Investment planning

Recognizing that every store of value, even a mattress, is an investment with potential risks and rewards, then anyone who possesses something of value is an investor. A natural first question, then, is, "How should I invest?" That is, into what asset classes should I place my funds and in what proportions? Or, what should my asset allocation be and how do I determine it and adjust it over time? The discussion below attempts to provide guidance in addressing that question using the canonical example of saving for retirement. However, some (not all) of the techniques and tools presented below can be applied to other savings goals.

Investment is risk. It is not possible to separate the two. So a natural place to begin is an assessment of one's appetite for risk.

Willingness, Ability, and Need
The canonical measures of one's appetite for risk are willingness, ability, and need. Willingness to take risk is your comfort level with potential or actual loss of principal associated with an expected return. For example, suppose a hypothetical investor has $1,000. His willingness for risk is how readily he would take the chance of losing some of it for the chance of earning an expected profit. For instance, he might feel comfortable taking the risk of a 50% probability of losing half the investment ($500) in exchange for a 50% probability of doubling it (to $2,000). Or he might not feel comfortable with that level of risk but would be willing to risk a 25% probability of losing half for a 75% probability of doubling it. His willingness for risk is higher in the first example than the second.

A rule-of-thumb test for willingness to take risk is the so-called "sleep test". Having made or just contemplating an investment decision with a certain level of risk, if you can sleep well at night then it passes the sleep test. You have not exceeded your level of willingness for risk with that investment. On the other hand, if your decisions are causing you unrest you're probably taking too much risk. One's investments should not be a source of discomfort.

While one's level of willingness for risk may be somewhat vague, ability to take risk is more quantifiable. To be able to take risk you need to have something to invest. If you have nothing of value, no money, obviously you have no ability to take risk. But it doesn't stop there. There are certain things a prudent investor should have in place before putting money at additional risk. One is an emergency fund. Another consideration is debt. If you're carrying high-interest consumer or student loan debt it is probably a good idea to pay it off before investing. While many do not consider it a prerequisite to pay off fixed-rate mortgage debt before investing in other instruments, it may be worth addressing more risky mortgage debt such as adjustable-rate debt or mortgages with balloon payments. Such mortgage instruments can be like ticking time bombs. They could explode just when you do not have the means to make the higher payments. But if your only debt is a fixed-rate mortgage at a reasonable rate, it is not imprudent to consider other investments.

To determine one's ability for risk, one merely has to determine how much in cash one has available to invest. This can be done through a simple household budgeting exercise. Such a process will reveal how much, per month, you can afford to invest after you meet your other household financial obligations. For example, suppose a hypothetical investor has an annual gross pre-tax income before all expenses of $100,000 and suppose his taxes and other expenses consume $88,000, according to his household budget. That leaves $12,000 to invest, or $1,000 per month. This is a measure of his ability to take risk. He has $1,000 per month that he does not require to meet his obligations. Put another way, were he to lose some or all of those excess funds he would not be putting his current lifestyle in peril. (These figures for our hypothetical investor--$100,000 annual gross income, $88,000 annual expenses--will be used in subsequent examples below. It will also be important to know that our hypothetical investor is 27 years old and wishes to retire at 67.)

Like ability, need for risk is quantifiable but the process of doing so is much more difficult. Need for risk, more than anything else, drives one's required asset allocation. Developing the relationship between need and allocation is the subject of the rest of this page.

Estimating Retirement Income Needs
The goal of retirement investment planning is to build a source of funds (a nest egg) that will generate sufficient income in retirement. What is sufficient? How much income will you need in retirement? If retirement is decades away this seems like an impossible question to answer. Yet, answer it we must, somehow.

Rules of thumb exist. A typical one is that you'll need 70% of your pre-retirement income in retirement. That may be too high or too low in your case. A more accurate way to estimate retirement income needs is to plan a retirement budget. A place to start is your current monthly household budget, which you created to determine your ability to take risk, above.

Examining your current budget, you should be able to identify expenses that you will not have in retirement. These may include investing for retirement, investing or paying for children's education, and paying a mortgage. Other expenses may be lower in retirement such as those for transportation (no commuting expenses, possibly owning fewer vehicles) and clothing (no more buying business suits). It is the elimination or reduction of expenses like these that justify an estimate of retirement income below current income.

On the other hand, there may be expenses that increase in retirement. You may plan to take more trips or to buy a vacation home. Your health care costs may be higher as you age. To the extent you expect increased or additional expenses in retirement, you should increase your budget.

Going back to the hypothetical investor of the previous example. Recall he has a current gross annual income of $100,000 and annual expenses of $88,000, not including any investments or savings. Suppose also that his mortgage payments total $18,000 and his other expenses associated with working total $2,000 annually. Let's assume he does not expect any new or increases in expenses during retirement. Expecting to pay off his mortgage before retirement and, by definition, not working in retirement means our hypothetical investor can expect his retirement income needs to be approximately $88,000 - $18,000 - $2,000 or $68,000.

Some retirement income needs may be met by sources you do not directly control, such as Social Security or a pension. Each year the Social Security Administration sends each tax payer not sure if that's the correct universe of people a statement that estimates their expected Social Security benefit upon retirement. Assuming no future changes to Social Security benefits, part of your retirement income needs will be met from this source. (Relying on Social Security, like relying on future tax law, is a form of political risk.)

Let's assume our hypothetical investor has an expected Social Security retirement benefit of $18,000 annually. Continuing the example from above, this reduces the amount of income he'll need to fund to $50,000 (=$68,000 - $18,000).

Note that if you also expect a pension, you can reduce your needed income by that amount. Be careful though, while Social Security benefits are indexed for inflation, not all pensions are. If you do not have an inflation adjusted pension then the income benefit of your pension goes down in real terms over time. If this is the case, see inflation adjustment for guidance. For the remainder of this page we assume no pension benefit for simplicity. (Incorporating an inflation-adjusted pension can be done in the same manner we dealt with a Social Security benefit above.)

It is worth noting at this point that the income needed to be generated by the hypothetical investor considered above, $50,000, is only 50% of his gross income of $100,000.

Source of Income: Nest Egg
Knowing what income you need to generate for retirement ($50,000 in the running example, as described above), the next issue is how to provide it. The source will be your nest egg, that is the sum of your financial assets at time of retirement. How large a nest egg do you need to generate a certain income? A full answer to this questions depends on several factors, including: (1) what return on your investments you receive during retirement, (2) how long you will live, (3) whether you have a goal of leaving a certain sum for your heirs, among others. To keep things simple, this section covers the situation in which the investor will live for up to 30 years and does not have a goal of leaving funds to his heirs.

Given the stated assumptions, we imagine a circumstance in which the retiree draws required retirement income from his nest egg and possibly depletes the nest egg over a time span no shorter than 30 years. The key idea is the safe withdrawal rate or SWR. Studies based on past market performance have shown that a 3% SWR is conservative, even over a 30 year period and for a wide range of asset allocations (AAs). Though it may not yet be clear to the reader, this is all we need to estimate the required nest egg size to support necessary income in retirement.

To make the connection explicit, the definition of an SWR is a percentage of the initial nest egg size (e.g., the size on the day of retirement), even allowing for future inflation. That is,

[Eqn. 1] retirement income = SWR x (nest egg size)

where the "retirement income" is in constant dollars. This implies that for a certain target retirement income the nest egg needs to be

[Eqn. 2] nest egg size = (target retirement income) / SWR.

Recall from the the running example above, that the hypothetical retiree requires $50,000 in income. Thus, the nest egg would need to be $50,000/0.03 = $1,666,666.

There are two important points. First, the nest egg so calculated is in today's dollars. By the time of retirement inflation will have reduced the purchasing power of a dollar considerably. We will actually require a higher retirement income in nominal dollars and a correspondingly higher nest egg. Inflation will be accounted for below when we calculate the required return on investment to build the nest egg.

The second important point is that the nest egg size implied by this calculation leaves little margin for error. If you end up needing more income than you thought then you'll need a larger nest egg or you'll have to increase your withdrawal rate. If you must do the latter you increase longevity risk. However, one should view the nest egg size as calculated above as a lower bound on what will be required to support the level of income expected to be needed in retirement.

Having established the required nest egg size, we turn to the next step: to design an investment plan to build a nest egg of this size over the amount of time left until retirement. Before addressing this issue, it is worth mentioning another approach (or set of approaches) to providing retirement income: annuities. '''TBD. may need someone more familiar with annuities to write a few sentences. I'll come back to it later. Sewall 01:12, 2 March 2009 (UTC)''' See Variable Annuity, Fixed Annuity, Immediate Variable Annuity - SPIA, and Immediate Fixed Annuity - SPIA.

Estimating Required Return
We have now established a well-defined investment goal: to build a nest egg of known size in a known amount of time. This goal will be achieved by investing money not otherwise required to meet the household budget. Those investments should provide a return so that our principal is augmented by reinvested dividends and capital appreciation. It is this return that will accelerate the portfolio's value toward the set goal. What return is required given the investment goal?

The return required to meet a goal is a classic problem in finance, easily solved using a financial calculator or spreadsheet. The problem can also be solved using any of the online savings calculators listed in the sidebar. Any of these calculators can be used in an iterative fashion to solve for the rate of return required to meet a savings goal.

While the simple online savings calculators listed in the sidebar are sufficient for determining the required rate of return, there are more sophisticated online tools for retirement planning. Many of these retirement planning tools illustrate how much income a retirement plan will generate, given certain assumptions. In effect, they bundle many of the steps listed on this page into one calculation. They serve as good companions or reality checks to the step-by-step calculation suggested on this page. However, they require many assumptions, not all of which are explicit. As with any complex calculation tool, one should treat the output with caution (garbage in, garbage out). If you do not fully understand how a calculator arrives at its conclusions and what assumptions are implicit it may not be answering the question you intend to pose. For this reason, the step-by-step approach on this page is a worthwhile exercise, even if used as a starting point for an online retirement calculator.

Let's use one of the savings calculators and apply it to the hypothetical running example. In order to do so we need to know how long the investor has until retirement. Let's assume the investor is 27 years old and wishes to retire at 67, a 40 year span. Over those 40 years the investor will save $1,000 per month to build a nest egg of $1,666,666 in order to support a $50,000 income at a SWR of 3%. Using http://www.bankrate.com/brm/calc/savecalc.asp, we enter the goal ($1,666,666), the number of years over which to save for that goal (40), a guess of the rate of return (interest rate) required (start with 5%), and click "calculate." The calculator provides a monthly contribution amount of $1,088, a bit higher than the $1,000 the investor has. This means we require a higher return so we can afford a lower monthly investment and still meet the goal. Updating the required return to 5.25% the calculator provides a monthly deposit amount of $1,019. We could iterate further to refine the interest rate but this is close enough.

The required rate of return calculated using this procedure is the real rate of return, excluding consideration of inflation. We will actually require a higher rate to ensure that our dollars grow to offset the reduction in purchasing power caused by inflation. The return required just to keep up with inflation is about 2.5-3.5%. We'll use 3% below but you should select a different value depending on current predictions of future inflation. Our hypothetical investor will require an average rate of return of 5.25% + 3% = 8.25% to build his nest egg.

It is worthwhile at this point to step back and, once again, consider risk. A significant threat to the success of a retirement plan is risk of under-performance, which is essentially the same thing as longevity risk: the risk that you will not have saved enough and will outlive your money. This consideration motivates us to seek a greater return so as to build a larger nest egg and thereby minimize the risk of outliving our funds. However, every additional potential gain comes with additional risk of loss. Market risk can strike anytime. A 30-50% loss of value in one year is not unheard of. Nor is it ancient history (2008). Under-performance risk and market risk must be balanced.

Time is a crucial tool in striking the balance. A young investor, with a 20-40 year time horizon, has time on his side. The key weapon in his arsenal is human capital. He can reap dividends from his investment in knowledge, training, and experience through employment. If necessary, he can take on additional work to earn greater income, providing additional funds to invest. The capacity of human capital serves to mitigate market risk. One can take additional risk, strive for greater gain, early in life. If the market should wipe out some of one's fortune early in life, there is still time to make up the difference by increasing one's investments, earning additional income to do so if necessary. In contrast, a substantial loss near retirement can be devastating. There is insufficient time to add substantial amounts of additional principal. It is painful indeed to have one's portfolio blow up with little time on the clock. Near-retirement is not a time for risk.

What does this mean for rate of return? It suggests that one should design an AA plan to strive for higher rates of return (taking on higher market risk) early in life, moderate rates of return in the middle years, and low rates of return (taking on low market risk) near and in retirement. The high rates of return earned early on balance the lower rates earned later. The overall design achieves the required average rate of return and balances the risks of under-performance and market volatility.

What is meant by "low" and "high" rates? The lowest acceptable rate of return is the inflation rate. We at least can not tolerate a loss of purchasing power. Striving for a tad more is not unreasonable. This suggests a minimum rate of return in the 5-7% range (3% for inflation protection plus 2-4% more). The maximum rate of return that doesn't invite unreasonable risk is, perhaps, the historical rate of equities, about 10%. Therefore, one should design an AA plan expected to achieve no more than 10% in the early years (say, 20-40 years before retirement) and 5-7% when nearing retirement (within 10 years), and a mid-range, perhaps 6-8%, in the middle years (10-20 years before retirement).

One can use the savings calculators (see sidebar links) to select more precise return percentages over specific time periods to accommodate such a plan. For example, returning to our hypothetical investor who requires a nest egg of $1,666,666 by age 67, let's use the calculator at http://www.dinkytown.net/java/CompoundSavings.html. If we start ten years prior to retirement, at age 57, and plug in a starting amount of $1,000,000, and contribute $1,000 monthly for ten years at a 3.75% return compounded daily, we achieve about $1.6 million by age 67. This implies that if our hypothetical investor can save $1,000,000 by age 57 he requires a 3.75% return to reach his goal. This rate of return is before inflation, implying a need for about a 6.75% return in the ten years before retirement to account for inflation.

How can our hypothetical investor save $1,000,000 by age 57? Using the calculator, we can back up ten more years, to age 47 to see what the hypothetical investor requires as a starting value and a return over the ten year period between ages 47-57 to reach that $1,000,000 by age 57. After experimenting a bit, we find that if he has $500,000 at age 47 he can reach about $1,000,000 by age 57 with a 5% rate of return (or 8% after accounting for inflation).

Repeating this process, we find that the hypothetical investor can save $500,000 over the 20 year period from age 27 to 47 as follows. Starting with no savings and adding $1,000 per month, a 6.5% rate of return will generate about $500,000 by age 47 (9.5% rate of return when accounting for inflation). We could work our way back through the calculations to refine the assumptions to reach the ultimate goal, adjusting rates of return and monthly contribution amounts as we like. When we reach the end of this process we will have calculated three return values associated with an assumed monthly contribution amount: one return value for the early years, one for the middle years, and one for the late years. This process of balancing under-performance and market risk, considering age and human capital factors, is called lifecycle investment planning. Note that the AARP Retirement Calculator is one retirement calculator that allows up to four different rates of returns over different lifecycle time spans. Not all retirement calculators permit this degree of flexibility in this characteristic.

Let's assume that our hypothetical investor plays around with the calculator for a while and settles on the following set of target returns assuming a constant $1,000 monthly contribution: 9.5% for ages 27-47, 8% for ages 47-57, and 6.75% for ages 57-67 (all include an additional 3% for inflation). Notice that all of these rates of returns are below the historical average for equities (about 10.4%). Because our investor has started young he does not need to take tremendous risk (strive for peak gains) at any point in his life. If he were able to increase his monthly contribution he could accept even lower rates of return, especially if he could do so in the early years (taking maximal advantage of life-long compounding). It is again worth emphasizing, however, that the nest egg goal is the minimum requirement. It may be prudent to take slightly more risk than appears necessary or save more than originally assumed (i.e., more than the $1,000 per month for the hypothetical investor) in order to build a buffer. Any additional risk should be taken early in one's investment lifecycle, allowing for the possibility of recovery (through the injection of additional capital gained through employment earnings) if the market should suffer a large decline.

We have just reduced the investment planning problem to finding an investment plan that provides an expected schedule of returns. The next step is to design an AA plan to achieve this.

Asset Allocation: Returns and Risks

 * Rate of return and AA: Asset Class Returns
 * According to Vanguard website, from 1926-2007, the average annual return for bonds was 5.5% (best year 32.6%, worst year 8.1%, years with loss: 13). The average annual return for stocsk was 10.4% (best year 54.2%, worst 43.1%, years with loss: 24).
 * Efficient frontier
 * Many ways to skin the cat
 * Keep it simple
 * Adjustments over time

Troubleshooting and Adjustments

 * What if required rate of return is unreasonably high?
 * What if inflation skyrockets?
 * What if Social Security benefits are reduced?
 * What if my expected retirement income needs change?
 * What if we enter a vicious bear market?
 * How often should I revisit and adjust?
 * The long view: 20-40 years out.
 * The red zone: 20 years out.
 * The goal line: 10 years out.

Final Thoughts

 * Risk is not your friend
 * Don't fool yourself. You can lose your nest egg.
 * It's up to you to do the work and to get it right.
 * Buyer beware. Understand what you buy.