How To Use Your Goals To Make Decisions Under Uncertainty, And Not Your Feelings.
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Reacting to short term losses and market uncertainty can lead to costly long-term decisions. Use technology and a goals-based approach to put current losses and volatility in the right perspective, and find better solutions.
With the market gyrations and economic uncertainty we are experiencing, investors are feeling the pain of market losses and many may lose faith in their investment plans. The potentially bigger risk, however, is that the focus on short-term losses can lead investors to bad long-term decisions. It’s natural to feel anxious and wonder if there is anything we should be doing to improve the situation. We just have to make sure our natural tendencies do not lead to bad decisions. Remember that investing is a long-term endeavor, and it is important to put the short term losses into the right perspective before you can make any changes to your investments. Here is how.
Zoom Out
Say you find out you lost 15% of the value of your retirement account this week. You read the news and things are pretty bad, and no one knows when things will get better. Should you sell your stock investments today and wait until things have cleared out? That is the question many investors naturally ask, but it’s the wrong question. The right question should be, what does this 15% drop mean for my ability to reach my retirement goal?
Say you are 45 with the following retirement plan. You have saved $350,000 so far, make $100,000 a year, and are saving $1,200 a month (including employer contributions) towards retirement. You expect to retire at 67, and expect $26,000 from social security. You desire a retirement income of $80,000 a year, including Social Security. Are you on track for your goal? It’s easy to answer this question using a retirement calculator like Dimensional’s My Retirement Income Calculator.* If you plug in the numbers of this plan, you’ll see that you would be on track for a retirement income of about $81,000, using reasonable assumptions. This should be the starting point for you to analyze questions about your plan.
Now consider the impact of the 15% loss. Your savings drop to $298,000, a $52,000 loss in a week. That sucks. But what is the impact on your goal? Your expected income, including Social Security, is now $76,000, about 94% of the initial estimate of $81,000. Focusing on the short-term movement, the loss feels really worrisome. Put it within the right context of your plan, and it does not seem that big. The reason for that is that your future savings have a large impact on your desired outcome. While painful, current losses are a smaller contributor.
Source: Dimensional Fund Advisors.
What to do about it?
Framing the question this way also helps you find real solutions, instead of panic reactions. If you believe the drop is temporary, or if you think $76,000 is still within a reasonable range for you, you may decide to do nothing right now. If you feel $76,000 is not enough and you’d rather correct that gap starting today, the tool lets you see the impact of your choices. If you increase your savings by $100 a month, you can bring the estimated income to above $78,000. $200 will bring it back to $81,000. You may also have the ability to retire later. Retire one year later, and the estimate goes up to $81,000, with no increase in monthly savings required. Any combination of these can be a viable option for different people.
One solution could be to increase the savings by $100 now and automate this increase. In a year, if things look much better, you could use the extra savings to increase your target spending or simply cut back on future savings. If things don’t get better, you can increase savings, reduce expected consumption in retirement, or retire later. By using all available levers, your adjustments are unlikely to be too big. Professor Schlomo Benarzi at UCLA suggests the 1-2-3 approach after big losses: plan to retire one year later, increase savings by 1% for the next two years, and reduce planned spending in retirement by 3%. This can probably do the job in most cases.
Use Goals-Based Investing
You can repeat the same analysis above for any of your goals, not just retirement. In fact, we believe that’s how you should build your entire investment plan. The approach of building an investment plan starting from well-stated goals is called goals-based investing. Our example illustrates how a goals-based strategy can improve investor performance without trying to outguess markets. That is why we make this approach the foundation of our investment philosophy and leverage technology to provide meaningful information to investors and make better decisions.
The improvement in investor performance can be large. Studies show that reacting to short-term performance can be a large drag to investor performance. Lower returns mean you’ll have to save more to achieve the same goal. A plan focused on your goals can help you make better decisions and substantially improve your long-term performance.
Until Next Time!
Massi De Santis is an Austin, TX fee-only financial planner. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
*For full disclosure I led the development of this calculator in my previous career, but DESMO Wealth receives no compensation of any kind for using it.
