Archives For Stocks

Quiz!

If you are retired, can stick to an investment plan, and spend 3%-4% of your money per year, which of the following are important for handling your biggest risks (any number of answers may be correct):

  1. Limiting yourself to fast growing investments.
  2. Picking the right stocks, to avoid big losses.
  3. Diversifying into various asset types, including stocks, bonds & real estate.
  4. Staying disciplined with your plan, and avoiding panic sales.

Outpacing the Longevity Escape Velocity

Ray Kurzweil, director of engineering at Google & inventor, predicts that in 10-12 years we will reach longevity escape velocity. This is the point when science and technology will add more than a year to our lifespan for every year we remain alive, leading to an infinite life. With an 86% accuracy rate for his prior predictions about the future, there is some chance that this will be true as well. He may be almost completely wrong, with a lifespan of a mere 200 years or 2,000 years, instead of infinity. When planning my investments, I wouldn’t bet with 100% confidence that he is completely wrong, especially when losing the bet would mean spending most of my long life broke.

Unfortunately, many retirement plans do make this bet. A retirement plan with a 95% chance of providing 30 years of retirement income is typically considered appealing. That means a 1-in-20 (5%) chance that if you live for 30 years, you will go broke later in life, just when financial stress is the toughest to handle. If you live longer than 30 years, the odds of failure go up. I have personally known a retired woman that gradually depleted her assets, and faced one of two tough cases: dying soon or going broke. This memory is carved in my mind, and I am not ready to see any of my clients reach the same position.

Accepting some chance of an infinite life, or simply a very long one, requires infinite income. While the word infinite sounds dramatic, it is not impossible to plan for infinite income with very high odds. You simply need to apply a similar principle of escape velocity to your investments, with more growth than spending, in an average year. Stable investments (bonds, money market) grow too slow to support long-lasting withdrawals that accelerate with inflation. So, we need to seek faster growing investments, and handle the volatility, by accounting for withdrawals during downturns. By using investments that grow fast enough, you can make up for the penalty of withdrawals during declines, as long as the investments are diversified, and the withdrawal rate is low enough. Two stock portfolios fit the requirements:

  1. Long-Term Component (LT) is likely to support 4% withdrawals forever.
  2. Extended-Term Component (ET) is likely to support 3% withdrawals forever.

For the disciplined investor with low withdrawal rates, longevity risk turns some common risk-planning principles on their heads: bonds and cash become risky, and diversified stocks become safe! This is because running out of money becomes a greater risk than losing it all during a temporary decline (through small withdrawals).

Once your withdrawal rates from these portfolios go below the stated rates, you would likely reach escape velocity, providing you with income for as long as you live, even infinitely. But instead of just solving the longevity financial risk, you get a big bonus. After reaching a sustainable withdrawal rate, your portfolio is expected to keep growing over full cycles despite your withdrawals. You can choose between higher security or higher income (or some of each) with every new peak.

My clients tend to be conservative, and don’t count on any specific limited lifespan. I tend to reject more aggressive investors.

Quiz Answer

If you are retired, can stick to an investment plan, and spend 3%-4% of your money per year, which of the following are important for handling the biggest risks you may face (any number of answers may be correct):

  1. Limiting yourself to fast growing investments. [The Correct Answer]
  2. Picking the right stocks, to avoid big losses.
  3. Diversifying into various asset types, including bonds, stocks & real estate.
  4. Staying disciplined with your plan, and avoiding panic sales. [The Correct Answer]

Explanations:

  1. If you end up living a long life, you need high enough growth to support annual withdrawals that grow with inflation. With low growth, you can run out of money.
  2. Trying to pick the right stocks introduces the risk of picking the wrong ones – this is a big risk to take when your lifelong income depends on it.
  3. Low-volatility investments are necessary for high withdrawal rates for a short horizon, and for people who panic during stock declines. You have the benefit of discipline and low withdrawal rates, and may face a long horizon.
  4. It is critical to stay disciplined with your plan, and avoid panic sales. A couple of panic sales can negate the entire benefit of the high average gains.
Disclosures Including Backtested Performance Data

Quiz!

Which of the following is typically true?

  1. It is best to buy insurance for most risks for peace of mind.
  2. It is best to avoid insurance and invest money in stocks, because stocks grow fast and can be used to cover the otherwise insured risks.
  3. It is best to insure against devastating risks.
  4. It is best to insure against non-devastating risks, and buy stocks to handle devastating risks.

Insurance vs. Diversified Stocks

The table below presents a basic comparison between diversified stocks and insurance. The first two rows show similar benefits, while the remaining rows show where each approach shines.

Topic Diversified Stocks Insurance Comments
Distribute risk at any point The growth of 1,000 stocks overshadows one company’s bankruptcy. By pooling 1,000 homeowners, the premiums paid cover the cost of one flooded house. Both help diversify risks at a given instant.
Distribute risk over time The growth of stocks over a full cycle overshadows the decline periods within the cycle. The premiums paid by a large group of homeowners over time cover hurricane damages to a large group of homeowners. Both help diversify risks over time.
Devastating risks House burns down without big money saved => bankruptcy. House burns down => covered by insurance. Insurance is critical for covering risks that would devastate you.
Non-devastating risks Can sell from stocks to cover the low risks. Otherwise, the saved insurance premiums that are invested in stocks are likely to grow dramatically over a lifetime. The insurance premiums are lost. Stocks are typically more beneficial for risks that are not devastating.
Availability The money is available for you at all times, without being at the mercy of an insurance company, but the value will be lower during stock declines. Claims can be declined for various reasons. Insurance: Read carefully the exclusions list for insurance, and have money set aside for declined claims.
Stocks: Have plenty more than the self-insured amounts, to account for stock declines.
Negotiated pricing Not applicable This applies for some types of insurance. Health insurers negotiate lower prices. You get negotiated healthcare costs even with high deductible health insurance, in case this item tips the scale for you.
Risk of under-treatment Risk of avoiding treatment that would otherwise be covered by insurance. Having low-deductible health insurance can encourage treating high-risk problems that seem minor at first If choosing self-insurance using stocks (e.g. by having high-deductible health insurance), be careful to not avoid necessary treatments that you would get with low-deductible insurance.
Overhead No overhead Insurance involves administrative costs and profits to the health insurer, that you pay for. Unless you are a high risk person for using the insurance, your overall average cost may be higher with insurance.

Quiz Answer:

Which of the following is typically true?

  1. It is best to buy insurance for most risks for peace of mind.
  2. It is best to avoid insurance and invest money in stocks, because stocks grow fast and can be used to cover the otherwise insured risks.
  3. It is best to insure against devastating risks. [The Correct Answer]
  4. It is best to insure against non-devastating risks, and buy stocks to handle devastating risks.

Explanations: Read the article for explanations.

Disclosures Including Backtested Performance Data