Dow 12,000. What Happened to All of the Fear?

So, we finally did it. The Dow attained that lofty, never-before-attained level of 12,000 (Dow Finishes Above 12000, WSJ, 10/19/06). Now we can all get back to our regularly scheduled programming.

I clearly recall a day back in mid-June of this year when one of my clients called to say that his wife was concerned about the state of world affairs and their portfolio's exposure to equities. I'm not sure why the wife couldn't call me to express her fears and felt a need to send her surrogate. This couple, in their early 60s, is invested about 60% in diversified equities. They have plenty of wealth (but not too much) and a long time to live. Anyway, the client (not the wife) proceeded to tell me her fears about the falling Dow (10,706), gas prices ($2.91/gal on 6/13/06, but higher in California where they live), oil prices ($68.56/barrel on 6/12/06), bad outcomes in Iraq, potential for a crash in real estate prices, and assorted other worries. Of course, we all felt cranky back then with the dearth of blockbuster summer movies and Al Gore's litany of inconvenient truths. Things just seemed bad and were likely to get worse.

My advice to the client? Do nothing. I realize that when we're feeling fear and emotion the natural reaction is to do something. OK, then go buy a 72-hour kit or a hybrid car. But, don't let it affect your sound, reasoned long-term plan for wealth accumulation and preservation. What I gave the client was a dose of discipline and told him he'd feel better in the morning.

Fast forward to today. Gas prices at $2.21/gal (still higher in California), oil at $59/barrel, Iraq is worse, Congress is in a heap, no good movies, and more inconvenient truths. And, the Dow at 12,000+. See, I knew he'd feel better in the morning.

Many times the best strategy is to do nothing. You're better off kicking the cat than kicking yourself later.

The Danger of Simplified Projection Techniques

In my last post I reviewed The Number, a wonderful book that will help you understand the issues in arriving at your own number. It's been interesting to read the book's reviews on Amazon.com. So many of the readers/reviewers really miss the point of the book. The author of "The Number" never intended the book to be a "how-to" on projecting one's retirement needs. It's not about formulas and projections.

A recent reviewer proposed his own formula for projecting the wealth needed by a hypothetical couple. Here are the assumptions he used:

"Let's say you want to retire on $100,000 a year. Assuming that you and your spouse will pull $30,000 a year from Social Security, and $20,000 a year from old defined benefit pension plans; you have a gap of $50,000. As a short cut, you can use the Dividend Discount Model to value stock. Using a conservative after tax investment return of 7.5% and a long term inflation rate of 2.5%, by dividing $50,000 by (7.5% - 2.5%) you need $1,000,000 in your own retirement funds (401K, IRAs) to retire. In reality, you need a bit less because the Dividend Discount Model assumes you live forever."

The true result of this projection is so far off base and really highlights how people can underestimate the wealth they need. I ran a Monte Carlo projection using the reviewer's figures with the couple retiring at age 60. I used the same 2.5% inflation figure and I allowed the pension, social security, and living expenses to grow at this rate. I also assumed a 60% equities, 40% fixed income diversified allocation with an 8.1% average return and a standard deviation of 10.8%. I put 50% of the $1 million of additional retirement wealth in a taxable investment account and the other 50% in an IRA. The result is a 95% chance of exhausting the couple's wealth by age 95. If the retirement is delayed until age 65 there's still an 80% chance of running out of money by age 95. Forget his formula. It will end in financial disaster.

Why was the reviewer's projection so far off base? First, there was no mention of taxes. He assumed that the annual distributions of $30,000 of social security and $20,000 pension and the $1 million of savings would be free of tax. This just can't be. To live on $100,000 per year you need distributions totaling about $150,000 before tax. Second, the issue of volatility is completely ignored. Where do you get a 7.5% after-tax return with zero volatility? Not on this planet.

Seat-of-the pants, back-of-the-envelope projections? Forget 'em. You'll end up in the poorhouse. Or, in your children's spare bedroom.

What’s Your Number?

In late January of this year I read a review of Lee Eisenberg’s book “The Number.” I was intrigued by the book title and the subject matter. Probably the question I’m most frequently asked is “how much money do I need?” It’s always a question that’s easily asked but most difficult to answer. It’s a question that’s regularly pondered by advisors and all sorts of other folks. It’s a puzzle dealt with in books, articles, seminars, and software programs. I’m convinced there’s no simple, single answer. Even if you discover your “number” you should expect it to me an ever-moving target.

I devoured “The Number” over one weekend. This is not "Financial Planning for Dummies." The author assumes you have a number or the hopes for a number. If you have no wealth, aspirations for wealth, or hope of wealth, this book won't magically create it. There are no magic recipes, formulas, or templates. Instead, Mr. Eisenberg takes you on a journey of discovery – uncovering the issues, elements, and questions integral to the search for your number. The author does this through a very entertaining writing style full of many interesting stories and examples. If you’re easily bored by all of the figures, statistics, and formulas in most finance books, you’re in luck. That’s not what this book is about.

The Number will help you rethink your number and the whole concept of retirement or ‘the new rest of your life.’ I highly recommend this wonderful book. See: http://www.thenumberbook.com/

Dow Tops All-Time High. Significant?

So, today the Dow Jones Industrial Average hit an all-time ("Dow Tops All-Time High," WSJ 10/3/06) of 11727, bursting past the old mark of 11723 (1/14/2000). My reaction is "so what?" It's interesting how we humans put significance on insignificant numbers. The Dow high is just another number. It's information. But, what are investors supposed to do with that information? My answer, contrary to the many other advisors and pundits running about with this useless bit of trivia, is that investors should do absolutely nothing. That's right. Nothing.

You see, the world didn't change from yesterday to today as we all waited breathlessly for this incredible threshold to be passed. The truth yesterday, today, and forever is still the same. And, that truth is that investors should be diversified and not speculate in any narrow sector or index.

The Russell 2000 (index of small company stocks) also hit an all-time high this year. In May 2006 (somewhere around May 1st) this index topped 785. Where was the fanfare, balloons, cut the cake, write it up in the journals? Didn't happen. Why? Don't know, except too many investors (and, their enablers) seem enamored with large company stocks 24/7. It must the familiarity of these companies. We fly on their planes, drive their cars, buy their toasters, eat their burgers, and take their medicine. So, why not buy them? OK, but spread it out. There are more than 5,000 publicly traded companies in the U.S. and many more than that overseas.

Is the Dow too high? Over-priced? Don't know. Ask me again in 2015.