Personal Finance on a Napkin

[RonBoyd]

Carl Richards, a financial planner, has been explaining the basics of money through simple graphs and diagrams.

NYTimes: Your Money

For instance:

3. Your portfolio was worth $500,000 at the top of the tech bubble in early 2000, and you still think about that value each time you open your statement and see that it’s worth less than that. You just want to get back to your high-water mark of $500,000.

This may not have any impact on your decisions, but it sure is affecting your life. I know people like this, still holding on to a value in the past. It is like that guy next door who is still telling stories of his glory days in high school football.

The past is the past. All that matters now is making the correct decision for today.

or

Investor behavior matters a lot. In fact, it probably matters more than skill. To understand why this is true, first you need to understand one fundamental concept: Investment returns and investor returns are almost always different.

An investment return is what you get if you invest your money at the start of a period and then don’t touch it. You don’t buy or sell. You just buy and hold. But real people in the real world don’t invest that way.

Real people are always chasing performance and investing by looking in the rear-view mirror. The result of this never-ending hunt for the best investment causes us real trouble.

 

[rescueme]

I would have to agree that folks (at least me) look at any "high water mark" in our investment history to use as a cornerstone in any future returns.

I fell into this "trap" after retirement in early 2007. 2008 came along and lowered my retirement portfolio drastically (as it did for most other folks). In late 2009, I wanted to do a bit of "restocking" of my cash bucket (used for retirement income) but felt that I could not do anything since I was still "down", regardless that 2009 restored most of my perceived losses of the prior year.

After much soul-searching (and reading some articles on this "emotional response" to investing), I realized that even after a reduction in portfolio, I still had more than enough to meet my retirement goals to age 100.

I then did an analysis that measured my cost of purchase over the years of funds vs. their current value. Since I (along with my DW) are long term holders and I hold extensive records (going back to 1982), I found that even though I was below the high-point of early 2007, I was certainly well ahead of the original cost of purchase (sometimes, many hundred %).

So I swallowed my pride and sold a bit off; sure below the all time high, but above purchase price. That's when I understood that "paper profits" are just that; it makes no difference what you "imagine" a fund is worth, but it doesn’t really matter till you actually sell that fund and compute if you are up/down, based upon "actual numbers".

I believe I felt the "standard way" that all accumulators do, when they are working toward their "number". However, since I was fortunate to hit (and even exceed) my number by quite a bit, I was willing to consider alternate theorems.

So the napkin is correct, in my mind. However that $50 shown should not be the prior high-water history, but rather than the actual cost of purchase of the holding.

I know that a lot of folks in the world consider "paper profits" are all that is important (I was one of them). Paper profits are a good indicator of what's happening overall (such as how fish are doing in a polluted river) but it does not indicate the future (you can always clean up a river).

Only when you buy (set the "mark") and sell (compare to the "mark") can you determine if you actually made a profit and more importantly, on track to meet your retirement income needs...

 

[Gone4Good]

I would have to agree that folks (at least me) look at any "high water mark" in our investment history to use as a cornerstone in any future returns.

Even supposedly "professional" Wall Street investors do this. I know one such gentleman who's successful career is based on giving investment advice to institutional investors (from Fidelity to SAC Capital). But in his own portfolio he sets price targets governed by his average cost, not what he objectively thinks the investment is worth. It is remarkable to see.

Loss avoidance is a powerful force. I have a simple rule to cope with it. Any investment in my portfolio that I wouldn't buy again at today's price, I sell at today's price.

 

[walkinwood]

While I do track the real value of my portfolio at ER (May 1, 2008), I don't "hold" on to that value. I track it because my 4% of initial portfolio value SWR is supposed to leave the purchasing power of the portfolio intact over long periods - and I want to see if it does. Right now, it doesn't - but we're only 2+ years into ER.

Thanks for the excellent link. Lots of other napkin drawing too.

 

[haha]

While I do track the real value of my portfolio at ER (May 1, 2008), I don't "hold" on to that value. I track it because my 4% of initial portfolio value SWR is supposed to leave the purchasing power of the portfolio intact over long periods

This is one of the most intersting paradoxes (or delusions) of the whole asset allocation/SWR paradigm.

Say Joseph retired October 2007 with $1mln. With this he bought 10,000 shares of World Market Index, a very diversified balanced index fund. Josefina retired roughly 18 months later, in March 2009. She also had $1mln, and invested it in the very same low expense fund that Joseph bought about 18 months earlier. But her million bought 15,000 shares, 50% more shares than Joseph was able to buy.

So each retired with $1mln, and each expected a "safe" 4% withdrawal rates, adjusted annually for CPI inflation, so they each take $40,000 the first year and CPI adjust the withdrawal in the following years

Is it even remotely possible that these two people should have the same expectations of success?

Not in the universe that I know.

Ha

 

[ziggy29]

So each retired with $1mln, and each expected a "safe" 4% withdrawal rates, adjusted annually for CPI inflation, so they each take $40,000 the first year and CPI adjust the withdrawal in the following years

Is it even remotely possible that these two people should have the same expectations of success?

Not in the universe that I know.

Translation: Valuation matters -- it's just hard to translate it into a fixed, mechanical formula. Same as with asset allocation, I think. Conceptually it seems "right" that one should allocate less to stocks when they are at 1999 nosebleed levels and overweight them in March 2009 when they are pretty cheap -- but there's no good mechanical way to express it so many people don't even try.

 

[REWahoo]

Is it even remotely possible that these two people should have the same expectations of success?

Not in the universe that I know.

Depends on how you measure success.

Using a 4%, $40,000 initial SWR for both, history says* Josephina would likely have a much larger portfolio balance than Joseph at the end of 30 years.

The expectation of success for both would probably be enhanced if Joseph hooked up with Josephina and they pooled their resources.

* Yes, past performance is no guarantee of future results...

 

[Gone4Good]

Is it even remotely possible that these two people should have the same expectations of success?

Not in the universe that I know.

Ha

Yes. Because if the PV of all my future spending is $100, I still have a 100% chance of success regardless of whether I start with $200 or $300. The only difference is the margin of error.

 

[dex]

Carl Richards, a financial planner, has been explaining the basics of money through simple graphs and diagrams.

Would we be discussing this if it was a power point presentation instead of a napkin? It is good marketing of a simple idea.

I think it is a psychological mistake to track the highs of your net worth. If it goes down people tend to see what they 'lost', feel bad and possibly change their behavior because of it.

I do track my net worth at 12/31 of each year - an arbitrary date. You could use your birthday. I also, project my net worth 30 years out using conservative growth rates and incorporating estimated spending.

The reason to track your net worth is for perspective and certainty. Without that what we have is emotion - usually fear. You can not deal with generalized fear. The first step is to give the fear a name or description; then you can deal with it.

 

[MichaelB]

3. Your portfolio was worth $500,000 at the top of the tech bubble in early 2000, and you still think about that value each time you open your statement and see that it’s worth less than that. You just want to get back to your high-water mark of $500,000.

This may not have any impact on your decisions, but it sure is affecting your life. I know people like this, still holding on to a value in the past. It is like that guy next door who is still telling stories of his glory days in high school football.

This is common around here. Many posts on this forum, especially in threads polling for returns, carry a reference to the all-time high or a recent stock market peak.

 

[ERD50]

This is one of the most intersting paradoxes (or delusions) of the whole asset allocation/SWR paradigm.

Say Joseph retired October 2007 with $1mln. With this he bought 10,000 shares of World Market Index, a very diversified balanced index fund. Josefina retired roughly 18 months later, in March 2009. She also had $1mln, and invested it in the very same low expense fund that Joseph bought about 18 months earlier. But her million bought 15,000 shares, 50% more shares than Joseph was able to buy.

So each retired with $1mln, ...

Is it even remotely possible that these two people should have the same expectations of success?

But isn't there also a paradox (or delusion) in your example - the same one I see on the home page of FIRECALC?

If a broad index dropped 33% in 18 months, and Josefina still had $1mln to invest, then the two were not equal to start with. Joseph's account dropped from $1mln to $667K in that time, so Josefina must have had $1.5mln 18 months ago, when Joseph had $1mln. How else could she still have $ 1mln to invest after the market drop (other than being in cash, and then this is a market timing story).

So yes, I would expect Josefina to have a better chance of success - more money is always better.

Maybe I'm looking at it wrong, but I think that is a big flaw in the intro story to FIRECALC.

-ERD50

 

[MichaelB]

Translation: Valuation matters -- it's just hard to translate it into a fixed, mechanical formula. Same as with asset allocation, I think. Conceptually it seems "right" that one should allocate less to stocks when they are at 1999 nosebleed levels and overweight them in March 2009 when they are pretty cheap -- but there's no good mechanical way to express it so many people don't even try.

Agree - valuation matters. Maybe Shiller PE10 can help set a reasonable expectation for future returns.

Is it even remotely possible that these two people should have the same expectations of success?Ha

Even if the market were “reasonably valued” when he retired, there’s nothing wrong with each having reasonable expectations of success. We are comparing his expected success rate on 10/07 vs her expected success rate on 3/09. Just because his was reasonable doesn’t prevent a crappy outcome.

 

[LOL!]

Agree - valuation matters. ....

And luck matters even more.

 

[ziggy29]

And luck matters even more.

Which increasingly seems influenced by when you were born.

 

[MichaelB]

And luck matters even more.

No, it gets in the way and obscures one's vision.

 

[ziggy29]

No, it gets in the way and obscures one's vision.

It absolutely is a factor. It should not, however, be used as a convenient excuse for failure.

I think folks born around my time are going to be among the most screwed, long term, from all that's happening today -- particularly in the area of employment and retirement issues. But that's still no excuse for me to shrug my shoulders and say "what's the use." It may not seem fair that I have to knuckle down that much harder than those born a generation before me, but life ain't fair and the alternative is poverty or working until I die. No thanks, I'll try harder.

 

[MichaelB]

It absolutely is a factor. It should not, however, be used as a convenient excuse for failure.

I think folks born around my time are going to be among the most screwed, long term, from all that's happening today -- particularly in the area of employment and retirement issues. But that's still no excuse for me to shrug my shoulders and say "what's the use." It may not seem fair that I have to knuckle down that much harder than those born a generation before me, but life ain't fair and the alternative is poverty or working until I die. No thanks, I'll try harder.

Nothing lucky about living beneath your means and saving the difference.

Agree with your post, I didn't really mean luck doesn't count - but I do think it gets in the way as some confuse it with ability.

 

[bbbamI]

This is common around here. Many posts on this forum, especially in threads polling for returns, carry a reference to the all-time high or a recent stock market peak.

Yep.

I've been keeping track of our investments for several years on a monthly basis.

Looking back when DH retired last year (mid year), we have $50k more in our total net funds. If I take a look at 12/31/09 we are $10 ahead as of this date ($50,010.).

Since we no longer add to the pot, I guess we're doing ok. It sure would be nice to never have to touch the principal...

 

[Rich_by_the_Bay]

This is one of the most intersting paradoxes (or delusions) of the whole asset allocation/SWR paradigm.

Say Joseph retired October 2007 with $1mln. With this he bought 10,000 shares of World Market Index, a very diversified balanced index fund. Josefina retired roughly 18 months later, in March 2009. She also had $1mln, and invested it in the very same low expense fund that Joseph bought about 18 months earlier. But her million bought 15,000 shares, 50% more shares than Joseph was able to buy.

So each retired with $1mln, and each expected a "safe" 4% withdrawal rates, adjusted annually for CPI inflation, so they each take $40,000 the first year and CPI adjust the withdrawal in the following years

Is it even remotely possible that these two people should have the same expectations of success?

Not in the universe that I know.

That's a good and clear analogy, Ha. It's also why we try to not invest our life savings in one fell swoop. Had that couple in your example invested periodically over long periodds of time, the discrepancy would diminish accordingly.

Still, remnants of what you are referring to persist: if you choose to take 4% SWR the valuation on decision day are all that matter. Wait a month or two and everything will be different, sometimes markedly so.

I kind of favor a percent-of-portfolio distribution plan for that reason. It responds to bottom line market value on a periodic basis.

 

[rescueme]

It sure would be nice to never have to touch the principal...

Especially if you're not his DW/GF ...

 

[ERD50]

That's a good and clear analogy, Ha. It's also why we try to not invest our life savings in one fell swoop. Had that couple in your example invested periodically over long periodds of time, the discrepancy would diminish accordingly.

Actually, I don't think that is what is being illustrated here at all. Or if it is, it isn't very typical.

For the scenario to play out as you are painting it, it means our two 'J' investors kept their entire portfolio in a MM while they were accumulating, and then lump sum invested this money in an equity fund when they retired. That's backwards from the typical action of getting more conservative as we age.

If they were both investing similar amounts periodically over a long period of time, they'd both have about the same amount of funds, because they both would have experienced the downturn (only offset by 18 months of income versus spending).

Am I wrong? Maybe I'm looking at it backwards, wouldn't be the first time.

-ERD50

 

[Rich_by_the_Bay]

Actually, I don't think that is what is being illustrated here at all. Or if it is, it isn't very typical...

Am I wrong? Maybe I'm looking at it backwards, wouldn't be the first time.

I could see Ha's scenario happening in a windfall situation.

If I were ever so fortunate, I'd probably want to get that windfall invested sooner rather than later but I am not sure I'd do it in one shot.

 

[bbbamI]

Especially if you're not his DW/GF ...

Won't touch this...

 

[ERD50]

I could see Ha's scenario happening in a windfall situation.

That could be - again, assuming that the windfall-er ( windfall-ee? is there such a word?), had it all in MM.

What I'm really getting at is it isn't the typical retiree scenario, and therefore not a very useful (and maybe harmful?) way to look at it for most all of us.

To look at it from a positive angle - sure, I would rather retire with $1M after a big drop in the market than retire with $1M at the peak of a bubble. But that does not explain where that $1M came from - it ends up not being apples-to-apples. Assuming a typical accumulation phase and and typical AA, it really describes one retiree with more money than the other.

And that is an obvious choice.

-ERD50

 

[MichaelB]

Actually, I don't think that is what is being illustrated here at all. Or if it is, it isn't very typical.

For the scenario to play out as you are painting it, it means our two 'J' investors kept their entire portfolio in a MM while they were accumulating, and then lump sum invested this money in an equity fund when they retired. That's backwards from the typical action of getting more conservative as we age.

If they were both investing similar amounts periodically over a long period of time, they'd both have about the same amount of funds, because they both would have experienced the downturn (only offset by 18 months of income versus spending).

Am I wrong? Maybe I'm looking at it backwards, wouldn't be the first time.

-ERD50

If their primary source of retirement assets was generated from stock options and lump sum separation payments it could be a situation many faced in ’00-’02 and again in ’07 –’08. While I don’t have precise records, of the money I had when I retired (9/99) more than 90% was generated in the previous 5 years, between 50% - 75% was in cash or very short term cash eq., and I invested most of it in early ’00. While I did not face the dramatic situation in Ha’s example, my early FIRE years could easily have become my short sabbatical instead.