Investors had a rough start to 2016. Stocks plummeted in January and February, then completely reversed course in March, promptly erasing all their losses and finishing the first quarter right about where they started the year.
As I monitored various online discussion boards during that period, I saw time and again people looking for “safe investments” to park their money in. Understandably, they were spooked by the crazy rollercoaster ride they’d seen over the last couple of months and wanted to pull their money out of stocks before the next crash invariably happened.
The Appeal of Safe Investments
Safe investments are appealing because they are predictable. The ultimate low-risk investment is a certificate of deposit which pays you a fixed amount of interest every month or every quarter and is guaranteed to never lose money. However, current rates remain paltry at less than 1% for a 5 year CD.
When investors ask for safe investments, they often say, “I’m OK with earning smaller, steadier returns as long as I’m guaranteed not to lose money.”
The Problem – Playing “Not to Lose” Too Early
Here’s the problem. Opting for safe investments too early as you are saving for retirement may feel great because you don’t need to endure the ups and downs of the market, but can cause you to “lose the game” of meeting your long term savings goals and having enough money to retire.
Sports teams do this all the time. Let’s take football as an example. A team can come out on fire, playing to win and building a big first half lead. Then come out of the locker room in the second half playing not to lose, having their lead slip away and ultimately losing the game.
If you’ve built a nest egg of a few hundred thousand dollars it can feel like you are winning the investment game. This is probably the most money you’ve every saved in your life and it’s a very natural inclination to want to protect it when the stock market gets rocky and you see that statement come rolling in for the first time with a $30,000 loss for the quarter.
Let’s look at two investors (James and Abby) who find themselves in this exact situation, but choose two very different courses of action.
James and Abby have a lot of similarities. They are both:
- 50 years old
- Planning to work until they are 70
- Making $100,000 a year
- Saving 15% of their income each year
- Getting a 3% raise every year
- Want to maintain their standard of living when they retire. By the time they are 70, they are making $175,000 a year after getting a 3% raise each year.
- Paying their financial advisor 1% a year of assets under management for investment advice
- Paying an average of 0.25% in investment fees and trading costs.
And as of recently they both:
- Had saved $330,000 toward retirement.
- Just experienced a $30,000 loss (which isn’t all that uncommon) in their investments and now have $300,000 left.
James Plays Not To Lose
James opens his statement, yells a few things that I can’t repeat and vows to “get out of stocks.” He calls his advisor and moves all his money out of the stock market into bonds, which still have some risk, but aren’t nearly as wild a ride.
While past performance is no guarantee of future returns, we can look at historical data for bonds and see that since 1929, they have averaged a gain of 5.23% per year. After paying his advisor 1% and an additional 0.25% in fees, this brings James’ net return down to 3.98% per year.
With the assumptions listed above, James works and saves for 20 more years and ends up with a final nest egg of $1.25 million.
That’s a lot of money, but probably not enough to comfortably retire on. Using the 4 Percent Rule originally developed as a guide for retiree withdrawals from savings, James can take out about $50,000 a year ($1.25 million nest egg x 4%) to fund his retirement. Social Security isn’t going to cover the remaining $125,000 of his $175,000 salary he was earning at age 70, so he’d better plan on working a few more years or accepting a significantly reduced standard of living in retirement.
Abby Plays to Win
On the same day that James’ statement arrives, Abby gets her statement, sees the same $30,000 loss and experiences the same feelings of anger and panic.
However, after chatting it over with her investment advisor (and with some friends who also got lousy statements), she decides to stick with her long-term investment plan and stay invested in stocks.
Looking at the same historical data referenced above, stocks have returned an average of 11.41% since 1929. If we take out the 1% in advisory fees and 0.25% in expenses, this reduces her potential returns down to 10.26%.
Let’s also say that it’s a below average 20 year period for stocks and further trim down Abby’s returns by another 2% to 8.26%
20 years of saving and investing later, Abby retires with a nest egg of $2.42 million. Withdrawing 4% a year will net her a retirement income of $97,000 a year and she will likely be able to fill in the rest with Social Security and a few hours of part-time work in an area she is passionate about.
Dips in the stock market happen. I’m an investment professional and I still don’t feel good when I open my own statements and see a loss. However, the next time this happens, and you also happen to be in your 40’s or 50’s, resist the urge to play not to lose.
Instead, stay focused on your long-term investment plan even if it means putting up with the occasional lousy statement to build that bigger nest egg for retirement!