Wednesday, June 22, 2011

One Problem with Successful Investing....

So, you do everything right, make a lot of money, and retire.   Think it's all over?  The fun is just starting!

If you save your money, invest it wisely, and do well, you may end up with a lot of money.  Unfortunately, this means even slight changes in the market will create big jumps and dips in your portfolio.

The Dow is down this month, after a stellar rise over the last few months.  And if you don't have a lot invested, you didn't gain a lot or lose a lot.   But, if you've been socking away money in your 401(k) over the years, even minor fluctuations in the market can show up in your portfolio as a lot of money "lost" or "gained".  And having the courage not to let these bother you is difficult.

Suppose, for example, you have a half-million in your 401(k).  This is not as much money as you might think - perhaps $20,000 a year income for life, upon retirement, using the 4% rule.  That sucks.  But a half-million is a half-million, and that is a lot of dough.

If the market goes up even 5%, you gain $25,000 in your portfolio - enough to buy a new car!  Woo-Hoo!  And that is the problem with market values - they are numbers on paper, not real wealth.  So in the go-go 1990's and 2000's, when everything was going up and up and up - our "consumer confidence" went up as well, and we all went out and spent money, because on paper, we were making a lot.

But when the market goes down, as it did this last month, you can lose just as much - and losing $25,000 seems like a "lot" of money, until you realize it is just 5% of your portfolio, and markets fluctuate that much all the time.  But to you, Joe Salary Slave, twenty-five grand is a lot of dough, and when you lose that much, even on paper, it is hard not to panic - big time.

And panic people do.  During the recession in 2009, a lot of people "sold it all" when the market tanked in February - and locked in their losses.  For average Joe and Josephine, the idea of losing a brand new car in a month is scary.

But it is a predictable effect of having a larger portfolio.  And it takes getting used to.  And what is even odder, is that you have to program your brain to accept the fact, blandly, that your investments fluctuate by huge amounts, while at the same time, in your personal life, you are chasing after $100 in savings here or even $10 there.  There is a cognitive dissonance here.

So, for example, you check the balance on your mutual fund and find out it dropped by $5,000.  Sort of makes saving $50 on your cell phone bill seem pretty insignificant.  And at another time, you check your balance and it went up $10,000 - so you think that spending $20,000 on a new car isn't a big deal - after all, you made $10,000 just in one month.

And even when retired, a lot of people look at their investments this way.   "Never touch the principal!" they say (but you will have to, eventually, of course).  So they spend the interest, or earnings.  And if the market is doing great, they spend more, and if it does less well, they spend less.  And that is a bad idea, too.

Why?  Because eventually, markets tank, and one year, you will have NO earnings and then be forced to spend your principal.  When the market recovers, your earnings will be less, as now you have less principal to earn from.  And then what happens is very, very bad.  The retiree now tries to cut spending (too late) and live on less, to build up the principal again.  But it is hard to create principal from interest, once you have savaged the principal.

A better approach is to figure out a flat spending level that your savings can support - the 4% or 5% rule is one example,  If your investments do well, say 10%, then save the excess for those times when they won't do as well.  And yes, eventually you will eat into your principal.   But hopefully by that time, you are being sized up for a casket, and it won't matter.

As I have noted before, this whole 401(k) and IRA thing is a big, wacky, socio-economic experiment being played out - with people's financial lives at stake.  No one really knows how it will work out, and few of us have the understanding of money and investing necessary to make the right decisions.  And for some of us - even making the "right" decisions - the outcome will be less than optimal.

Asking the average citizen in America to save up huge sums for retirement is problematic, as most of us are ill-equipped to deal with large sums of money - and when they change in value, even by a small percentage amount, the huge swing in value (as it appears to us) will make most of us very nervous, indeed.