This is a guest post by Robert Bockel.
I have spent much of my career questioning much of the dogma of what people should be doing with their money and how people can become financially successful. Lately, it’s been occurring more frequently and people are more defensive towards those threatening the sacred cows of personal finance. In some cases I am labeled a heretic for even daring to ask questions about basic concepts that are now accepted as second nature. People have asked me on several occasions to write an article to expand on these thoughts. There is more than enough information for a book (maybe someday) but for now let’s start here.
What is Traditional Financial Advice?
Traditional advice is pretty much most of the common advice you see in articles, TV, newspapers, and blogs. You also see it in industry publications, on social media, and you hear it from financial planners and advisors. They give you what you want to hear in the form of simple, blanket, one-size-fits-all, advice so you can live a happy, successful financial life.
I’m sure you’ve heard some (or all) of these tenants before:
- Max out your 401(k)
- Buy index funds/ETFs
- Pay off debt as quickly as possible
- Save as much as possible
- Live below your means
- Buy “cheap” insurance
It varies somewhat but these features are relatively universal. The way I see it, there are two parts to this equation:
- Saving money
- What you do with that saved money.
The first part I feel most of us would agree on. We must save money. We must save a certain percentage of our gross income and segregate that money from our lifestyle money. The exact recommended percentage can vary greatly from around 10% of your gross annual income all the way to the FIRE (Financially Independent Retire Early) crowd advising saving 50% or more of income.
Side note: from an economic standpoint the percentage of income you save needs to be at least 15% of your gross income to keep up with all of those factors that erode wealth (more on that later). If you make more than 150-200k/yr, that percentage should be upped to 20% or even 25%+. The reason behind this is that the more income/assets you have, the more you are affected by the things that erode your wealth.
Is Traditional Advice Good for Today’s Problems?
I hope we can agree that the current financial situation of most Americans is somewhere between not good and a complete disaster. There is not a day that goes by where I do not read an article that mentions that most American cannot handle a $1000 emergency or that most Americans have less than $100,000 saved for retirement.
Why is this? Why are most people failing? Why are even high income earners falling well below their financial potential? The common answer is that we are not saving enough money. This is certainly true – we are not saving enough money. We like immediate gratification, we like to buy stuff….all of this is certainly true. However, this ignores the second part of the equation – what we do with the money that we saved.
By focusing only on the lack of savings it completely lets the industry off the hook for giving poor, failing advice. It has become a laminated excuse card for whenever things go awry. It is always just save more money… just throw more money at it. Just like politics there are many people whose livelihood depends on maintaining the status quo. We have excuses for everything. We have trouble admitting when we’re wrong – when we have failed. Yes we are not saving enough and yes the advice we follow has been failing us – for decades.
This “advice” became common around 1980. Around the time when defined benefit pensions went away and were replaced by the defined contribution 401(k). This also coincided with inflation beginning to calm and the start of one of the greatest stock market bull runs in history. A huge shift in where our wealth was stored went from insurance companies to banks to now the brokerage industry. Because pensions we going away and people were now losing the guaranteed income they needed a “planner” to help them figure this out on their own as their company was no longer on the hook for their retirement. The risk was now on them. And so traditional retirement planning was born.
This planning strategy essentially boils our financial lives down to a linear math equation. The “planner” would put the onus on you by asking you how much money you want at retirement. Let’s say you want a $1,000,000 retirement nest egg when you retire in 30 years. The planner would then say well if we assume an 8% rate of return you will need to give me (lower your lifestyle by) $666.54 each month to reach your goal.
Mathematically this works and makes perfect sense, however, our lives are not linear math equations. Life is uncertain. Here we are using variables as constants. A $1,000,000 goal is an arbitrary number, we don’t get 8% each and every year (markets fluctuate), taxes and tax law fluctuates, there is inflation, fees, debt, health, and countless other unknowns. Also, since everything changed every year the planner had to charge you a fee every year to “fix” all those variables that were wrong.
Let me use another example to further illustrate how illogical this system is. In the 70s many executives were making around $24,000/yr. which was good money back then. Their “goal” was to retire on $18,000 30 years later. Had the planner helped them achieve their “goal” they would’ve been living well below the poverty line.
Financial Planning vs. Investment
Let’s break this type of planning down even further. It is essentially an investment plan. One of its main determinants of success is the performance of the underlying investments in the plan – usually stock based with some bonds. So people would have a group of investment plans for retirement, education funding, a second home, a boat, whatever.
Now there is nothing wrong with investments. I love investments. In fact, my background is as an equity option floor trader. It was my first job out of college and I did it for 8 years. My problem is when investments are sold as something they are not. They are not a panacea. They contain risk. They fluctuate up and down. You can’t just plug in an average 8 or 10% return each and every year and expect that to reflect reality. It doesn’t – but this is how all kinds of investments are sold to this day.
In addition, the typical investor averages something like a compounded 2.6% average per year. A number lucky to barely keep up with inflation. The reason is that we are hardwired to be bad investors. When markets are doing well we want to mortgage the farm and buy everything right at the top. When markets are doing very poorly we can’t take it anymore and we want to sell everything and get out. We do the exact opposite of what we should be doing – we buy high and sell low. However, everyone thinks that they won’t be that guy. They will be the one who buys and sells at the proper time. It’s tough.
This is not to say that investments are bad. They are fine. Just like every financial product there are things that they can do and things that they can’t do. The problem is that investments are not a financial “plan” in and of themselves. They certainly can be an important part of an overall financial strategy but they need to be positioned properly with other areas that make up for where they lack. It’s important not to confuse our investments with a financial plan. A true effective financial strategy focuses not only on offense (investments) but defense (protection, liquidity, savings, growth, debt, cash flow, etc.).
Investing in Offense and Defense
The offense vs defense conversation I believe is an important one. Offense is generally more fun to talk about and is generally more exciting. However, there are old adages like “defense wins championships.” They both are important.
In most cases investments (offense) are the foundation of the financial plan. The problem here is that they are unpredictable, they fluctuate, and are frequently at the mercy of forces well beyond our control.
When it comes to offense there are many ways to build wealth:
- Equity (stock) based investments through individual securities
- Mutual funds
- Active management
- Passive index investments
- Bonds and other type of debt instruments
- Real estate
- Investing in collectibles
- Starting a business of some type.
All of these are great and can certainly work. They also have their unique attributes and risk characteristics. I would encourage anyone to utilize any of these instruments that they were comfortable getting involved with…. In fact, I would most likely help in any way that I could.
The question becomes what are we trying to accomplish here? Is the goal to just go for the most money possible here as if it were a game? If that were the case we would just choose the investment we thought would give us the best return and put every red cent we had into it. But we don’t do that because we rightly have a fear of loss. We want to have as much money as possible in the end but we know we need to have assets there when it is all said and done. We can’t afford to have little to nothing there as we age.
Today people talk about retirement as if it were optional. It’s not. We age. Our bodies and minds decay. We can’t work forever. So we have to have a nest egg in the future when we go from people at work to only money at work. Because of this, we diversify (a great industry buzzword) our wealth.
Knowing that this may very well hurt our overall rate of return because we can’t afford to have nothing there later. So the goal is not actually to have the most money possible. The goal is to grow our money, hopefully well beyond the rate of inflation so we can maintain our spending power with the caveat of not losing too much along the way. If this is the case, using a specific rate of return or an index as a benchmark may not always be the best determinant of success. There are just too many variables in play to make that assumption.
Now defense is a different story. In many cases we don’t have countless options like we do when it comes to playing offense with our saved wealth.
For instance, if you’re a doctor and you want to manage the risk of you making a professional mistake that causes a severe loss in which you would be liable. The first thing you would do to mitigate this is to purchase medical malpractice insurance. In most cases, in fact, you are required to purchase this in order to practice. If you are insuring against loss you’re responsible for when driving you would buy car insurance and possible additional liability insurance. Also property insurance, disability insurance, medical insurance, long term care insurance, life insurance, etc. Also, you would coordinate these products with other asset protection strategies with your attorney for proper legal structure to protect you as much as possible from various potential lawsuits. Also, we need liquidity for defense if we ever need money quickly for unforeseen circumstances. Usually this limits us to certain accounts that are very safe and we can have 100% access to the money at any time.
Offense and defense need to be properly coordinated together as they are both of crucial importance. These are not segregated financial decisions. They work hand in hand. Ideally proper defense makes the offense stronger. The big difference between the two is that we have to have defense set up properly before any event happens. We do not get the opportunity to get it right after a peril occurs. For this reason it is understandable to have a defense first strategy. Defense wins championships. If structured properly this can be done without sacrificing wealth.
How to Let Go of Linear Financial Planning
I have to wrap this up at some point but I could go on forever. Maybe I will write additional articles in the future expanding on certain areas. For now, I want to talk about how we measure solutions:
- Are they working?
- Are they effective?
- Are they actually giving us what we really want?
As I said earlier the products are the products. They all have advantages and disadvantages. They all have things that they do and things they cannot do. The question becomes how do we fit together all of these known products in the proper ratio to develop a well-oiled machine of a financial strategy? How do we essentially create a Swiss army knife of a financial plan?
To do this we have to identify what we actually want. We have to identify the known risks that are in our way and have a set of diagnostic tools to measure which strategy gets us to where we want and mitigates as many of the known risks as possible. In other words there has to be some scientific verification beyond simple opinion and basic math.
The only certainty is uncertainty so we have no idea what the future will bring. So the best plan will give us the best chance of success under the widest range of circumstances. It will be flexible and in our control so we can zig and zag as the world changes. It will have contingencies and back up plans when certain aspects do not go our way. We first need to identify the risks we face during various phases of our financial lives.
Conventional wisdom would have you believe that these phases are very rigid as we progress from one phase to another. However, we really are always in all three phases at any given time. Meaning we can’t “plan” for retirement beginning at age 64. We can’t begin estate planning at age 85. Not if we plan on being effective anyway.
I have mentioned many of the risks we face throughout our financial lives, but for our purposes here I am going to use some specific risks that affect us at retirement. The reason for this is that retirement is usually the first thing on peoples’ minds when it comes to saving money and financial “planning.”
- Market Volatility – market fluctuations can negatively affect our returns and in retirement we no longer have time to wait for a recovery as our regular paycheck is gone. It can affect our spending power.
- Loss of Principal – beyond only market fluctuations – unforeseen needs and other unknowns can reduce the value of the account which will affect future spending and income.
- Outliving Money – People are living longer and may need a nest egg to last 30+ years. This affects the amount that can be safely withdrawn for retirement income. Spouses too.
- Tax Rates & Law – these can change and affect retirement income.
- Inflation – this reduces buying power over a lifetime ( i.e. health care, prescription drugs, travel, etc.).
- Lifestyle Changes – technology is constantly changing and it cost money to keep up with these changes. Also, things we own breakdown and need to be replaced. Our standard of living can also increase either by choice or by a breakdown of our or our family’s health.
So we need to look at strategies to see which ones best address the things we want and protect us from these things we don’t want.
I try to be a man of science. I am not officially, but I try. I was pre-med in college for a year or so until I realized it wasn’t for me. My father is a retired radiologist and I work with many medical professionals. However, it amazes me how little economic science is used in making financial decisions and coming up with financial strategies even from those in the science fields.
For example, the first piece of advice almost everyone gives today is max out your 401(k). Can it be part of your plan? Sure. Is it a plan in and of itself? No. It needs help. Does it mitigate the above risks? Well, 401(k)s are usually invested in risk assets so the market fluctuations can be even more of a problem at retirement. Can it lose principal? Yes. If the underlying investments perform well for an extended period of time it will keep up with inflation and help keep us from running out of money, it’s certainly not guaranteed. As far as a tax efficient vehicle at retirement, it’s a horribly tax inefficient product at distribution. All withdrawals are taxed at ordinary income rates, there is no dividend of long term capital gain tax treatment, you cannot write off losses.
I encourage you to do this exercise with all commonly recommended products to be used as the basis for retirement planning: Bonds, passive index & ETFs, actively managed accounts, mutual funds, annuities, real estate, businesses, etc.
The Bottom Line
I would love to be able give some one-size-fits-all, blanket advice so everyone could be successful, but I can’t. I don’t know what you have, I don’t know what’s important to you, I don’t know how you feel about risk, debt, your family, your legacy, investments, insurance, cash, real estate, cash flow, income, savings, etc. However, I do know that the current methodology is failing and has been for some time. The answer is to have a proper structure with assets properly positioned and coordinated with one another with balance in the areas of offense and defense. We need to save as much as we can with that savings cash flow going toward protection, savings, growth, debt, etc.
I realize this is a long, rambling, stream of consciousness. It was designed to be so. It is a starting point to hopefully get you to think, to identify problems which can lead to solutions. My purpose is to change things, improve upon things, and add value so more people can become successful.