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Quiz!

Which of the following are factors that determine investment returns (may be multiple answers)?

  1. Past known world events.
  2. Central bank actions.
  3. Future unknown world events.
  4. Valuations

What Determines Investment Returns?

Most investors focus on one factor when trying to predict investment performance: past world events. In reality, investments are impacted by different factors, including: future world events, central bank actions (the Fed in the US), momentum, valuations and the natural growth of companies. Here are a few scenarios that tend to surprise investors and lead to unexpected results:

  1. Recently there was a negative event that led to declines. The next day brought a positive event along with gains. The reverse also happens.
  2. Recently there was a negative event that led to declines. A central bank (the Fed in the US) took actions to support the economy, leading to optimism and gains. Even as little as indication for future support can lead to gains.
  3. An investment is more likely to continue its trend of recent months. A high investment can keep going higher and a low investment can keep going lower.
  4. An investment with low valuations is likely to enjoy greater than average gains in the upcoming 5-10 years. In addition, it is more likely to revert from negative momentum to positive momentum.
  5. Beyond all factors above, you can expect diversified stocks to grow on average, thanks to the productivity of the underlying companies. It doesn’t happen in every specific day, month or year, but it happens on average, supporting long-term investors. And it happens more (on average) for certain groups of stocks including: small companies, cheap stocks (low valuations), and emerging markets.

Quiz Answer:

Which of the following are factors that determine investment returns (may be multiple answers)?

  1. Past known world events.
  2. Central bank actions. [Correct Answer]
  3. Future unknown world events. [Correct Answer]
  4. Valuations [Correct Answer]

Explanations: Past known events are already reflected in stock prices. Read this month’s article for further explanations.

Disclosures Including Backtested Performance Data

Quiz!

Say you earn $100k per year ($80k net) and save 10% of your gross salary. After a number of years, you built an investment portfolio of $120k. You recently got a big raise from $100k/year to $200k/year ($150k net). You double your saving rate from 10% per year to 20% per year. What is the impact on your financial security soon after the raise:

  1. Increased by 20%
  2. Increased by 10%
  3. Did not change
  4. Declined by 36%
  5. Declined by 54%

Is Your Growing Income Making You Less Financially Independent?

Say you earn $100k per year and save 10% of your gross salary. After a number of years, you built an investment portfolio of $120k. You recently got a big raise from $100k/year to $200k/year. You double your saving rate from 10% per year to 20% per year. The table below shows the impact on your finances (all amounts are in dollars):

Increase Spending Based on Income: Financial Security Drops

Before raise After raise Change
Gross income 100k 200k
Net income (an example) 80k 150k
Saving rate 10% 20% x2
Saving amount 10k 40k x4
Spending (net income – saving amount) 70k 110k +57%
Spending rate = annual spending / total saved. Lower = higher financial security. 70k / 120k = 58% 110k / 120k = 92% +59%

The paradox. You just doubled your saving rate, quadrupled the amount saved each year, have 57% extra to spend, yet you quickly become more stressed about money than before the raise! What happened? Your spending increased by 59% relative to your total savings, making you less financially secure and more dependent on your job. The stakes are higher, making work a lot more stressful. I believe that this is a big reason for rising stress and declining happiness along with rising incomes.

Is there a Solution? Yes. Instead of counting on potential earnings, increase your spending only (1) based on new money that you already saved, and (2) in a sustainable way. In the example above, you keep your spending at $70k right after the raise, and increase it only using 3% of the money that you already saved and invested. 3% is an example of a likely sustainable withdrawal rate from a diversified stock portfolio. The table below shows the progression over 3 years (all amounts are in dollars):

Sustainable Increase of Spending (3% of New Money Saved): Total Spending & Financial Security Keep Going Up

Calculation Formula Before raise Year 1 Year 2 Year 3
Savings
Year-start savings Last year’s Year-end savings 120k 120k 212k 269k
Investment growth [Made up returns, with 10% average] 10% -10% 34%
Investment dollar growth Year-start savings x Investment growth 120k*10% = 12k -21k 91k
New savings Net income – last year’s Total spending 150k–70k = 80k 78k 76k
Year-end savings Year-start savings + Investment dollar growth + New savings 120k 120k+12k +80k = 212k 269k 436k
Spending
Added sustainable income New savings x 3%, rounded 80k x 3% = 2k 2k 2k
Total spending Last year’s Total spending + Added sustainable income 70k 70k + 2k = 72k 74k 76k
Financial security (annual spending / total saved), lower is better Year-end savings / Total spending 58% 34% 28% 17%

Key points:

  1. Higher income never hurts financial security. This plan eliminates the big dip in financial security after the raise. Instead, it provides growing financial security. Note: Your overall financial security could decline during big enough down years for your investments, but this is not related to your increased spending. It is the result of owning volatile investments. Volatility is the price of high long-term expected returns. It can hurt you when between jobs, but should help while you are in saving mode (see: How to Use Volatility to Make Money http://www.qualityasset.com/2018/07/31/how-to-use-volatility-to-make-money/).
  2. Sustainable new spending. By increasing your spending by a small percent of new savings, the new spending is expected to be sustainable even in the face of severe investment declines.
  3. Plan not reactive to investment volatility. The plan does not change spending along with the investment’s ups and downs. Declines don’t hurt spending, while gains are left to compound until you reach financial independence (retirement). When independent (spending/investments <= 3%), you can further increase your spending to 3% of your investments, whether you are working or not.
  4. Relatively simple calculation. By tying your spending only to money you save from your income, the calculation stays relatively simple: Once a year, you can total your additions (minus withdrawals, if any) to your investment portfolio, and you can raise your annual spending by 3% of that amount. Your investment advisor should have this information, and do the calculation for you.
  5. Reward for rising income. By tying your spending only to money you save from your income, you reward yourself for increases in income, instead of investments that you cannot control.
  6. Spending, total savings, and financial security all set for growth. Thanks to compounded investment growth, the available money to spend, the total savings, and financial security, all should grow exponentially over time (beyond the dips during down periods in the cycle).
  7. Baseline spending. The first step is setting your baseline spending. To find that, go over every item in your spending, and ask if you are willing to trade it with a more relaxed life. Once you completed all the trades (spending reductions), you maximized your financial relaxation. The lower the baseline, the higher your financial security, the faster it will grow, and the sooner you will reach retirement – the point from which you can keep growing your spending, independently of income.
  8. Resolving the paradox of: higher income = more stress. Many people have strong desires for increased spending immediately as their income goes up, making this plan seem too extreme. If you feel that way, think about something even more extreme: the prospects of becoming more stressed and less happy “thanks” to your higher income. Keep this paradox in mind before rushing to add to your spending based on growing income and not actual savings.

Quiz Answer:

Say you earn $100k per year ($80k net) and save 10% of your gross salary. After a number of years, you built an investment portfolio of $120k. You recently got a big raise from $100k/year to $200k/year ($150k net). You double your saving rate from 10% per year to 20% per year. What is the impact on your financial security soon after the raise:

  1. Increased by 20%
  2. Increased by 10%
  3. Did not change
  4. Declined by 36% [The Correct Answer]
  5. Declined by 54%

Explanations: Read this months’ article for an explanation.  Technical note:  The 59% increase in spending rate mentioned in the article is equivalent to a 36% decline in financial security: 1/(1+59%)-1 = -36%.

Disclosures Including Backtested Performance Data