How much do I need to retire?

As financial advisers, a huge part of our job is answering money questions. Out of all the questions we are asked, there is one which comes up with almost every client.

How much do I need for retirement?

The Herald released this article the other day. Taking figures from an annual Massey report on retirement spending, they believe $809,000 in savings is needed by a city-dwelling couple. From an initial lump sum of $809,000, they believe this couple could spend about $1,500 per week throughout retirement.

As a rule of thumb, $800,000 seems like a good target for the average Auckland-based couple. But nobody truly fits the average.

How much do New Zealander's need for their retirements? I'm happy to use the Massey figures for that. How much do you need for your retirement? That takes a little more work to figure out.

Starting with spending

There are many factors which influence how much you need. Of course, the best place to start is figuring out how much you expect to spend. And to estimate how much you expect to spend, you should understand how much you spend now.

When we help clients plan for their retirements, we start with their current outgoings. Ideally, you could leave your last day of work without your spending changing at all. Instead of the money coming in from working, it comes from retirement savings.

Sure, some things in your budget will change. You may no longer be driving into the office each morning or maybe you will spend more time eating out. But for a ballpark figure, what you spent previously is a good estimate. If you have some extravagant plans, add it on top.

Retirement is long

You may spend a similar amount of time in retirement as you do in your working years. It can be daunting to plan for such a long period without regular income.

During retirement, you can still have flexibility to change plans as needed. Part of the benefit of planning now is you can see where your plans can be flexible.

Many people choose to live it up early, with lots of travel and big purchases. Others prefer to ease into it, without making any big changes at all. Consider what sounds most appealing to you.

We typically plan for spending up until the age of 90. Ideally you are confident your savings will last until this point. You may want to choose a different timeframe over which to plan your retirement. Keep in mind, downsizing is a popular and effective method to raise capital once your retirement savings are all spent.

Another common concern is the cost of healthcare later in life. Typically people's spending does not change significantly as they reach this point as these costs are balanced by reduced spending elsewhere. When we get older, we tend to spend less on big trips and fancy cars.

If you wanted in-home care, it might be something to consider earlier. For most New Zealanders, rising healthcare costs are not as significant a concern as often thought.

Risk capacity and risk tolerance

If you understand how much you will spend and for how long, you may be getting an idea of how much you need before retiring. But, for the majority of retirees, their savings shouldn't be in cash. Investing these funds helps provide the extra returns needed to outpace inflation and provide for your needs late in retirement.

When deciding how to invest your retirement savings, it is important to understand both your risk capacity and your risk tolerance. In short, risk capacity is how much risk you can or should take, risk tolerance is how much risk you feel comfortable with.

Risk capacity describes how much risk is appropriate for your financial goals and position. For example, a young, working person has a high risk capacity, as their savings are not needed for a long time. They can afford to take risks. For someone drawing upon their savings, their risk capacity is lower, as investment losses may severely affect their ability to continue their withdrawals.

Exceeding your risk capacity means risking your ability to reach your goals if your investments perform poorly. Undershooting your risk capacity means not achieving the returns needed to fund your goals.

Risk tolerance describes how much risk you are comfortable taking on. Typically your tolerance is measured using a questionnaire and assigning a score out of 100. A person with a low score is risk averse and may be uncomfortable with market downturns, uncertainty in returns or investments they don't fully understand. A person with a high score is comfortable with the ups and downs of investment markets.

Investors rarely invest below the limits of their risk tolerances, unless it has been understated or their goals require them to take less risk. More concerning is when investors invest above their limits. The most common reason investors perform worse than the market as a whole is due to selling when share prices fall. Also, those who take on more risk than they can handle have a poor investment experience, with much anxiety  when performance is not great.

Understanding both your risk tolerance and your risk capacity will help you decide what type of portfolio is right for you.

How much is enough?

Once we know how much you want to spend and for how long, we can state this as your retirement goal. Knowing your risk capacity and risk tolerance shows which portfolio is appropriate for you. The last step is to estimate how much you need saved up to last the whole nine yards.

Instead of simple estimate of returns and withdrawals, we use Monte Carlo analysis for this last step. Monte Carlo is a statistical process which helps us estimate how your portfolio will perform in different scenarios. It accounts for periods where performance is strong and periods where it is weak in order to give a probability your portfolio survives. With a high probability of success, we deem the initial portfolio value enough for retirement.

As the years go by, we are able to track each client's progress against these projections. When needed, adjustments can be made to keep everything on track.

For a rough estimate, you may choose to simply add the return you expect each year, subtract the expected withdrawals and adjust for inflation. If you want help with a more sophisticated plan and strategy, we recommend speaking with a financial adviser.

The Nature of Headlines

Following a 5% dip in September, the S&P 500 index is back at new highs, having gained more than 20% for the year to date.

Funnily enough, I haven't seen anything in the Herald about this recovery. When markets were on the way down, it was impossible to miss.

It isn't very suprising and is in line with how financial journalism works. Not only do journalists have to report the news, but they must also attract readers.

Reading financial news is interesting, but not useful for long-term investors. However, it does not always feel this way when scrolling past articles of doom and gloom. Often these articles make us want to do something with our investments.

Below I have compiled a few things that may affect how you feel about these articles. Maybe you will notice a few yourself as you read the news. 

No news is usually good news

On most days, nothing really happens in share markets. Prices do bounce around a bit, but big jumps tend to happen when another significant event happens.

So if there isn't any news about the market, it's probably good news (or no news at all). On an average day, we expect prices to go up slightly, because share markets go up over time. But a headline like "Shares up slightly for no particular reason" isn't getting clicks.

This means, for most people, the only articles we see regularly about share markets is when they fall (and a couple when things recover). No wonder many people have a pessimistic view when it comes to the risks of investing.

In reality, most days are no news days. It is hard to notice when something is missing, but keep this in mind when scrolling through the headlines.

Emotive language is used

A trend we can see in all headlines is the type of language used. A person is not criticised, they are slammed. Many problems are escalated to crises. Countries are plunged into lockdowns.

With share markets, prices don't rise, they soar. When they fall, we hear of value wiped out, as if gone forever. You may click on an article to find a discussion of fear-selling, panic and desperation.

In reality, we know share markets often go down in value. These decreases are a normal part of investing and happen frequently. More importantly, we understand that nothing has been wiped away, it is just the shares we own are worth less than they were previously. Not many people would sell their house in a panic if the price fell, why should shares be different?

Yet this emotive language, used to capture readers, can affect the way investors behave. Those that act on these emotions tend to underperform their peers by a startling amount. Author, columnist and adviser Carl Richards describes this as the behaviour gap.

The behavior gap is the difference between the rates of return that investments produce when an investor makes rational decisions and the rates of return investors actually earn when they make choices based on emotions.

When reading headlines like this, consider the language being used and whether it is exaggerating the facts. While it can sometimes be hard to control our nerves, understanding what we can control is key to having a good investment experience.

New highs are nothing special

"Stocks reach new all time highs" is a cliché at this point, as it should be. People invest in shares because they want to grow their investment over time. While most companies pay dividends to shareholders, this growth comes predominantly from share prices increasing.

We can expect all time highs to come fairly regularly as prices increase. Looking at the S&P 500 for this year, more days brought new highs than failed to. Yet financial journalists seem to treat these highs as signs of an over-pressurised system.

Our last email included a piece by Jim Parker discussing this. Here a couple of key paragraphs:

Financial journalists periodically stoke investors’ record-high anxiety by suggesting the laws of physics apply to financial markets—that what goes up must come down. “Stocks Head Back to Earth,” read a headline in the Wall Street Journal in 2012. “Weird Science: Wall Street Repeals Law of Gravity,” Barron’s put it in 2017. And a Los Angeles Times reporter had a similar take last year, noting that low interest rates have “helped stock and bond markets defy gravity.”

Those who find such observations alarming will likely shy away from purchasing stocks at record highs.  But shares are not heavy objects kept aloft through strenuous effort. They are perpetual claim tickets on companies’ earnings and dividends. Thousands of business managers go to work every day seeking projects that appear to offer profitable returns on capital while providing goods and services people desire.

So remember, when reading about all time highs, this is the reason we invest in shares. New highs are not a sign of bad times to come, a reason to sell up or a reason to hold off investing. They are a symptom of a functioning share market.

The economy is not the share market

Last year was a good lesson in this fact; the economy is not the share market. Although the two are linked, share markets are forward looking and reflect all available information.

Following a big crash in February and March 2020, many could not comprehend how share prices recovered as the global economy seemed to be getting worse and worse. If you fell into the trap of equating the two, you would have missed out on the period of huge gains which followed.

When we read about a struggling economy, or coming inflation, or interest rates rising, we may initially think of how our investments will be affected. However, share markets are very efficient information-processing machines. If you are reading about it, the information is already in the price (i.e. people buying and selling shares, of which there are a lot, have already accounted for it).

Don't be surprised if good/bad news for the economy does not show up as good/bad results for your investments. While the two are linked, they are very complicated systems which don't always move together. And that article from this morning includes nothing useful for your investment strategy.

Best/worst cases (since the last best/worse case)

Another staple of financial headlines, "shares face worst/best day since X". Clearly the first thing journalists looks at following a good or bad day on the market was the last day it was better or worse. It is alarming to read these headlines at first, but with further thought, the opposite can be true.

I mentioned in a previous email my thoughts upon seeing the headline Wall Street marks biggest drop since May as Evergrande crisis intensifies.

The first thought I had was, what happened in May?

The headline implies it must have been worse than the current drop, but I couldn't remember anything significant happening. I also knew our portfolios had increased in value since then, so it obviously wasn't a big deal in hindsight.

It is safe to assume that back on that terrible day in May, there was a headline somewhere which said, Wall Street marks biggest drop since January as something bad happens. Or maybe it was the biggest since mid-2020 or earlier. It seems the first thing financial journalists do when the market falls is find the last time it fell by just a little more.

Funnily enough, the S&P 500 has already recovered from that little dip, as well as the dip in May and the dips before that. All of this while the Evergrande situation remains unclear.

The first thought you may have is, it must be bad if it is the worst day since X. When I see headlines like this they remind me how normal drops like this are and how frequently they occur. After all, if we made it through the last one and the ones before that, we should be fine through this one too.

Cherry-picking trends, signals and correlations

There are many different trends which people use to predict what the market will do next. With so many widely known strategies used for forecasting, you would assume active managers would do pretty well timing the market and choosing winning stocks.

However, as we've said time and time again, these managers are failing to do so. It turns out these indicators or trends don't offer the foresight needed to outguess the market.

We should really ignore most articles based around a predictor of markets. Further to this, it is important to recognise, these articles will pick the parts which agree with their main point.

You will be familiar with seeing opinion pieces with opposing views. Both will have a slew of information supporting their point of view. It is the same with financial news; the indicators used will be those which support their prediction. Other indicators will be ignored.

Performance in Lockdown

We hope everyone is coping well with our current lockdown. Hopefully we are more than halfway through and case numbers fall in the coming weeks. For those outside Auckland, the drop to level 3 offers some added freedoms (can't wait for takeaway Fridays myself).

As Phil and I continue to manage client portfolios through lockdown, we noticed the NZ share market jumped upwards as we returned to working from home. A similar, but much larger jump happened last year as we went into level 4 for the first time.

Throughout all of 2020, as COVID-19 spread across the globe, most of the people I spoke to didn't understand how share markets continued to soar. I can't pretend to know myself, although explanations always pop up in hindsight.

It is possible the collective wisdom of all investors worldwide looked past the economic fallout and correctly predicted where we would find ourselves this year. The recent job shortages and inflation fears come as economies strengthen again, more than a year since the big share market drop in Feb/March 2020. Who knows.

If we can take any lesson from these big swings, it is that you cannot predict where markets will go next. I would also add, due to the great complexity in economies and share markets, trying to make predictions based on a few factors is not advisable.

Below is a chart of the S&P/NZX 50 Index from the start of 2020 to now. This index represents the performance of the 50 largest publicly-listed companies in NZ. I have added two green lines representing when the first NZ case occurred and when our borders were closed. The gold bands represent times Auckland or NZ as a whole were in level 3 or 4 lockdowns.

Common sense suggests the sudden announcements of lockdowns, which clearly impact the economy, should crater share prices. However, this isn't what the chart shows. In fact, the lowest point reached was on the 23rd of March 2020, the day our first lockdown was announced.

Remember the first lockdown? I returned from a holiday in Japan (cut short) to find the supermarket shelves emptied and toilet paper a scarce commodity. Amidst all this panic, it was the absolute best time to be investing in NZ shares.

This isn't to say we should wait until lockdown to start investing. The sample size is small, and the rest of the chart shows no pattern whatsoever. It does suggest we shouldn't use information regarding COVID-19 to make investing decisions.

The best time to start investing is yesterday. The next best time is today.

Stocks and the economy

The state of the economy and the share market are linked, but not as closely as many believe.

Share prices are forward-looking, as investors make predictions about what will happen to a company's profits over the long-term. The current price of a company's shares reflect all investors collective knowledge and opinions related to the company's future earnings.

Figures for the economy reflect the state of businesses right now. This will affect the opinions of investors as they decide which shares to purchase and at which price. The two are not perfectly correlated.

A great analogy, provided by Ritholtz Wealth Management adviser Joshua Brown, compares the link to a woman walking her dog. You can listen to the 9-minute interview at NPR.

BROWN: And I’m now going to give you my favorite analogy. So a woman is walking through Central Park, and she’s got a dog. What’s a very active kind of dog?

VANEK SMITH: Oh, like a Jack Russell terrier or something like that?

BROWN: Fine. Jack Russell Terrier is great. If you just looked at her, what is she doing? She’s taking normal steps. She’s going in a straight line. She’s walking, you know, upright at a moderate pace – nothing terribly exciting. Then let your eyes pan down a little bit. Look at the dog. The dog is going crazy. It’s chasing birds. It’s digging up clumps of mud. It’s running at trees. It’s peeing all over the place. The dog is the stock market. The woman is the economy. The dog is chasing butterflies, then it’s sniffing itself, you know. So if you’re just watching the dog, you’re not watching the economy. You’re watching the manifestation of hundreds of millions of people’s greed and fear with buying and selling. But you’re not watching an actual representation of how the economy’s doing. So it’s important to understand that, yes, the stock market leads the economy and, to some extent, reflects the economy…

VANEK SMITH: Yeah, they’re connected, like the dog and the…

BROWN: Yeah, the dog’s going walk in the general direction that the woman walks the dog. So the economy and the dog – or the economy the stock market are somewhat connected. But they do not look the same. They do not act the same even if they’re walking in the same direction.

What this means for investors

The country moving into lockdown shouldn't affect our investment decisions. The COVID responses of other countries are equally irrelevant, as economies and share markets are too complex for these single-factor models.

When we decide to invest in riskier assets such as shares, we have to accept some times will be bad, even though most are good. We do this because over time the good outweighs the bad and we can earn a higher return. For most investors, this higher return is what will provide the retirement we spend decades working towards.

Knowing we don't need to time the market, correctly predicting when to jump in and out, makes this easier for long-term investors. Focus on the horizon and ignore the short-term noise.