As I sat on a panel at the annual Bogleheads conference a few weeks ago, I was struck by just how many of our answers, while completely reasonable, amounted to educated guessing.
The right withdrawal rate in retirement? Only apparent in hindsight, when you know what your portfolio returned, how long you lived, and whether your long-term care costs spiked later in life.
The right asset allocation? Absolutely evident only in hindsight, which is why sane people counsel diversification.
The right time of year to make retirement contributions? Even this is impossible to answer with 100% certainty. While historically it has been better to make contributions early in the year--the better to take advantage of compounding--can we know for sure that the assets you'll invest in won't embark on a pattern of losing in January and rallying late each year during your particular investing horizon? Nope.
My estimable fellow panelists--Bill Bernstein, Jonathan Clements, Wade Pfau, Mike Piper and Allan Roth--were appropriately humble in the face of these questions, and I hope I was too. But in other quarters, it's striking how a sense of certainty--rather than humility--often pervades financial guidance.
Commentators on financial television programmes stridently suggest that energy stocks are set to take off; advisers sagely advise their clients to stick with their equity-heavy mixes because this rally still has legs. Of course, hubris isn't the exclusive domain of financial professionals; plenty of individuals engage in self-confident prognostication on uncertain matters, too. Wherever you turn, it seems, you run into a shocking amount of confidence in matters that are open-ended at best.
Is your humility in line with the uncertainty?
- There ought to be some sort of an uncertainty/humility score for various financial jobs we might do or decisions that we make.
- The higher the uncertainty, the more humility we ought to apply to it--and the more wiggle room we should apply to our plans.
- The lower the uncertainty of the job, or the decision, the more confident we can be in our approach to it.
Setting your withdrawal rate for retirement is the epitome of a financial job where the uncertain factors are many. You don't know your time horizon (how long you'll live). Nor do you know what your portfolio will return over your particular time horizon, or whether you'll incur some big, unanticipated costs later in life--long-term care expenses, for example, assuming you haven't bought insurance. That jumble of uncertainty suggests that it's wise to be ultrahumble when setting your withdrawal rate--and be open to revisiting the data on an ongoing basis--because things may not play out the way you planned.
At the other end of the spectrum are matters where the range of outcomes is extremely limited or even guaranteed. Debt paydown is a good example: By retiring debt, you're guaranteed a "return" equivalent to the interest you would've shelled out but didn't, less any tax breaks you were receiving on that interest. Given today's low interest rates on other guaranteed products, you can be quite certain that prepaying debt is the highest-return guaranteed investment you can make. You can attack your debts with a swagger in your step; you don't need to be humble. Low uncertainty calls for low humility.
Known unknowns: It's a long list, people
When you think about it, though, the list of uncertain factors related to investment planning dwarves the list of items with a greater degree of certainty. That's to be expected. Not only is the return on anything that's not CDIC-insured not guaranteed, but a lot of the other variables that affect the success or failure of a plan could slosh around: time horizon to and during retirement, tax rates (secularly and your own tax situation), inflation, and so on.
I'd divide the uncertain factors into two camps: those that are secular and those that are personal/depend on your own situation.
At a secular level, uncertain factors include:
- Long-term asset class returns
- Intra-asset-class returns (Foreign vs. domestic, small vs. large, value vs. growth, etc.)
- Currency swings
- Tax rates at large
- Inflation
Meanwhile, personal uncertainty factors include:
- The amount that you're able to contribute to your goal (could be lower than you expected due to income disruption, change in income or higher living expenses)
- Time horizon to your goal (you may be forced to tap your money sooner than you expected)
- Duration of multiyear goals (it could take your child more than four years to earn an undergraduate degree; you could live to be 107)
- Your ability to stick with your plan due to discomfort with downward fluctuations
- Your personal tax situation
- Large unforeseen expenses before or during retirement, including long-term care expenses not covered by provincial health insurance.
What it means for you
So your plan is hopelessly affected by uncertain variables that are mostly or entirely out of your control. It's enough to make you want to stick your money in the bank and curl up in a fetal position. But the fact is, you must be willing to tolerate some uncertainty -- and indeed risk -- in your plan if you want to out-earn the inflation rate. Over time, higher-risk assets, namely stocks, have returned substantially more than guaranteed and low-risk assets, and it's reasonable to assume that pattern will hold in the future, too.
It also bears remembering that you take small calculated risks in many other aspects of your life all day long -- when you leave the house without an umbrella, venture onto the highway in a car, or take a new job. Things could go wrong, but tolerating uncertainty and risk -- both major and minor -- is how we get things done and make progress.
The same is true for your financial plan. The key is to think through how much uncertainty underlies a given financial level or task. If there are many uncertain variables swirling around, your job is to ensure that your plan can still work even if those variables don't play out as you're expecting them to. Here are a few ideas to help you do that.
Focus on the known knowns.
The list of uncertain variables that could affect your plan is disconcertingly long. That's why it's valuable to focus your energies on the shorter list of variables that you can actually control. Upping your own investment contributions is guaranteed to improve your investment plan and can go a long way toward making up for lacklustre investment returns; ditto for limiting all of your investment-related costs. Debt paydown and taking advantage of tax-sheltered retirement-plan contributions also fall into the "high certainty" bucket.
Look for humility in your financial helpers.
If you're interviewing financial planners or advisers (or if you have one already), do they acknowledge that there's a lot that they couldn't possibly know? Does the recommended plan include accommodations in case something doesn't play out as planned -- stocks lose money for an extended period, or you or your spouse lose your jobs prematurely?
Exercise caution on big-ticket decisions when uncertainty is high and the downside of being wrong is also high.
There are a million financial decisions we all make where the uncertainty is high but the stakes are pretty low. For example, let's say a 30-year-old tweaks his RRSP portfolio to devote 5% to an emerging-markets fund. That could turn out to be a poor decision, but such a small bet on uncertain variables is unlikely to make or break his plan; his savings rate and whether he takes enough risk overall will be the main determinants of his success or failure.
On the other hand, say he expects a market crash will materialize within the next few months, and so transitions his entire portfolio to cash and leaves it there for the next few years. In this case, betting wrong on uncertain variables has a higher potential cost to the success of his plan than making a smaller bet. Be very careful about big decisions where the outcome is uncertain and the downside of getting it wrong is high.
Be open to course corrections.
If you're embarking on a job or decision with a high degree of uncertainty attached to it, such as setting a withdrawal rate, it's important to course-correct as the situation dictates. For example, you might take a 4% initial withdrawal from your portfolio in retirement, but if your portfolio plummets the following year, it's wise to reduce your expenditures in year 2. It's important to have a plan, but when you're dealing with uncertain variables, flexibility is key.
