1. Never, ever, pay a load on a mutual fund or annuity. And never pay an ongoing 12b-1 fee for a mutual fund or excessive annuity fees.2. Do not chase the performance of active managers. Not only does past performance not predict future manager performance, but excellent performance leads to the rapid acc.u.mulation of a.s.sets, which increases impact costs and reduces future return.3. Be cognizant of the corporate structure and culture of your fund company. To whom do its profits flow? Is it an investment firm or a marketing firm?

11.

Oliver Stone Meets Wall Street No matter how cynical you become, it's never enough to keep up.

Lily Tomlin The third, and least obvious, leg of the financial industry stool is the press, for it is reporters, editors, and publishers who inform and drive the investment patterns of the public. The relations.h.i.+p between the fourth estate and the brokerage and mutual fund industries is subtle, complex, and immensely powerful. We've already touched on this issue with the story of Michael Ka.s.sen's 1983 vault to fame on the strength of a single Money Money magazine cover. Two decades ago, it astounded everyone that nearly a billion dollars in a.s.sets could be moved with a single article. Now, when a fund arrives at the top of the one-year or five-year rankings for its category and is showered with billions in new money, no one blinks. magazine cover. Two decades ago, it astounded everyone that nearly a billion dollars in a.s.sets could be moved with a single article. Now, when a fund arrives at the top of the one-year or five-year rankings for its category and is showered with billions in new money, no one blinks.

The engine of retail brokerage and fund flows is the financial media. In the words of songwriter Paul Simon, we live in a world suffused with "staccato signals of constant information"; try as you may, there is no escape from Money, The Wall Street Journal, USA Today Money, The Wall Street Journal, USA Today, and CNBC. Unless you don't subscribe to any newspapers or magazines, don't watch television, don't listen to the radio, don't surf the Internet, and have no friends, you cannot help but be influenced by the world of business journalism. And the better you are at dealing with it, the better off your finances will be.

The bread and b.u.t.ter of the finance writer is the "successful" fund manager, market strategist, or newsletter writer. Having read this far, the flaw in this style of journalism should be obvious to you. All "successful" market timers are simply very fortunate coin flippers. Almost all apparently successful managers are lucky, not skilled. You might as well be reading about lottery winners. They may be fascinating from a human interest perspective, but there's no need to send them large checks.

Newsweek personal finance columnist Jane Bryant Quinn labels this style of journalism "financial p.o.r.nography"-alluring, but utterly lacking in redeeming value. So why do investors take it seriously and use it to influence their investment decisions? Because they know little of what you have now mastered. That there are no gurus. That there are no money masters. That even if such people did exist, they wouldn't be managing a mutual fund, writing a newsletter, or spilling that most precious of investment commodities-information-for nothing to Lou Rukeyser and his 20 million viewers. personal finance columnist Jane Bryant Quinn labels this style of journalism "financial p.o.r.nography"-alluring, but utterly lacking in redeeming value. So why do investors take it seriously and use it to influence their investment decisions? Because they know little of what you have now mastered. That there are no gurus. That there are no money masters. That even if such people did exist, they wouldn't be managing a mutual fund, writing a newsletter, or spilling that most precious of investment commodities-information-for nothing to Lou Rukeyser and his 20 million viewers.

More germane is the question, why do journalists continue to grind out this trash? The answer is complicated. At the bottom rungs of the profession, most reporters just don't get it. Journalism attracts people with exceptional linguistic talent, but I've found that very few have the mathematical sophistication to appreciate the difference between skill and luck. The language of finance is mathematics, and if you're going to do first-rate financial journalism, you have to be able to crunch your own numbers and understand what they're telling you. Not many writers can do that.

Secondly, a competent financial journalist should have a grasp of the scholarly literature pertaining to investing. By scholarly literature I mean journals that publish original academic research, usually produced by a profession's national organizations. For example, your doctor finds out about the latest advances in medicine from "peer-reviewed journals"-periodicals such as the New England Journal of Medicine New England Journal of Medicine and and Journal of the American Medical a.s.sociation Journal of the American Medical a.s.sociation, in which the articles are all carefully reviewed, vetted, and edited. You'd be very alarmed if your physician admitted that most of her continuing education came from USA Today USA Today, wouldn't you? Unfortunately, that's just where most financial journalists (and most finance professionals, for that matter) turn. They rely on their brethren in the popular financial press and ignore finance's scholarly peer-reviewed literature-Journal of Finance, Journal of Portfolio Management, and the like.

On the other hand, the folks at the top of the greasy pole-the regular columnists for the major national periodicals-are usually well-informed and smart enough to understand the futility of market timing and stock picking. But they do have one slight problem: they like to eat on a regular basis. You can only write so many articles that say, "buy the market, keep your costs down, and don't get too fancy," before it starts to get very old. Whereas there is a never-ending supply of fund-managers-of-the-month who can provide much-needed fodder for articles.

The picture becomes complete when we understand the sad fact that most investors pick their mutual funds and brokerage houses on the basis of press coverage. So the circle closes. The relations.h.i.+p between money managers and the financial press is usually not a "conspiracy" (although as we'll see shortly, sometimes it is), but it is clear that each party desperately needs the other. Without active managers, there are no stories; without glowing manager interviews, there are no patsies to invest in the managers' funds. (Or, in Keynes' aviary, "gulls.") The symbiosis between money managers and the press is hardly unique; consider fas.h.i.+on, automobiles, and travel reportage. But it is hard to come up with another example with an economic impact as large as that of financial journalism. Just as many automobile purchasers will buy on the basis of a favorable review in Car and Driver Car and Driver, a glowing money manager story can move vast amounts of capital.

This is the most benign interpretation of the relations.h.i.+p between journalists and the financial industry. Unfortunately, in recent years there has been a trend towards an increasingly sinister alliance between the "watchdogs" of the press and the industry it is supposedly overseeing on our behalf.

For example, in the late 1980s it was revealed that Money Money had begun to conduct joint focus groups with a major fund company. Its rationale was that they were both, after all, in the same business. Really? The business of most fund companies is the extraction of fees from shareholders. Is that also part of had begun to conduct joint focus groups with a major fund company. Its rationale was that they were both, after all, in the same business. Really? The business of most fund companies is the extraction of fees from shareholders. Is that also part of Money's Money's mission? Given that almost all financial periodicals increasingly benefit from a steadily rising stream of advertising revenue from the fund families, it seems likely that in many cases, they may indeed be on the same team. mission? Given that almost all financial periodicals increasingly benefit from a steadily rising stream of advertising revenue from the fund families, it seems likely that in many cases, they may indeed be on the same team.

Journalists tend to be a cynical lot, but it's hard to find many as hard-bitten as intelligent, successful financial writers. They know that what they're writing isn't good for their readers, but there are deadlines to meet and mouths to feed. In a 1999 issue of Fortune Fortune, an anonymous writer penned a notorious piece ent.i.tled, "Confessions of a Former Mutual Funds Reporter." Its writer admitted, "We were preaching buy-and-hold marriage while implicitly endorsing hot fund promiscuity." Why? Because, "Unfortunately, rational, pro-index-fund stories don't sell magazines, cause hits on Web sites, or boost Nielsen ratings." The article went on to admit that most mutual fund columnists invest in index funds. (As do an increasing number of brokers, a.n.a.lysts, and hedge fund managers.) At the very top of the financial journalism heap are a select number of writers who are so popular and craft prose so well that they can get away with a regular output of unvarnished reality. As we've already seen, Jane Bryant Quinn is one of these. Scott Burns of the Dallas Morning News Dallas Morning News, Jonathan Clements of The Wall Street Journal The Wall Street Journal, and Jason Zweig of Money Money are three other compulsive truth tellers. (And mark you well: Jason is are three other compulsive truth tellers. (And mark you well: Jason is no no relations.h.i.+p to Martin.) But they are a few faint points of light in what is otherwise a swirling professional cesspool. In general, you are better off ignoring the entire genre-print, television, and Internet. relations.h.i.+p to Martin.) But they are a few faint points of light in what is otherwise a swirling professional cesspool. In general, you are better off ignoring the entire genre-print, television, and Internet.

Let's add some flesh to the topic with a few real-life examples. A representative attention-grabber was the headline from the August 1998 issue of Worth Worth magazine: "Beat the S&P With Our Five Top-Ranked Funds." Their recommendations were Eclipse Equity, Barron a.s.set, Vanguard Windsor II, MFS Ma.s.sachusetts Investors Growth Stock, and GAM International. These funds were picked not only because of their superb prior performance, but also because of the magazine's overall favorable impression of the managers and their techniques. During the next two years, two beat the S&P, three didn't, and the average return of the five they recommended was 23.17%, versus 33.63% for the S&P. This is exactly what you'd expect from simply tossing darts at the newspaper's fund tables-a few winners, but more losers, with sub-par performance overall. magazine: "Beat the S&P With Our Five Top-Ranked Funds." Their recommendations were Eclipse Equity, Barron a.s.set, Vanguard Windsor II, MFS Ma.s.sachusetts Investors Growth Stock, and GAM International. These funds were picked not only because of their superb prior performance, but also because of the magazine's overall favorable impression of the managers and their techniques. During the next two years, two beat the S&P, three didn't, and the average return of the five they recommended was 23.17%, versus 33.63% for the S&P. This is exactly what you'd expect from simply tossing darts at the newspaper's fund tables-a few winners, but more losers, with sub-par performance overall.

The most prestigious of all fund ranking systems is the Forbes Forbes Honor Roll. This is one exclusive list. Not only must the fund have a long track record of excellent returns and consistent high-quality management, but it must also have above average returns in bear markets. Few periodicals have Honor Roll. This is one exclusive list. Not only must the fund have a long track record of excellent returns and consistent high-quality management, but it must also have above average returns in bear markets. Few periodicals have Forbes's Forbes's depth of expertise and talent. If anyone can pick funds, it ought to be them. depth of expertise and talent. If anyone can pick funds, it ought to be them.

So how have they done? Actually, not too badly. From 1974 to mid-1998, the average domestic Honor Roll fund returned 13.6%, versus 13.3% for average actively managed funds. So it appears that by using careful selection criteria, Forbes Forbes can pick mutual funds that will do slightly better than average. But, unfortunately, not better than the market, which returned 14.3%. can pick mutual funds that will do slightly better than average. But, unfortunately, not better than the market, which returned 14.3%.

Now the bad news. First, many of the Honor Roll funds carried loads, which were not included in the calculation and would have reduced returns by about another 1% or so. Second, the turnover of these funds would have generated far more in taxable gains than simply holding an index fund. And last, the turnover of the funds on the Honor Roll is notable in and of itself. Only a small number of the funds stay on the list for more than a decade. What does that say for a fund selection system that results in such a rapid shuffling of names? If successful managers stayed successful, surely they would stay on the list year after year. And yet, as we see, that kind of performance-the kind that persists-doesn't exist.

To Whom Do I Listen?

If the popular media is at best worthless, and at worst a downright dangerous place to seek investment guidance, then to whom does the intelligent investor turn for information? The real epiphany of the markets is: the market itself is the best advisor the market itself is the best advisor. The reason is blindingly simple. When you buy the market, you are hiring the aggregate judgement of the most brilliant and well-informed minds in finance. (Recall the disappearance of the Scorpion. Even the smartest a.n.a.lysts didn't know exactly where the submarine had sunk, but their collective judgement was stunningly accurate.) By indexing, you are tapping into the most powerful intelligence in the world of finance-the collective wisdom of the market itself.

The only real guidance you'll need is in two areas: * Your overall a.s.set allocation. We've already begun to discuss this problem and we'll finish the job in the next chapter.* Your self-discipline. That is, you'll need to keep your head while everyone else is losing his. No, you won't have to time the market, call the top or bottom, or leap tall buildings in a single bound. You'll only need to remember two things. First, that in the not too distant future, there will be exciting new technologies and once again, you will hear the siren song, "This time it's different; the old rules don't apply any more." Your neighbors and friends will get caught up in the frenzy, and they will earn higher returns than you. But only for a while. All you have to do is . . . nothing. Stand pat, keep to the plan. Do not exchange your boring old economy stocks and bonds for shares in the new tech companies. Second, there will come a time when the markets are in turmoil and you'll hear another song, this one in a sad minor key, "The end is near. Only a fool owns stocks." Again, all you'll have to do is . . . nothing. Or, if you're feeling brave, take some of your cash and buy more stocks.

Just because you don't have to pay too much attention to finance doesn't mean you shouldn't. Presumably, you're reading this book because you're at least vaguely interested in the topic. There is a world of useful investment information out there, and it's yours for the taking. The surprising thing is that the news you need to know is mostly old-sometimes very old. For example, if forced to make the choice, I would trade all of the financial research done in the last decade for the contents of Fisher's The Theory of Interest The Theory of Interest, which was written more than 70 years ago and formed the basis of Chapter 2 Chapter 2.

So here's how I'd proceed. First, do not read any more magazine or newspaper articles on finance, and, whatever you do, do not watch Wall Street Week, Nightly Business Report Wall Street Week, Nightly Business Report, or CNBC. With the extra hour or two you'll gain each week from turning off the TV, I would start a regular reading program. Begin with two cla.s.sics: 1. A Random Walk Down Wall Street A Random Walk Down Wall Street, by Burton Malkiel, is an excellent investment primer. It explains the basics of stocks, bonds, and mutual funds and will reinforce the efficient market concept.2. Common Sense on Mutual Funds Common Sense on Mutual Funds, by John Bogle, will provide more information than you ever wanted to know about this important investment vehicle. Mr. Bogle has been an important voice in the industry for decades and writes beautifully. It is both opinionated and highly recommended.

Take your time. Read no more than 10 to 20 pages an evening, then do something recreational. After you're finished with these two books, you will know more about finance than 99% of all stockbrokers and most other finance professionals. You're then ready for the "postgraduate course" that will take you through the rest of your life. Remember, most of what you need to know is ancient history, sometimes literally.

As we learned in Chapters 5 and 6, there is nothing really new in finance; the recent events on Wall Street would not have surprised the denizens of the Change Alley coffeehouses of the late seventeenth century. The more history you learn, the better. This is where finance becomes fun, because the best financial historians tend to be gifted literary craftsmen. I can guarantee you that you won't be able to put most of the following books down: * A Fool and His Money A Fool and His Money, by John Rothchild and Where are the Customers' Yachts? Where are the Customers' Yachts? by Fred Schwed. Ground-level trips through Wall Street in the 1980s and 1930s, respectively, providing an eye-opening view of the capital markets in those eras. by Fred Schwed. Ground-level trips through Wall Street in the 1980s and 1930s, respectively, providing an eye-opening view of the capital markets in those eras.* Once in Golconda Once in Golconda, by John Brooks. The story of how things got nasty between New York and Was.h.i.+ngton in the aftermath of the Great Depression and how Uncle Sam finally got his hands on Wall Street, to the benefit of just about everybody.* Devil Take the Hindmost Devil Take the Hindmost, by Edward Chancellor. A history of manias and crashes over the centuries. If this book doesn't bulletproof you from the next bubble, nothing will.* Bernard Baruch, Money of the Mind, Minding Mr. Market Bernard Baruch, Money of the Mind, Minding Mr. Market, and The Trouble with Prosperity The Trouble with Prosperity, all by James Grant. This man has a better grasp of capital market history than anyone else I know, and the quality of his prose is superlative to the point that it occasionally becomes distracting.* Capital Ideas Capital Ideas, by Peter Bernstein. An engaging history of modern financial theory and its far reaching influence on today's markets.* Winning the Loser's Game Winning the Loser's Game, by Charles Ellis. A succinct look at the essence of money management by one of the country's most-respected wealth managers.

All of the above works are easily accessible to the average reader. If you're good with numbers and don't mind a bit of effort, I'd also recommend the following: * Global Investing Global Investing, by Gary Brinson and Roger Ibbotson. A panoramic view of stocks, bonds, commodities, and inflation the world over. Now more than a decade old, it's beginning to show its age but is still well worth it.* a.s.set Allocation a.s.set Allocation, by Roger Gibson. An excellent primer on portfolio theory and the mathematics of arriving at effective allocations.

But what about "keeping up" with progress in finance? I'm afraid that if someone were to publish a yearbook t.i.tled "Genuine Advances in Investing," it would be a very thin volume most years. If you're good at math and a glutton for punishment to boot, you can log onto the Journal of Finance Journal of Finance's Web site (http://www.afajof.org/jofihome.shtml) to see what's new. You can even subscribe to the print journal for $80 per year.

Finally, in the day-to-day media there are two regular columns that, in addition to providing a good periodic review of practical finance, will also do an excellent job of keeping you up on the rare bits of useful news that occasionally trickle out of academia. The first is Jonathan Clements' "Getting Going" column each Wednesday in The Wall Street Journal The Wall Street Journal. (The Journal Journal is a superb national newspaper, but rely on it for news, not investment insight. Mr. Clements' columns aside, you won't learn much that's useful about investing from its contents.) The second is Jason Zweig's monthly column in is a superb national newspaper, but rely on it for news, not investment insight. Mr. Clements' columns aside, you won't learn much that's useful about investing from its contents.) The second is Jason Zweig's monthly column in Money Money.

What have we learned from our tour of the financial media? Two things. First, nearly all of what you will find in television, newspapers, magazines, and the Internet is geared to the care and feeding of the retail investment business and journalists, who depend on each other for their survival. It is of no use to you. And second, because there is little that is new in the basic behavior of the capital markets, the most useful way of developing investment expertise is to absorb as much market history as you can.

INVESTMENT S STRATEGY.

a.s.sembling the Four Pillars The Winner's Game Our voyage through the theory, history, psychology, and business of investing finally pays off in this section. Here's where we a.s.semble these four pillars into a coherent investment strategy that you can deploy and maintain with a modest amount of effort.

First we'll explore the retirement "numbers game": How much will I need to save to meet my goals? How much can I spend? How certain can I be of success? Then, in Chapter 13 Chapter 13, we reach the book's "main event": What factors must I consider in the design of my portfolio? Just what should my portfolio look like? What funds do I buy?

Nuts and bolts and practicalities are finally laid out in Chapter 14 Chapter 14. The first part is your portfolio's "a.s.sembly instruction booklet"; it ill.u.s.trates a powerful method for the psychologically tough task of slowly building your stock exposure. The second section is the "maintenance manual"; it describes the periodic "tune-ups" necessary to maintain your portfolio's health.

To paraphrase Winston Churchill, by the end of this section you will not have reached your investment journey's end; you will not even reach the beginning of its end. But you will have ended its beginning. This section will provide that journey's roadmap.

12.

Will You Have Enough?

Before we get our fingers dirty with real stocks, bonds, and mutual funds, it is important to consider just why why we are saving. As pointed out by the late Professor Irving Fisher in we are saving. As pointed out by the late Professor Irving Fisher in Chapter 2 Chapter 2, we save so that we may spend later. Investment is simply the execution of that deferral of consumption. At base, then, the pattern of that future consumption-when and how you spend your savings-is the single most important factor determining your a.s.set allocation. To wit, are you saving for retirement? Emergencies? A house? A child's education? The benefit of future generations?

In most cases, you'll be saving and investing simultaneously for several of these things. For example, most young families will likely be saving for all except the last reason. It makes little sense to have separate programs for each, but, rather, to combine all of your goals into one portfolio. Having one overall investment policy for all your a.s.sets will greatly simplify your financial management, reduce expenses, and increase your chances of success.

Retirement is the paramount objective for most investing, so we'll attack that first. After we've mastered this area, saving for the other goals, both separately and together with retirement, is not much of a stretch.

The Immortal Retiree The best way to understand retirement saving is to work backwards. We'll spend the first half of this chapter attacking the problem of how much money you'll need on the day you retire, and the second half discussing how to get there. Along the way we'll find out that various market scenarios affect young savers and older retirees in radically different ways.

Let's start with what at first seems a silly a.s.sumption-that you'll live forever. This is an extremely easy thing to plan for, as long as you remember to think in "real" (inflation-adjusted) terms. And it's not that silly an a.s.sumption; in financial terms, retirement essentially is "forever." Among annuity and insurance purchasers-admittedly a healthier-than-average group-15% of surviving spouses, usually the wife, live to at least age 97.

This means that many retirees will need to plan on more than 35 years of retirement. Financially, there's not much difference between living 35 years and living forever. To ill.u.s.trate this, a.s.sume that all of your money is in a Roth IRA, meaning that you don't have to worry about taxes at any stage and that you'll need $40,000 per year in current spending power in retirement. If you earn a 4% real return, then you can withdraw that 4% of your nest egg each year without reducing your princ.i.p.al. You will be able to maintain this forever, since the nest egg's value will rise along with inflation. The 4% you withdraw from it each year for living expenses will also keep up with inflation. This means that you'll need $1 million (calculated by dividing $40,000 by 0.04).

Next, imagine earning the same 4% real return and dying on schedule after 35 years with nothing nothing left over. In that case, since you will be spending down capital as well as earnings, you'll need only $746,585. (We'll discuss in a few paragraphs how this calculation is accomplished.) The key point is this-there's not a great deal of difference between living forever, which requires $1 million, and living for 35 years, which requires $746,585. Further, because of the uncertainties of the market and your own life, it's foolish to plan on dying on schedule with zero. left over. In that case, since you will be spending down capital as well as earnings, you'll need only $746,585. (We'll discuss in a few paragraphs how this calculation is accomplished.) The key point is this-there's not a great deal of difference between living forever, which requires $1 million, and living for 35 years, which requires $746,585. Further, because of the uncertainties of the market and your own life, it's foolish to plan on dying on schedule with zero.

This "back of the envelope" method of calculating retirement is a superb one-simply estimate your living expenses, including any taxes you'll owe on your retirement withdrawals, and adjust for what you expect from Social Security (which may not be much). Then divide by your expected real rate of return, as we did above. Four percent is a reasonable estimate, given the expected returns for stocks and bonds we calculated in Chapter 2 Chapter 2.

A more precise, but much more dangerous, technique uses the second example we described above-dying "on schedule" after 30 or 40 years with nothing. This method involves employing an amortization calculation, typically using a standard financial calculator, such as a Texas Instruments TI BA-35, which can be bought for about $20. This is an extremely common procedure among financial planners and is computed in exactly the same way as a mortgage (except that in this instance you are the bank, receiving monthly payments until the "loan" of your nest egg is paid off). This is how we arrived at the $746,585 figure mentioned above. To reiterate, amortization allows for no "margin of error." Make a few wrong a.s.sumptions, and you're eating Alpo in your golden years.

How much margin of error do you need? Unfortunately, a lot. You see, all of the calculations we've done so far contain an extremely perilous a.s.sumption-that our return is the same each and every year. For example, in the calculation above we a.s.sumed that you'll receive a fixed 4% return that never changes, year after year.

But in the real world, this does not happen. If you expect reasonable returns, then you have to bear risk. And by its very definition, the word "risk" means that you cannot expect to receive the same return each and every year. So you are going to have to live with the markets the way they are-good years and bad years, occurring in a completely unpredictable sequence.

The problem is that the precise sequence of the good and bad years is critical. This phenomenon was first brought to public attention by Philip L. Cooley, Carl M. Hubbard, and Daniel T. Walz of Trinity University. They looked at the success rate of various withdrawal strategies over numerous historical periods and came to the conclusion that only at a withdrawal rate of 4% to 5% of the initial portfolio value (i.e., $40,000$50,000 of a $1,000,000 mixed stock-bond portfolio) do you have a reasonable expectation of "success." (Which they defined as dying without debt.) The scariest thing about their results was that the period they studied had real stock returns of 7%. Future stock returns are likely to be lower, which means that even their 4% to 5% withdrawal rate may be overly optimistic. An excellent summary of their work is available at http://www.scottburns.com/wwtrinity.htm.

On a more basic level, however, you can apply a much simpler acid test to your withdrawal strategy: What would happen if the day you retired at a market top, say on January 1, 1966, which marked the beginning of a long, brutal bear market, and you lived for another 30 years, until December 31, 1995? For the first 17 years (19661982), the real return of the S&P 500 was zero. The return for the last 13 years (19831995) was spectacular, bringing the real return for the whole 30-year period from 1966 to 1995, up to 5.3%, not too far below the historical norm of 7%.

To study this, I a.s.sumed that you began the period with $1,000,000 and then calculated results of various withdrawal rates from the following mixes: 100% stock, 100% bond, and 75/25, 50/50, and 25/75 stock/bond mixes of both. I further a.s.sumed that the equity portfolio consisted of 80% S&P 500 and 20% U.S. small stocks with five-year Treasuries as the bond component. The results of 7%, 6%, 5%, and 4% withdrawal rates (that is, withdrawing $70,000, $60,000, $50,000, and $40,000 in real terms) are plotted in Figures 12-1 Figures 12-1 through through 12-4 12-4. Again, it is important to realize that the amounts on the vertical scale are in inflation-adjusted inflation-adjusted 1966 dollars. 1966 dollars.

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Figure 12-1. $70,000 annual real (1966 $) withdrawal. $70,000 annual real (1966 $) withdrawal.

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Figure 12-2. $60,000 annual real (1966 $) withdrawal. $60,000 annual real (1966 $) withdrawal.

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Figure 12-3. $50,000 annual real (1966 $) withdrawal. $50,000 annual real (1966 $) withdrawal.

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Figure 12-4. $40,000 annual real (1966 $) withdrawal. $40,000 annual real (1966 $) withdrawal.

These are profoundly disturbing results. Since real equity returns were 5.3% during the period, the conservative back-of-the-envelope method of withdrawing the real return every year should have allowed us to safely withdraw 5.3% annually and still have our real princ.i.p.al intact. In fact, such a withdrawal rate completely depleted all the portfolios, no matter what their stock/bond composition. The amortization method predicts that we should have been able to withdraw 6.7% per year if we were willing to completely deplete the portfolio in 30 years. As you can see from Figures 12-1 Figures 12-1 and and 12-2 12-2, a 6.7% withdrawal rate would actually have depleted all the portfolios in about 15 years. This means that a "penalty" of about 1.5%2% was extracted by "the luck of the draw." In other words, a particularly bad returns sequence can reduce your safe withdrawal amount by as much as 2% below the long-term return of stocks. Recall from Chapter 2 Chapter 2 that it's likely that future real stock returns will be in the 3.5% range, which means that current retirees may not be entirely safe withdrawing more than 2% of the real starting values of their portfolios per year! that it's likely that future real stock returns will be in the 3.5% range, which means that current retirees may not be entirely safe withdrawing more than 2% of the real starting values of their portfolios per year!

It's important to understand that in all of the above cases, we have been talking about withdrawing a constant real amount of the beginning portfolio value. For example, in Figure 12-1 Figure 12-1, we withdrew a real $70,000-7%-of a $1 million portfolio every year, increasing the initial $70,000 each year for inflation. This is not not the same as spending 7% of the portfolio value each year. Were we to do that, we would withdraw less money each year as stock prices fell. For example, if stock prices immediately fell by 20%, we could only spend $56,000. Think about spending a quarter of your portfolio each year. You will never completely run out of money, although your portfolio value will vanish into insignificance after a decade or two. But if you can tolerate the fluctuations in withdrawal amounts inherent in a more reasonable constant-percentage withdrawal (say, 4% or 5% per year), then you will never completely run out of money. the same as spending 7% of the portfolio value each year. Were we to do that, we would withdraw less money each year as stock prices fell. For example, if stock prices immediately fell by 20%, we could only spend $56,000. Think about spending a quarter of your portfolio each year. You will never completely run out of money, although your portfolio value will vanish into insignificance after a decade or two. But if you can tolerate the fluctuations in withdrawal amounts inherent in a more reasonable constant-percentage withdrawal (say, 4% or 5% per year), then you will never completely run out of money.

This gets to the heart of financial risk. The odds are that you will not not encounter the worst case of a prolonged and profound bear market at the beginning of your retirement. It is just as likely that the opposite may occur-a prolonged bull market at the beginning-and that you will be sitting in unexpected clover, able to withdraw 6% of your starting amount or more each year. But we cannot forecast the future. If you plan reasonable withdrawals (2 to 5% of the initial nest egg value, adjusted upwards for inflation in each year), there is the small risk of disaster, which you can lessen only by lowering your retirement living expenses. encounter the worst case of a prolonged and profound bear market at the beginning of your retirement. It is just as likely that the opposite may occur-a prolonged bull market at the beginning-and that you will be sitting in unexpected clover, able to withdraw 6% of your starting amount or more each year. But we cannot forecast the future. If you plan reasonable withdrawals (2 to 5% of the initial nest egg value, adjusted upwards for inflation in each year), there is the small risk of disaster, which you can lessen only by lowering your retirement living expenses.

The best way of performing a retirement calculation is with a so-called "Monte Carlo" a.n.a.lysis. This more sophisticated methodology runs thousands or even millions of "what if" scenarios and computes the percentage of times your strategy "succeeded" (that is, you didn't die poor). It uses the same three inputs as the amortization method: the initial nest egg amount, expected real rate of return, and length of retirement. It also needs a fourth bit of data, the "standard deviation" of the portfolio, which is a measure of portfolio risk. I've found that Monte Carlo gives results very similar to those obtained in the Trinity study, with the additional advantage that it allows you the flexibility of adjusting portfolio risk and return. Don't worry about having to do calculations manually; Efficient Solutions has written a simple and inexpensive Windows-based Monte Carlo tester.1 It's important to realize how the traditional amortization method and the more sophisticated methods relate (Trinity study, data in Figures 12-1 Figures 12-1 to to 12-4 12-4, and Monte Carlo). The amortization method, which a.s.sumes that you earn the same return each year, computes the withdrawal rate or nest egg size at which the more sophisticated methods indicate a 50% chance of success. That's not enough margin of error for most investors. There's a simple way of estimating how much you can withdraw to get to 90% success: Subtract 1% from your withdrawal rate for a portfolio that is mostly bonds and 2% for one that is mostly equity. Say you think that your stock portfolio has an expected return of 5%. That means that to have a 90% chance of success, you can only withdraw 3% of the real initial nest egg each year.

Finally, Uncle Sam has provided a tempting way out of this dilemma. Treasury Inflation Protected Securities (TIPS) currently yield a 3.5% inflation-adjusted return. If you can live on 3.5% of your savings and and you can shelter almost all of your retirement money in a Roth IRA (which does not require mandatory distributions after age 70 1/2), then you are guaranteed success for up to 30 years, which is the current maturity of the longest bond. For devout believers in the value of a well-diversified portfolio, this option is profoundly unappealing, as this is a poorly diversified portfolio-the financial equivalent of Eden's snake. (Although it's a very secure basket!) At a minimum, however, some commitment to TIPS in your sheltered accounts is probably not a bad idea. you can shelter almost all of your retirement money in a Roth IRA (which does not require mandatory distributions after age 70 1/2), then you are guaranteed success for up to 30 years, which is the current maturity of the longest bond. For devout believers in the value of a well-diversified portfolio, this option is profoundly unappealing, as this is a poorly diversified portfolio-the financial equivalent of Eden's snake. (Although it's a very secure basket!) At a minimum, however, some commitment to TIPS in your sheltered accounts is probably not a bad idea.

At the end of the day, you can never be completely certain that your retirement will be a financial success. Further, you are faced with a tradeoff between the amount of your nest egg you can spend each year and the probability of success-the less you spend, the more likely you are to succeed. And certainly, any retiree who annually withdraws much more than 5% of their real initial nest-egg amount over the decades sorely tempts the fates.

Retirees: Pray for Rain I apologize if the math in this section is a little steep. Even if you don't understand all of the numbers, there's one important concept I want to leave you with: the worst-case scenario for a retiree is to start out with a long period of poor returns. In this situation, the combination of poor returns and mandatory withdrawals for living expenses will devastate most retirement portfolios if the bear market lasts long enough. Even after the bad times have ended and returns improve, there just won't be enough capital left to benefit from those higher returns, and you'll run out. The only way out of this grim trap is to spend less and save more.

But at the end of the day, you also have to realize that it is impossible to completely eliminate risk. I'm amused when financial planners and academics talk about methods that predict a 40-year success rate of, say, 95%. If you think about it, this implies that our political and financial inst.i.tutions will remain intact for about the next millennium (40 years divided by a failure rate of 5% equals 800 years). Considering the history of human civilization, this is a pretty heroic a.s.sumption. The only way most investors can drive their chance of success above 90% is to completely deprive themselves both before and after retirement. At some point, enough is enough-in order to live a little, you've got to bear some risk of failure.

The very best thing that can happen to a retiree is to have a run of good years right off the bat. In that case, you'll be sitting on a wad of a.s.sets that you likely won't be able to spend, no matter how low returns are later.

The Savings Game The opposite is true for young savers: they should be praying for a bear market so that they can acc.u.mulate shares cheaply before they retire. The worst thing that can happen to savers is to have a prolonged period of high prices, which means that they will have acquired expensive shares that are likely to have poor returns in retirement. Again, to summarize: [image]

By this point, we've done most of the heavy lifting-figuring out how much you'll need to have on hand the day you retire. Here, the precise sequence of good and bad years, although it does influence your outcome, is far less critical. The reasons for this are complex and have to do with the "duration" of your portfolio.

As we found out in the first chapter, if you own a bond that yields a nominal 5% and bond yields rise to 10%, that is bad. Bond yields and prices are inversely related. But at some point, you will break even because you can reinvest your interest at the higher rate. The "duration" of your bond is that point at which you break even.

Next, consider a bond from which you are siphoning off half the interest coupon to pay for living expenses. Because you are reinvesting less at the higher interest rate, you have now effectively lengthened its duration. Conversely, if you augment the interest payments with additional cash, you are shortening the effective duration.

In the same way, any portfolio from which withdrawals are being made has a very long duration. This statement seems paradoxical-if you're spending down a portfolio, shouldn't that decrease decrease its duration? No. Because you are lessening the amount that can be reinvested at a higher yield, you are its duration? No. Because you are lessening the amount that can be reinvested at a higher yield, you are increasing increasing duration-defined as the time it takes to break even after a price fall. Conversely, shouldn't savings increase duration? No. In the same way that augmenting a bond's interest shortens its duration by reinvesting more at higher yields, by saving you are duration-defined as the time it takes to break even after a price fall. Conversely, shouldn't savings increase duration? No. In the same way that augmenting a bond's interest shortens its duration by reinvesting more at higher yields, by saving you are decreasing decreasing duration. This is why a price fall early in retirement is such a bad thing. It is almost certain that your portfolio duration-the break-even point-is longer than your expected survival. On the other hand, a portfolio into which savings is flowing has a short duration. This is why a young person in the savings phase of her life will do better with falling prices. duration. This is why a price fall early in retirement is such a bad thing. It is almost certain that your portfolio duration-the break-even point-is longer than your expected survival. On the other hand, a portfolio into which savings is flowing has a short duration. This is why a young person in the savings phase of her life will do better with falling prices.

For this reason, relatively simple calculations will work nicely for the savings phase. The easiest way to do this is with a financial calculator, such as the TI BA-35 I mentioned a few pages ago.2 I've calculated some final real nest egg amounts per real $100 saved each month in I've calculated some final real nest egg amounts per real $100 saved each month in Table 12-1 Table 12-1. For example, a.s.sume that you have 25 years until retirement and obtain a 4% real return for that term. If you save $100 per month, at the end of 25 years you'll have a real nest egg of $50,885. This is a real real $100 you are saving: this means you'll have to increase the $100 initial savings with inflation. If you can save a real $500 per month, you'll have $254,420 (five times the amount indicated in the table). Using our back-of-the-envelope method, at a real return of 4%, this will provide you with $10,177 real income per year. (That is, $254,420 0.04 = $10,177.) $100 you are saving: this means you'll have to increase the $100 initial savings with inflation. If you can save a real $500 per month, you'll have $254,420 (five times the amount indicated in the table). Using our back-of-the-envelope method, at a real return of 4%, this will provide you with $10,177 real income per year. (That is, $254,420 0.04 = $10,177.) Table 12-1. Final Real (Inflation-Adjusted) Nest Egg Amounts per Real $100 Saved Each Month. (See text.) Final Real (Inflation-Adjusted) Nest Egg Amounts per Real $100 Saved Each Month. (See text.) [image]

Let's approach this from the opposite end. a.s.sume you've decided you want to retire on $50,000 per year. Our back-of-the-envelope method tells us that you'll need a $1.25 million nest egg to do this ($50,000/0.04 = $1.25 million). And remember, this method gives you almost no margin of error for a bad initial-return draw of the cards.

How much do you need to save to obtain $1,250,000 for retirement? If you have 20 years until retirement, you'll have to save a real $3,436 per month! We determine this by noting from Table 12-1 Table 12-1 that saving a real $100 per month at a real rate of 4% produces $36,384 after 20 years. So, to produce a real $1,250,000 nest egg we will have to save ($1,250,000/$36,384) $100 = a real $3,436 per month for 20 years. that saving a real $100 per month at a real rate of 4% produces $36,384 after 20 years. So, to produce a real $1,250,000 nest egg we will have to save ($1,250,000/$36,384) $100 = a real $3,436 per month for 20 years.

By using a similar calculation, if you have 30 years until retirement, you'll need to save a real $1,824 per month; if you have 40 years, you'll need to save a real $1,077 monthly. In Table 12-2 Table 12-2, I've tabulated the monthly savings requirement for each real rate of return and time until retirement to retire on $50,000 per year. If you wish to retire on more or less, adjust the required savings in Table 12-2 Table 12-2 by the proportionate amount. So if you wish to retire on $100,000 per year, for example, multiply all the values in by the proportionate amount. So if you wish to retire on $100,000 per year, for example, multiply all the values in Table 12-2 Table 12-2 by a factor of two. by a factor of two.

Table 12-2. Monthly Savings Required to Retire on $50,000 per Year. (See text) Monthly Savings Required to Retire on $50,000 per Year. (See text) [image]

If you find these calculations grim, well, they are. The message is loud and clear: If you want to retire comfortably, you must save a lot. And you must start very early. In fact, every decade you delay saving for retirement can more than double the amount you must save each month. Although this book's focus is on investing, its message is useless if you cannot save enough to invest.

Now for the only sermon of the book. Our consumer society propels the average person to spend far more than is necessary or healthy. If you find it difficult to save, then you may have a problem. For starters, I'd read Thomas Stanley and William Danko's The Millionaire Next Door The Millionaire Next Door to understand how most people become rich. Want to know the auto most commonly driven by the wealthy? No, not a Mercedes-it is a Ford F-150 pickup. Another interesting fact: The average plumber retires far sooner than the average lawyer, even though lawyers make more money than plumbers. Why? Because the attorney "must" drive a nicer car, live in a nicer part of town, buy more expensive clothes, and take more exotic vacations than the plumber. The message is obvious. The easiest way to get rich is to spend as little as possible. to understand how most people become rich. Want to know the auto most commonly driven by the wealthy? No, not a Mercedes-it is a Ford F-150 pickup. Another interesting fact: The average plumber retires far sooner than the average lawyer, even though lawyers make more money than plumbers. Why? Because the attorney "must" drive a nicer car, live in a nicer part of town, buy more expensive clothes, and take more exotic vacations than the plumber. The message is obvious. The easiest way to get rich is to spend as little as possible.

Other Goals This book is not intended as a financial planning guide; topics such as mortgages, debt management, insurance, and estate planning are well beyond its brief. But there are a few financial planning topics pertaining to basic portfolio mechanics and financial theory that are worth mentioning: Emergencies. This falls under the mantra of the financial planner: "five years, five years, five years." That is, you should not put any money at risk that will be needed within five years. In addition, you should have at least six months of living expenses on hand in safe liquid a.s.sets-short-term bonds, CDs, money market, checking, and savings accounts. This doesn't mean that you need a separate account for this purpose-it can be part of your overall a.s.set allocation.

Your emergency money, however, must be held in your taxable accounts. Holding liquid a.s.sets in a retirement account doesn't accomplish this, as tapping an IRA before age 591/2 for an emergency will likely trigger an enormous combined tax bill/early-withdrawal penalty. Many retirement and 401(k) plans do allow borrowing in emergency situations. Doing so is a bad idea since defaulting on such a loan triggers a 10% early-withdrawal tax penalty.

House savings. Since you are unlikely to be saving for a house for much more than five years, you should also place this money into short-term bonds, CDs, and money market accounts. And, of course, it should be held in a taxable account.

College savings. This is an enormously complex area, and one that has recently undergone a revolution with the introduction of so-called 529 plans, which can be highly tax-advantaged. I'd recommend taking at look at www.collegesavings.org and also having a chat with your accountant about these plans, which come in many shapes and sizes. and also having a chat with your accountant about these plans, which come in many shapes and sizes.

From the a.s.set management point of view, college savings is a very sticky wicket, since its time horizon is intermediate between that of emergency savings and retirement planning. You may be saving for as little as a few years to as long as two decades, depending on the age of your child and your available funds. Unfortunately, as we've seen, stocks can have poor returns for even 20 years. Worse, if you have a decade of very poor returns, you will then find yourself within the five-year bond-only window mentioned above. If you begin saving when your child is four and have nine years of bad returns, you now have five years left until he or she enters college. What do you do? With some trepidation I'd recommend placing a maximum of 30% to 40% of your child's college fund in stocks, then begin to s.h.i.+ft that into bonds as matriculation approaches. When the college expenses come due, you can sell the residual stocks for tuition in the good years and sell the bonds in the bad years.

CHAPTER 12 SUMMARY.

1. Manage all of your a.s.sets-personal savings, retirement accounts, emergency money, college accounts, and house savings-as one portfolio.2. You or your spouse may live a lot longer than you think. You should plan on spending, at maximum, the expected real return of your portfolio each year-i.e., 3% to 4% of its value.3. Even this a.s.sumption may not be conservative enough. Should you experience a prolonged period of poor returns early in your retirement, you may run out of money before the market can rebound.4. You cannot start saving early enough. Most workers who begin their retirement savings after age 40 will find it impossible to retire when they want to.5. You cannot save enough. The most successful prescription for a successful retirement is to get into the habit of curbing your material desires. Now.6. Do not invest any money in stocks that you will need in less than five years.7. Have available at least six months of living expenses in safe investment vehicles in a taxable account.

13.