure since the future is by definition – unknown and unknowable.

Hope this helps, Todd

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Beth September 21, 2009 at 7:03 pm

@ Todd — Yikes! I didn’t mean to put you on the defensive! I’m sorry if you took my comments as attacking you or your ideas :(

Right now, the rates seem “laughable” because the recession hasn’t exactly made me optimistic :) When everyone talks about compounding, no one really talks about how much it will damage you if you’re missing out in the early years. (on the compounding, not the saving). Right now my rule is “do as much as you can.” The rules you listed above provide a good framework.

Thanks for your time and comments!

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Todd R. Tresidder September 21, 2009 at 7:42 pm

@ Beth – Sorry if my reply came across as defensive – that was not my intention.

I appreciate the conversation and was only trying to address your statements that Otar has “a better sense of what is going on” and that the rules of thumb discussed above were “meant for a period of history we no longer live in.”

I disagree with both those statements and thought it important to support the claims made because I not only believe in them passionately but also believe they are important to understand.

Maybe my passion for the subject accidentally came through as “defensive.”

Again, thanks for your input.

Todd

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Michael Harr @ TodayForward.com September 23, 2009 at 12:10 am

@Todd – I’m glad to see you use the net worth-to-expenses multiple because it isn’t talked about nearly enough. I think you top out at 25x, but really it should extend to around 33x for early retirees. There were a number of studies completed using Monte Carlo Analysis that you are probably familiar with and it was this information that gave legitimacy to these multiples. While these are rules of thumb, they are incredibly accurate when an individual tries to decide when to retire.

Also, it is important to note that these multiples when scrutinized under Monte Carlo hold up quite well even accounting for the toughest of downturns in stock prices.

While there were some comments about being well behind for retirement and other concerns of not having enough when the time comes, just remember that no matter your circumstances, it’s human nature to find a way through. I’m kind of a Four Agreements guy in that we can only do our best. If you fall short of your goal, but have done all that you can to get there, you’ll still be satisfied with your effort and the odds are very good that you’ll be well ahead of your peers. So what if you didn’t hit $3 million….if you’re at $1.5 million, it’s not so bad.

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Todd R. Tresidder September 23, 2009 at 8:49 am

@Michael Harr – I agree completely. Thanks for adding those points.

Todd

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Pete from CA September 24, 2009 at 1:02 am

Todd,

I’d be very interested in the details of those mathematical expectations that allowed you to sell equities at the end of the 90s and sell real estate in 2006. This kind of a market timing ability seems to be far more important to retirement than any rule of thumb of how much you should save.

Thanks in advance,
Pete from CA

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Michael Harr @ TodayForward September 24, 2009 at 11:07 am

@Pete – It was easy to see the overvaluation in stocks in the 1990s using p/e or p/e10 as both were pointing to expensive stocks. You can read more at http://www.econ.yale.edu/~shiller/data.htm

Same thing with real estate. You can see the data here at http://research.stlouisfed.org/fred2/data/HOUST.txt There was a really nice chart that the NAR put out a few years back, but I think you have to pay for it now. If you put the data from the link into a spreadsheet and make a chart, you’ll see that housing starts were well above historic norms and even above the historic range meaning it was pretty clear things were overpriced.

As for pulling out at the right time…I wouldn’t bother with it. When you see bubbles (they’re easy to spot when you look at empirical data and ignore media), generally it’s a good idea to simply pare back or target your money rather than pull out. The reason is that you could see the stock market was expensive as early as 1996, but you would have missed out on substantial gains through 1999. During that time, instead of going to cash or bonds, you could have simply reduced your exposure to stocks and with the stocks remaining, targeted the largely ignored part of the market – old companies with earnings that were trading at very attractive valuations.

With real estate, it was more of an all in or out. Your home is NEVER an investment, but if you were investing in other properties, you likely would leave the market altogether because of the high dollars required to sink into each investment which spells greater risk…not to mention if the properties were highly levered. An alternative (assuming the capital was there) would have been to decrease leverage and go with high equity and rent properties. Either way, I’m not a big fan of real estate in general because of the headaches and the fact that real estate is always local and never national.

At any rate, the empirical data was there for each bubble, but getting out is difficult to time perfectly and a bit of a foolish pursuit. However, if you pare back when assets are expensive or target less susceptible pieces of an asset class, you’ll be the better for it. Ultimately, it’s not really about getting the ‘best’ return, but the ‘best return you can stomach’.

BTW, I’ve always loved the quote, “Risk is the price you never thought you’d have to pay”. I think our experience this last decade gives this old saying some serious meaning.

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Todd R. Tresidder September 24, 2009 at 11:13 am

@ Pete from CA. – Your intuition is accurate. Let me add a little detail to your insight to help clarify for other readers…

When building wealth the most important part of the equation in the early going is how much you can contribute. The reason is simple: if you have 2K in your retirement savings and add 4K in contributions you tripled your account. Alternatively, if you increase your rate of return from 5% to 15% because of superb investing your change in savings is only $200 (15%*2K=300, 5%*2K=100 and 300-100=200) or a 10% increase. Contributions grows account 200% – investment skill grows account 10% – hmmm….

In the later stages of wealth building (which is where I’m at) the math is flipped upside down. When you are working in millions (or even hundreds of thousands) the return on your assets will dwarf the contributions you can make. The most important factor to success at this stage is your investment skill.

So your strategy as a wealth builder is to save as much as you can as early as you can in the early going and focus that time on building your financial and investment intelligence. Reading Jen’s and my blogs are great ways to regularly increase your financial intelligence. The reason your financial intelligence is so critical is because as your savings grows your investment decisions will make or break your financial success while your saving ability will diminish in importance. So learn your investment lessons early with smaller dollars and that way when you hit bigger dollars you aren’t making expensive, obvious mistakes.

One last point to your comment that plays into the financial intelligence issue: another reason your intuition is correct is that every study published supports the conclusion that upwards of 90% of your investment returns is determined by your asset allocation. In other words, if you are a stock picker you are spending 90% of your effort working for the last 10% of return – not real smart. You intuitively know that is correct because it doesn’t matter what stocks or funds you held in 2008 – they all went down together. That is because the asset class you allocated to was wrong.

It just happens that valuation is one of two statistically robust ways to manage asset allocation. I will be teaching both valuation and the other statistically robust way to manage asset allocation in future posts to my blog and in a forthcoming ebook that is about half-written titled “Buy and Hold Myth”.

Hope that helps clarify, and thanks for sharing your thoughts, Pete.

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Pete from CA September 24, 2009 at 7:42 pm

Thanks for your replies Michael and Todd.

Michael, to me the fact that it was “easy to see” that stocks were overvalued as early as 1996 simply means that it was not easy to see this at all. Or maybe I should say it was easy but at the same time dead wrong, if that makes any sense (the S&P500 was barely above 700 at the end of 1996 — it didn’t go that deep again until March 2009. And in the meantime it paid dividends.) The advice of not pulling out of stocks but instead focusing on companies with attractive valuations sounds good on the surface but doesn’t address the primary problem, which is how you determine whether a company’s valuation is attractive or not.

Similarly, I am wondering what conclusions you draw from the housing data you linked to. I did put it into an Excel sheet and it seems to me like 1500 is about the “norm.” Guess what, we have been consistently above that norm since 1997. Why would you not have sold in 2000, or 2003? If we accept that this data has any kind of predictive value for the future, then the most crystal clear conclusion I can draw from it is that right now is a hell of a time to buy real estate, as the numbers are down to ~500, which is not only way below the norm but simply an unheard-of depth (the previous minimum was around 800 in 1991). If I combine this info with the current P/E of the S&P 500, which is above 100 at this point if I am not mistaken, then I think it should be obvious that everyone should immediately get out of stocks and buy real estate. Would you be willing to bet your life savings on this?

Todd, I bookmarked your blog and I’ll be looking forward of the details of your valuation method.

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Michael Harr @ TodayForward September 25, 2009 at 12:04 am

@Pete – Your comment has me concerned. First, there is NEVER a time that you bet your life savings on any one asset class. Diversification provides a host of benefits, the most important of which is to always have a meaningful portion of your savings protected against declines in various asset classes and that these asset classes offer as little correlation as possible.

Next, the data provided doesn’t allow for a conclusion, but a starting point as these pieces are red flags that signal investors to do further research. Yes, housing starts are at/near all time lows, but you have to put that into perspective. We are coming off of a housing binge and it will still take some time to move back closer to the historical averages. In addition, you must factor in interest rates, household income, inflation, population growth, etc. There is always more than a single chart or data point in an analysis, but these red flags were screeming for attention, yet little was paid. Instead, investors, Bush’s Administration, and the media focused on the wonders of real estate – the investment that couldn’t go down in value.

W was so happy that more Americans owned their own homes than at any other time in history, but if that’s the case, how much more demand could exist for housing? Our population hasn’t grown all too much. How much more could values increase? Who exactly was going to buy more housing? As we’ve seen, we overbuilt. We financed the overbuilding in risky ways, and now we pay the price.

As for stocks, take the p/e10 and overlay it with the S&P 500 and you’ll see that leading up to massive declines, p/e10 was significantly above the mean in every case. Again, you can’t use just one piece of data to draw a conclusion, there are other factors that must be considered.

With respect to your question of finding companies that have attractive valuations, I don’t do anything with that (never have recommended individual stock trading unless you’re a professional money manager). There are plenty of fund managers that have demonstrated their worth and you can find them rather easily. As an example, I have been an Acorn Fund investor for a long while and under Ralph and then Charlie, they’ve beaten the pants off the index. Why would I want to try to beat those guys? Theirs is a growth at a reasonable price model that has performed well over time.

There are different styles of investing that go beyond simple ‘growth’ or ‘value’ and knowing the difference is what is important to investors. Style difference alone would predict winners and losers from high p/e markets. Growth will underperform value when the market tanks. Growth at any price will be the biggest loser and deep value will be the biggest winner. I don’t believe in trying to pick individual stocks, but I do like to pick managers and styles because this is a considerably easier task.

One more point, as this is getting to be far too much for a comment, there is no such thing as a surefire predictive model that tells you exactly when to ‘cash in your chips’. To determine this, you would require the trillions of inputs based on the decisions that billions of human being make at any given point in time. Obviously it’s not possible. However, you CAN be alert to red flags that pop up from time to time and elect to moderate exposure to potentially overvalued asset classes. I use the term moderate because while the odds (like in 1996 with the stock market or 2000 with real estate) may say a decline is approaching, they can NEVER tell you the day the decline will come. That’s what hindsight is for.

Hopefully this makes sense.

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Michael Harr @ TodayForward September 25, 2009 at 12:25 am

@Pete – I just realized I may not have answered your questions. I am slightly underweighted to stocks, don’t hold real estate as a major asset class (there are REITs that are held inside of the stock mutual funds), favor shorter maturities in fixed income, have loved corporate bonds since last October, and overweight towards cash. Yes, it is a good time to buy some real estate. Given a choice between real estate and stocks, I’ll take stocks every day of the week and twice on Sunday. I don’t consider direct ownership of real estate to be a better investment than more marketable securities. I focus little on individual securities selection and more on monitoring relative valuations of asset classes and categories. There it is in a nutshell.

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Pete from CA September 25, 2009 at 1:01 am

@Michael:

“First, there is NEVER a time that you bet your life savings on any one asset class.
[..]
the data provided doesn’t allow for a conclusion, but a starting point as these pieces are red flags that signal investors to do further research.
[..]
you can’t use just one piece of data to draw a conclusion, there are other factors that must be considered.”

In other words judging valuations of asset classes is not that easy, after all.

“There are plenty of fund managers that have demonstrated their worth and you can find them rather easily.”

I was lead to believe that this is not so. It is easy to find the fund managers that outperformed the market last year, or during the past 5 years, but I believe there is plenty of evidence that past performance doesn’t guarantee future returns. If you feel that you have a method for identifying the fund manager who will beat the market during the next decade then please share your insights.

What’s the ticker symbol for the Acorn Fund? ACRNX has data on Yahoo Finance since 1986 and it significantly underperformed the S&P500 since then. Did it have large distributions that are not reflected on Yahoo Finance?

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Michael Harr @ TodayForward September 25, 2009 at 8:55 am

@Pete – You’re obviously being thick because the ACRNX data you purport is false. Please use a reliable source for information and use a best fit index. ACRNX is not a large cap fund and comparing it to the S&P 500 isn’t fair to the S&P 500. http://quote.morningstar.com/fund/f.aspx?t=acrnx It seems to me that ACRNX is more than 9% per year above the S&P 500 over the last 10 and if you take the time to go further back, you find a similar story of outperformance going back to 1970. By the way, why so defensive?

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Todd R. Tresidder September 25, 2009 at 10:55 am

@Pete and @Michael,

I’ve enjoyed your conversation from the sidelines and will now toss my hat into the ring…

My first statement is that active asset allocation is not an easy game. Nor is it an easy game to pick managers who will outperform in the future. Notice, I’m not saying impossible – I’m just saying it is not easy.

Intuitively, we know this is true because so many highly educated and deeply experienced professionals fail on a daily basis at both pursuits.

So anyway, that much we can agree on.

For me personally, I have been successful consistently (but not easily) at active asset allocation but have met with mixed results on finding managers who will outperform in the future. I’ve been in the active asset allocation game since 1984 real time through every combo of market condition so there is no chance my results are random. I spent 12 years testing and developing computer models while putting real capital at risk on those models for the last 25 years (I stopped research in 1997).

For that reason, I feel I understand the issues quite well and can teach the active asset side while I am still working out the bugs on selecting best managers. I always prove things with my own money first, then I further prove them into a system by teaching my financial coaching clients until they succeed with the same, then I provide the free article or paid ebook based on all that is learned.

With that said, teaching active asset allocation and risk management is too big of a subject to do it justice in a blog comment. Michael is partially correct in some of this statements, and Pete is also correct in the trouble he is having with them. It is like the Indian folk tale of the blind men and the elephant, where each blind man is experiencing different (but correct) pieces of the elephant. The blind man holding the tail sees the elephant like a rope, the blind man holding the ear sees the elephant like a fan, and the blind man holding the leg sees the elephant like a tree trunk. Each is partially correct in the version of reality he understands, but none is understanding the whole elephant.

That is what I’m experiencing in this conversation.

What I will say is you can successfully apply active asset allocation over the very long term (emphasis on very) with just valuation components but you will experience a lot of pain and require the discipline of a celibate monk to end up successful. Few have those abilities. In that way, Michael is correct in discussing valuation providing red flags to point a direction for further research. Similarly, Pete is correct in saying it is an indadequate stand-alone timing tool.

I disagree with Michael’s solution about never vacating an asset class 100%, but that is my personal preference and there are many experts who would disagree with me and agree with Michael. Where Michael is correct is it’s a mathematical fact concentration increases risk which places a much higher premium on active risk management. I just happen to be extraordinarily skilled at risk management so concentration works for me. That may not be true for others and will likely not be true for most readers of this blog making Michael’s position closer to correct for most readers but not a truth in and of itself as it was stated.

With that said, it is clear I have offered little of substance in this already too-long blog comment which takes me back to my opening. Active asset allocation and selecting managers who will outperform in the future are subjects too vast and deep to be covered in a blog comment.

Just to bring some perspective to the subject, I have one ebook partially written on these issues called the Buy and Hold Myth. The first part, debunking buy and hold as a viable long term investment strategy is already completed and is about 30 pages long. The universal response from the few close relations who have read it is they immediately dropped buy and hold as an investment strategy. It is conclusive.

The part that isn’t completed is offering people a solution that they can implement. I know what the solution is, I have taught it to coaching clients, but I have yet to get it into written form in a way that will hold up to the inevitable criticism that results from taking on a sacred cow in the investment world.

The other ebook is about investment risk management and is currently only in outline form sitting in a file drawer with much more work to do.

Anyway, I’m just trying to let you know the scope of the discussion you are both getting involved in here. I appreciate the conversation and both of your passion for the subject. It is a big elephant.

Thanks, Todd

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Michael Harr @ TodayForward September 25, 2009 at 1:33 pm

@Todd – You’re correct on all points so far as I can tell. To give a little perspective to the discussion, I come from a fee-based comprehensive financial planning background and as such, I am a generalist and not an investment specialist. As a result, I advocate individuals using whatever investment strategy works best for them. For buy-and-hold passive investors, putting together a well suited asset allocation, using low cost index funds/ETFs, and rebalancing periodically is just fine as long as they understand that the goal is to maintain solid relative returns and that absolute returns will fluctuate – sometimes wildly.

On the other end of the spectrum are tactical/dynamic asset allocators who will always look for the best places to invest on a continual basis. This strategy requires a great deal more effort to maintain and this is a good reason why most investors will need the help of an advisor or have a great deal of time available.

Sitting between these strategies is where I fall in methodology. This is where you design a suitable base asset allocation and make moderate changes to it based on asset valuations and personal circumstances. There is never an all-in bet, and it’s never as static as the typical buy-and-hold passive asset allocation strategy.

There are risks inherent to each of the three groups. Buy-and-hold followers believe that relative returns trump absolute returns and as such are also subject to the market ups and downs. The only protection is in the design of the initial asset allocation model since there is little in the way of adjustments made year to year.

Tactical/dynamic asset allocation followers do so in order to obtain better investment performance (meaning higher returns and/or better risk adjusted returns), but also have the potential to make the wrong bet and significantly trail a benchmark index.

Those in the middle get a little of both.

The reason I’ve used the middle ground is that maximizing investment returns has as much or more to do with the individual investor’s behavior during times of good fortune and hardship. If the buy-and-hold investor experiences a major downturn and sells, then the strategy has failed. If the tactical/dynamic asset allocator makes a bad bet, but then chases a return, the strategy has failed. If the middle grounders break strategy, then it has failed them. Ultimately, the investment strategy most suitable to an investor is the one that they can stick to over the long run through all kinds of markets – good, bad, or ugly.

In short, investor behavior limits the effectiveness of any given investment strategy and finding the strategy that matches one’s behavioral ‘limits’ is the one that should be used.

As an aside, I’ll never forget the DALBAR study released in 2000 that showed a 16% average annual return since 1986 in the S&P 500 with the average investor getting just 5.32%. Much of the difference was attributed to chasing returns, but the chase usually stems from a lack of a well defined strategy and/or not fully understanding the chosen strategy’s limits.

At any rate, enjoyed the post and the discussion.

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Pete from CA September 26, 2009 at 8:59 am

@Michael

The data on Yahoo Finance shows that the S&P500 outperformed ACRNX between 6/14/1985 and 9/1/2009 by about 100%. That is a fact that anyone with basic computer skills can verify. You are right that the tables were turned over the past 10 years but what does that prove? I don’t care what the return was for the past 10 years, I want to know what the returns will be over the next 10. What makes you think that the ACRNX performance between 2009 and 2019 will be like it was between 1999 and 2009, and not like between 1985 and 1995?

Saying that a comparison between the S&P500 and ACRNX is not fair is beside the point, as far as I am concerned, because the S&P500 is the standard no-brainer stock investment vehicle that you can invest in with zero effort. I think it is reasonable to expect that your investment choice should beat it if you put any effort into selecting it. But guess what, the S&P400 Midcap index (ticker symbol ^MID) outperformed ACRNX over the past 2, 5, or 10 years. Again, according to Yahoo Finance.

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Pete from CA September 26, 2009 at 9:44 am

@Todd

“you can successfully apply active asset allocation over the very long term (emphasis on very) with just valuation components”

According to Jeremy Siegel’s statistics, over the very long term a diversified stock portfolio has historically generated 6.8% real return (yearly, on average). How does active asset allocation improve on this?

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Michael Harr @ TodayForward September 26, 2009 at 10:23 am

@Pete – I don’t use Yahoo! Finance for research, but for the aggregated articles. However, I did look into your response and the reason we have a difference of data is because you are using the chart function that does not include dividends and capital gains disturbutions reinvested – meaning the total returns are not represented by the information you are quoting. The charts available on Yahoo! Finance are for technical analysis for stock traders and such, and they are not total return growth charts. For this reason, you need to use a different charting service if you want to compare mutual funds over the long-term and the chart you’re looking for is a total return chart or cumulative return chart that includes all fund distributions.

Also, ACRNX has returned 14.5% per annum since inception in 1970. This leaves the fund in very small company as it has consistently outperformed all stock indices over longer periods of time (10 years or more). I apologize for giving you a hard time, as it looks like you just had some bad data. If you’re really into mutual funds and ETFs, Morningstar is probably the best data source available.

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Michael Harr @ TodayForward September 26, 2009 at 10:36 am

@Pete – The reason I believe that long-tenured, veteran fund managers who have beaten the index over the long-term will continue to do so is that this particular group has demonstrated their investment strategy works. These long in the tooth managers don’t change their strategy based on market conditions the way that younger, less seasoned managers do. In short, I have faith that they will weather any storm as they’ve done it in the past and I believe they will do it again. Does it guarantee outperformance? No, but it does seem to make it more likely.

Earlier this year, Smart Money did a feature on 100 battle tested mutual funds and the list has some of the best money managers on the planet who have been doing it better and longer than others in the business. Besides, the psychological principle of rigidity favors veteran fund managers sticking to their guns during good times and bad.

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Todd R. Tresidder September 26, 2009 at 2:20 pm

@ Pete – (What kind of returns from active asset allocation?) As stated above, I need to complete the research to provide a definitive answer that will hold up to public scrutiny. That is what is holding up publishing that book. My own experience and related research indicates low to mid-teens with reduced risk is reasonable.

See http://www.crestmontresearch.com/pdfs/Stock%2020%20Yr%20Returns.pdf for an example of the expected returns based on valuations. Research by Hussman and many others corroborate the above. (Please understand when examining this data that it is not a risk management system or a trading system. It is merely showing the robust statistical inverse correlation between investment returns and valuations in the stock market. It points a direction, but does not provide an actionable solution. The difference in the two is very large.)

Anyway, if you are on my newsletter list you will know when the book is released and you will have a definitive answer at that time – hopefully sooner rather than later, although I have many projects on my plate.

With that said, the probable answer is that related research and actual practice points toward low to mid teens with significantly less risk. I just can’t hand you a set of actionable rules with final, supporting research at this time to give you a definitive answer.

Hope that helps, Todd

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Pete from CA September 27, 2009 at 11:38 am

@Todd

I am curious what you are reading out of that PDF. What is the value in comparing returns to the *change* in P/E? I don’t know what the P/E will be 10 years from now, so I can’t make an investment decision based on the future change in P/E. In fact it would appear a no-brainer that there is a strong correlation between the change in P/E and the return because both of them are strongly correlated to price.

I am not sure what the bottom right quarter is trying to say but I think it’s pretty much the same thing as the upper half.

The bottom left quarter is a good one, and of course I’ve seen this picture before. That, to me, shows that we have quite a few examples of a low P/E associated with a low return. To put it another way, there is a huge difference between the data shown in that graph and being able to sell all equity holdings at the and of the 90s and sell all real estate holdings in 2006.

The biggest problem I have with all this, however, is the timeframe. 20 years is too long. That’s what I meant when I asked how valuation based asset allocation improves upon a passive stock portfolio, not how the returns will be better (sorry about not being clear in my question).

Why is a 20 year timeframe a problem… Say I need $30K/year to survive (ie. financial freedom), and I assume a modest (?) 6%/year real return. How much money do I need for financial independence? The naive answer is $500K, right? However, if the shortest timeframe over which that 6% yearly return can be assumed is 20 years, then I need not $500K but ($500K + 20*$30K=) $1,100K for financial independence.

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Pete from CA September 27, 2009 at 11:58 am

@Michael

Does the Morningstar graph include dividend reinvestment for the indices? I looked at the S&P400 index on both Morningstar (as shown in comparison to ACRNX) and Yahoo and there is a small difference (Morningstar shows bigger gains) but the difference is not big enough to convince me that this is due to Morningstar including the dividends.

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Michael Harr @ TodayForward September 27, 2009 at 6:48 pm

@Pete – Yes, the ‘growth of $10,000′ chart always includes reinvested dividends and (for the mutual fund in question) capital gains distributions. The small difference you saw is probably attributable to the delay in data from Yahoo! Finance compared to what is on Morningstar. When I was looking at it, there was a 5 day gap in the return number (not sure why since Yahoo! is getting much of their information from Morningstar anyway).

I did find it very troubling that both providers neglect to clearly define what is being charted. I’ve used Morningstar’s Principia and Advisor Workstation products for years, so I wasn’t as familiar with their retail site. Regardless, I think both sites could do a much better job in detailing the purpose and limitations of their charts, but whaddoiknow?

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Todd R. Tresidder September 28, 2009 at 9:27 am

This is my last comment reply and then I am signing off to get back to other work as it appears all current conversations are complete except Pete’s. I’ve enjoyed the feedback and appreciate everyone’s interest in these important subjects.

@ Pete – regarding your comment about hindsight on change in P/Es, please look at the chart carefully. It is clearly labeled as based on starting P/E’s. There is no hindsight. I can understand how you might have been confused by the bottom box showing the change in P/E, but that is just an outcome. It is not the causative factor. The starting P/Es are known in real time just as they are known today. This chart examines equity returns into the future based on a known PE today. If you look closely at the results you will see it is every bit as important and significant as I portrayed it.

BTW, this is not the only study. Numerous other researchers have noted the identical phenomenon and produced studies showing consistent results to this one. I just chose this study because it was easy to get at. You can find others as well.

Regarding your other questions, you are opening entirely new conversations. If you are truly serious about learning this stuff then I would encourage you to consider financial coaching as it appears you have many questions unresolved which would probably be best handled outside the arena of blog comments.

Your questions on “how much is enough to retire” are handled completely by my ebook with the same title available on my web site. Jen provided links above in the original guest post.

I’ve enjoyed the conversation and wish everyone at MillionaireMommyNextDoor the best. I look forward to engaging with you again on the next guest post.

Thanks Jen! I am passing the baton for additional comments to this post back to you.

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andy July 22, 2010 at 9:45 am

In the current market environment, a 5% return is hard. So I would say you need to multiply by 30 to determine a suitable nest egg. However, social security is still a big factor to consider – because it could make up 20% of people’s income in retirement.

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