“Retirement at sixty-five is ridiculous. When I was sixty-five I still had pimples.”
It’s pretty well known that we’d rather have pleasure now than pleasure later. A whole self-help industry popped up in the 1980s based on the notion of delaying gratification and the benefits of doing so rather than giving into our Monkey Brains and buying the 138” wide screen TV for our man caves now. It’s also the same reason that we’re willing to pay a monthly gym membership, but we don’t actually go – instead, we tell ourselves that we’ll go tomorrow and never wind up going.
In the same vein, we’re actually not that good at assessing our own tolerance for risk. Many times, we think that we are risk seeking, but only because we’re so willing to discount whatever our future selves will experience for whatever we can get today. It’s Wimpy from the Popeye cartoon, gladly eating a hamburger today and paying on Tuesday, regardless of the costs. Think of people who smoke. Smoking certainly causes negative health repercussions down the road, but because the lung cancer, emphysema, stinky clothing, etc. are in the future, smokers discount the negative outcomes for the hit of nicotine now, even though there can be no doubt in their minds that they’re playing with fire (both literally and figuratively in this case). Yet, how many emphysema or lung cancer sufferers think to themselves “Boy, am I glad I smoked all of those years! It was WORTH it!”
It is the combination of psychological foibles we exhibit which also causes us to invest suboptimally when we make retirement investing decisions. A recent study by Harry Markowitz (of the Modern Portfolio Theory fame), Sanjiv Das, Jonathan Scheid, and Meir Statman in the Journal of Financial and Quantitative Analysis shows just how the combination of future discounting and poor risk awareness add up to poor retirement portfolio planning.
If you talk about retirement planning, the concept actually covers several goals. It includes your basic living expense needs – what you’ll need to get in income to keep you off the streets and eating cat food when you have exhausted your human capital. It includes your lifestyle goals – the income you want to have in order to meet some of your other non-essential goals in retirement, such as cruises, travel, or that mid-life crisis convertible. Retirement planning also includes having assets set aside to cover for expense shocks, such as deteriorating health or boomerang kids needing your support. Finally, it includes your estate planning goals, such as inheritance for the kids and grandkids and charitable contributions.
Each of those goals has a separate risk profile. For the basic living expense goal, failure is nearly catastrophic. At some point, even if your mind is willing, you’re pretty much going to be physically unable to work as you advance in age. Not meeting your basic living expense needs at that point will put you in a horrible, nearly untenable situation. Therefore, your risk tolerance for meeting basic living costs (food, shelter, basic healthcare) is exceptionally low.
However, as you move up a hierarchy of goals, the similarities will mirror the Maslow hierarchy of wants. While you may be disappointed if you can’t give to charity when you pass on, it won’t cause you years of suffering like not having enough to cover food and shelter would. Your risk tolerance should be, rightly, higher. The same goes with some of your lifestyle goals. You might be willing to put money in riskier investments if that money was allocated to more or less vacations or to the grandkids’ education funds. Failure, while disappointing, would not be ruinous.
Yet, because we don’t consider the relative allocations of our portfolios for our retirement goals, we tend to lump everything together and wind up with a riskier portfolio than necessary. Financial planners often tell you to put money aside in IRAs, 401(k)s, 403(b)s, 457s, etc., and go with asset allocations such as 110 – your age for the stock/bond split, and send you on your merry way. It’s an incomplete approach because it doesn’t probe deeply enough into what matters to you.
How can we align our investing strategy with our retirement strategy?