In my previous post I described the stock and bond markets by analogy with a casino, but you might reasonably question the validity of that analogy. Are market returns really as unpredictable as coin flips? The real payoff probability distributions obviously aren’t binary; what do they actually look like?
After spending a number of afternoons and evenings with friends and family over the last few months reviewing their retirement planning and investments, I’ve gone and done something a little bit crazy: I suggested to the GSC at Caltech that maybe I could give a talk on retirement investing to the grad student/postdoc population. Incredibly, they thought this sounded like a good idea, and so now I’m scheduled to give a talk in a couple of weeks. I’m going to try and write it up here in prose form first, to get it organized. It’s gotten to be a bit long… so I’m going to break it up.
- Taking responsibility for funding your own retirement is arguably more important now than it has been for a couple of generations. 100 years ago we had much more in the way of traditional (family, community) support in old age, and the systems that we put in place after the Depression (corporate pensions demanded by organized labor, social security) show few signs of being fixed any time soon. Generally today you do not even have the option of signing up for a “defined benefit” plan. It’s a 401(k) or the highway.
- Investment returns are for all practical purposes random, unpredictable events, and because of this there’s really no such thing as an “expert investor” in the sense that most people selling their investment management services try and imply. Nobody can reliably beat the broad markets, but you can do a perfectly good job of managing your own retirement funds if you’re willing to spend about 4 hours per year on it, say the other half of the day you spend doing your taxes.
- To maximize your chances of success, you must habituate yourself to spending less than you earn, making investing as automatic as possible, starting early and aggressively, and continuing throughout your entire career, regardless of what life and the markets throw at you. Because returns are exponential and not linear, the difference between starting to save at age 23 and age 32, assuming roughly an 8% rate of return, can be on the order of a factor of two in the final value of your retirement funds. Being comfortable living well below your apparent means makes it possible not only to save money now, but also reduces the amount of money you need in order to have “enough” in retirement, where “enough” means about 25 times your expected annual withdrawals, as you can take about 4% of your money out each year indefinitely.
- Maximizing the returns on your investments largely comes down to managing investment costs: how much you pay the people doing the actual investing (i.e. the mutual fund companies), and how much you pay in taxes. The difference between paying 0.2% and 2% in fees and taxes each year might not seem huge, but over the course of 35 years of investing, it makes roughly a factor of two difference in the amount of money you end up with.
- The two most important tools you have in managing investment risk are diversification and asset allocation. Diversification reduces the overall impact of many kinds of unpredictable events (high oil prices, the demise of the newspaper industry, war between India and Pakistan, collapse of the Icelandic currency… etc.) reducing the overall volatility of your portfolio. Asset allocation (mainly the split between stocks and bonds) allows you to choose what kind of financial risk you are exposed to, and to shift it over time as you get closer to actually needing to live off your investments. With stocks, you get the potential for future growth, at the expense of having to put up with wild fluctuations in their value. With bonds, you get less price fluctuation and less potential for growth, but the ability to draw a reliable income stream. With cash you get little to no price fluctuation, but essentially zero potential for real (inflation adjusted) growth.