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, one can use the same techniques for 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 you have $1,000 to invest. Your willingness for risk is how readily you would take the chance of losing some of it for the chance of earning an expected profit. For instance, you might feel comfortable taking the risk of a 50% probability of losing half your investment ($500) in exchange for a 50% probability of doubling it (to $2,000). Or you might not feel comfortable with that level of risk but you would be willing to risk a 25% probability of losing half for a 75% probability of doubling it. Your 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 your annual gross pre-tax income before all expenses is $100,000 and suppose your taxes and other expenses consume $88,000, according to your household budget. That leaves $12,000 to invest, or $1,000 per month. This is a measure of your ability to take risk. You have $1,000 per month that you do not require to meet your obligations. Put another way, were you to lose some or all of those excess funds you would not be putting your current lifestyle in peril. (These figures--$100,000 annual gross income, $88,000 annual expenses--will be used in subsequent examples below.)

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 previous example, suppose your current gross annual income is $100,000 and your annual expenses are $88,000, not including any investments or savings. Suppose also that your mortgage payments total $18,000 and your other expenses associated with working total $2,000 annually. Let's assume you do not expect any new or increases in expenses. Expecting to pay off your mortgage before retirement and, by definition, not working in retirement means you can expect your retirement income needs to be approximately $88,000 - $18,000 - $2,000 or $68,000.

Some of your 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 you're expected Social Security retirement benefit is $18,000 annually. Continuing the example from above, this reduces the amount of income you'll need to fund to $50,000 (=$68,000 - $18,000). 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. How large a nest egg do you need to generate a certain income?


 * A 3% withdrawal rate is considered conservative, even over a 30 year period, for a wide range of AAs. See safe withdrawal rates.
 * This implies the required nest egg size: nest egg = (retirement income)/0.03. Using example above, the nest egg would need to be $50,000/0.03 = $1,666,666.
 * Remember, saving this amount leaves little margin for error. If you end up needing more income than you thought then you'll need more or you'll have to increase your withdrawal rate. View this as a lower bound on your required nest egg size.
 * The goal is to build a nest egg of that size over the amount of time left until retirement.
 * Another approach: buy an annuity. See Variable Annuity, Fixed Annuity, Immediate Variable Annuity - SPIA, and Immediate Fixed Annuity - SPIA.

Estimating Needed Risk

 * How to reach nest egg size
 * Online calculators
 * Assumptions required
 * Being conservative
 * Required rate of return

Risk and Asset Allocation

 * Rate of return and AA
 * Table of historical returns by asset class (see VG website on investment planning)
 * Efficient frontier
 * Many ways to skin the cat
 * Keep it simple
 * Adjustments over time

Final Thoughts

 * What if actual rates differ from historical rates?
 * Tales of woe from current economic crisis
 * 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.