Everything You Are Being Told About Saving & Investing Is Wrong

Let me start out by saying that I am all for any piece of advice which suggest individuals should save more. Saving money is a huge problem for the bulk of American’s as noted by numerous statistics. To wit:

“American have an average of $6,506 in credit card debt, according to a new Experian report out pthis week. But which expenses are adding to that balance the most? A full 23% of Americans say that paying for basic necessities such as rent, utilities and food contributes the most to their credit card debt. Another 12% say medical bills are the biggest portion of their debt.”

That $6500 credit card balance is something we have addressed previously as it relates to the ability of an average family of four in the U.S. to just cover basic living expenses.

“The ‘gap’ between the ‘standard of living’ and real disposable incomes is more clearly shown below. Beginning in 1990, incomes alone were no longer able to meet the standard of living so consumers turned to debt to fill the ‘gap.’ However, following the ‘financial crisis,’ even the combined levels of income and debt no longer fill the gap. Currently, there is a $3200 annual deficit that cannot be filled.”

This is why we continue to see consumer credit hitting all-time records despite an economic boom, rising wage growth, historically low unemployment rates.

Flawed Advice

The media loves to put out “feel good” information like the following:

“If you start at age 23, for instance, you only have to save about $14 a day to be a millionaire by age 67. That’s assuming a 6% average annual investment return.”

Or this one from IBD:

“If you’re earning $75,000, by age 40 you need 2.4 times your income, or $180,000, in retirement savings. Simple as that.” (Assumes 10% annual savings rate and a 6% annual rate of return)

See, it’s easy.

Unfortunately, it doesn’t work that way.

Let’s start with return assumptions.

Markets Don’t Compound

I have written numerous times about this in the past.

Let’s assume an investor wants to compound their investments by 10% a year over a 5-year period.

The ‘power of compounding’ ONLY WORKS when you do not lose money. As shown, after three straight years of 10% returns, a drawdown of just 10% cuts the average annual compound growth rate by 50%. Furthermore, it then requires a 30% return to regain the average rate of return required. In reality, chasing returns is much less important to your long-term investment success than most believe.”

When imputing volatility into returns, the differential between what investors were promised (and this is a huge flaw in financial planning) and what actually happened to their money is substantial over long-term time frames.

Here is another way to look at it.

If you could simply just stick money in the market and it grew by 6% every year, then how is it possible to have 10 and 20-year periods of near ZERO to negative returns?

The level of valuations when you start your investing journey is all you need to know about where you are going to wind up.

$1 Million Sounds Like A Lot – It’s Not

I get it.

$1 million sounds like a whole lot of money. It’s a nice, big, round number with lot’s of zeros.

In 1980, $1 million would generate between $100,000 and $120,000 per year while the cost of living for a family of four in the U.S. was approximately $20,000/year.

Today, there is about a $40,000 shortfall between the income $1 million will generate and the cost of living.

This is just a rough calculation based on historical averages. However, the amount of money you need in retirement is based on what you think your income needs will be when you get there and how long you have to reach that goal.

If you are part of the F.I.R.E. movement and want to live in a tiny house, sacrifice luxuries, and eat lots of rice and beans, like this couple, that is certainly an option.

For most there is a desire to live a similar, or better, lifestyle in retirement. However, over time our standard of living will increase with respect to our life-cycle stages. Children, bigger houses to accommodate those children, education, travel, etc. all require higher incomes. (Which is the reason the U.S. has the largest retirement savings gap in the world.)

If you are in the latter camp, like me, a “million dollars ain’t gonna cut it.”

Don’t Forget The Inflation

The problem with all of these “It’s so simple a cave man could do it” articles about “save and invest your way to wealth” is not only the variable rates of returns discussed above, but impact of inflation on future living standards.

Let’s set up an example.

  • John is 23 years old and earns $40,000 a year.
  • He saves $14 a day 
  • At 67 he will have $1 million saved up (assuming he actually gets that 6% annual rate of return)
  • He then withdraws 4% of the balance to live on matching his $40,000 annual income.

That pretty straightforward math.


The living requirement in 44 years is based on today’s income level, not the future income level required to maintain the current living standard. 

Look at the chart below and select your current level of income. The number on the left is your income level today and the number on the right is the amount of income you will need in 30-years to live the same lifestyle you are living today.

This is based on the average inflation rate over the last two decades of 2.1%. However, if inflation runs hotter in the future, these numbers become materially larger.

Here is the same chart lined out.

The chart above exposes two problems with the entire premise:

  1. The required income is not adjusted for inflation over the savings time-frame, and;
  2. The shortfall between the levels of current income and what is actually required at 4% to generate the income level needed.

The chart below takes the inflation-adjusted level of income for each brackets and calculates the asset level necessary to generate that income assuming a 4% withdrawal rate. This is compared to common recommendations of 25x current income.

If you need to fund a lifestyle of $100,000 or more today. You are going to need $5 million at retirement in 30-years.

Not accounting for the future cost of living is going to leave most individuals living in tiny houses and eating lots of rice and beans.

Things You Can Do To Succeed

The analysis reveals the important points young investors should consider given current valuation levels and the reality of investing over the long-term:

  • Pay yourself first, aggressively. Saving money is how you pay yourself for working. 30% is the real magic number. 
  • It’s all about “cash flow.” – you can’t save if you spend more than you make and rack up debt. #Logic
  • Budget – it’s a four-letter word for most Americans, but you can’t have positive cash flow without it.
  • Get off social media – one of the biggest impacts to over-spending is “social media” and “keeping up with the friends.” If advertisers were not getting your money from social media ads they wouldn’t advertise there. (Side benefit is that you will be mentally healthier and more productive by doing so.)
  • Pick up a side hustle, or two, or threeOnce you drop social media it will free up 4-6 hours a week, or more, with which you can increase your income. There are tons of apps today to let you earn extra money and “No” it’s not beneath you to do so. 
  • Get out of debt and stay that way. No, you do not need a credit card to build credit.
  • If you can’t pay cash for it, you can’t afford it. Do I really need to explain that?
  • Future inflation expectations must be carefully considered.
  • Expectations for compounded annual rates of returns should be dismissed 

Don’t misunderstand me….I love ANY program that encourages individuals to get out of debt, save money, and invest. 

Period. No caveats.

There is one sure-fire way to go from “being broke” to being “rich” – write a book on how to do it and sell it to broke people. (See “Broke Millennial” and “Millennial Money.”– but hey that’s capitalism and you can do it too.)

But, if investing were as easy as just sticking your money in the market, wouldn’t “everyone” be rich?

It is always interesting reading article comments as they are generally full of excuses why saving money and building wealth can’t be done. The general thesis is that as long as you have social security (which is threatening payout cuts over the next decade) and/or a pension (which only applies to 15% of the country currently,) then you don’t need to save as much. 

Personally,  I don’t want my retirement based on things which are a) underfunded 2) subject to government-mandated changes, and 3) out of my control. In other words, when planning for an uncertain future, it is always optimal to hope for the best but plan for the worst.

However, the premise of the article was to clear up the disconnect between the cost of living today and 30-years into the future, as well as the amount of money needed to be financially independent for the entire lifespan after retirement.

Yes, we can all get by on less, in theory. But an examination of retirement savings statistics and the cost of healthcare in retirement (primarily due to poor healthcare habits earlier in life) doesn’t necessarily support those comments that saving less and being primarily dependent on Social Security is optimal. 

The Investing Problem

While “Part One”  focused on the amount savings required to sustain whatever level of lifestyle you choose in the future, we also need to discuss the issue of the investing side of the equation. 

Let’s start with a comment made on Part-One of this series:

“If you want to play it safe just buy a no-load, low fee, index fund and index into it regularly. Pay yourself first. Let the power of compounding do its magic.”

See, it’s so easy. Just buy and index fund, dollar cost average into it, and “bingo,” you have got it made. 

Okay, I’ll bite. 

If that is the case, then why this?

“More than half of Americans who were adults amid the Great Recession said they endured some type of negative financial impact, Bankrate found. And half of those people say they’re doing worse now than before the crisis.”

Or this:

“According to a brand new survey from Bankrate.com, just 37% of Americans have enough savings to pay for a $500 or $1,000 emergency. The other 63% would have to resort to measures like cutting back spending in other areas (23%), charging to a credit card (15%) or borrowing funds from friends and family (15%) in order to meet the cost of the unexpected event.”

As I stated in the previous article, I am all for any program and process which encourages people to save and invest for their retirement. My hope is that we can clear up some of the “misconceptions” to improve the chances that retirement years are not spent collecting food stamps and shopping at the local “Goodwill” store, 

Let’s start by clearing up the numerous erroneous comments on the previous article with respect to returns and investing.

Compound & Average Are Not The Same Thing

” Markets have returned roughly 10% per year of compounded growth, INCLUDING the down years.”

What the commenter is confused about is, as stated previously, is that markets have variable rates of returns. Historically, over the last 120 years, the market has AVERAGED roughly 10% annually. (6% from capital appreciation which is equivalent to the long-term economic growth rate, and 4% from dividends. Today, economic growth is averaging 2%ish since 2000 and dividends are 2% so do the math for future return expectations. 2+2=4%. (Since 2000, average growth has been just a bit more than 5% and the next bear market will roll that average back to 4%)

The chart below shows the difference in nominal values of $1000 invested on an actual basis versus a compounded rate of return of 6% (For the example we are using capital appreciation only.)

Mathematically, both of those lines equate to a 6% return.

The top line is what investors THINK they will get (compound returns.) The bottom line is what they ACTUALLY get 

The difference is when losses applied to invested dollars. The periods of time spent making up previous losses is not the same as growing money. (Bonds, which mature at face value and have a fixed coupon, have had the same return as stocks since the turn of the century.)

This “math problem” is the reason there is a pension fund crisis in the U.S. The massively underfunded pension system was caused by depending on 7%-annual returns in order to reduce saving rates.

Variable Rates Of Return Change The Game

In Part 1, we laid out a simple example of various current incomes adjusted for inflation 30-years into the future. I am presenting the chart again so the subsequent charts have context.

Now, let’s look at the impact of variable rates of returns on outcomes.

Let’s assume someone starts a super aggressive program of saving 50% of their income annually in 1988. (This was at the beginning of one of the greatest bull market booms in history giving them every advantage of front loaded returns and they get the benefit of the last 10-year long bull market.)  Since our young saver has to have a job from which to earn income to save and invest, we assume he begins his journey at the age of 25.

The chart below starts with an initial investment of 50% of the various income levels shown above with 50% annual savings into the S&P 500 index. The entire portfolio is on a total return basis and adjusted for inflation. 

Wow, they certainly saved a lot of money, and they met the amount need to completely replace their inflation-adjusted living standards for the rest of their lives.

Unfortunately, our young saver didn’t actually retire all that early.

Despite the idea that by saving 50% of one’s income and dollar-cost averaging into index funds, it still took until April of 2017 to reach the retirement goal. Yes, our your saver did retire early at the age of 54, and it only took 29-years of saving and investing 50% of their salary to get there.

Given the realities of simply maintaining a rising standard of living, the ability for many to save 50% of their income is likely unrealistic. If it wasn’t then we would not have statistics like this:

Instead, the next chart shows the same data but starting with 10% of our young saver’s income and adding 10% annually. (Which is the “Magic Number” for success)

Okay, it’s not so “Magic.” 

There are two important things to note in the charts above. 

The first is that saving 10% annually leaves individuals far short of their retirement needs. The second is that despite two massive bull market advances, it was the lost 13-year period from 2000 to 2013 which left individuals far short of their retirement goals. 

What the majority of investors misunderstand when throwing around numbers like 6% average returns, 10% compound returns, etc., is that losses matter, and they matter a lot.

Here are the TWO most important lessons:

  1. Getting back to even is not the same as making money.
  2. The time lost in reaching your financial goals can not be recovered.

It should be relatively obvious the last decade of a massive, liquidity driven advance will eventually suffer much the same fate as every other massive bull market advance in history. This isn’t a message of “doom,” but rather the simple reality that every bull market advance must be followed by a reversion to remove the excesses built up during the previous cycle.

The chart below tells a simple story. When valuations are elevated (red), forward returns have been low and market corrections have been exceptionally deep. When valuations are cheap (green), investors have been handsomely rewarded for taking on investment risk.

With valuations currently on par with those on the eve of the Great Depression and only bettered by the late 1990’s tech boom, it should not be surprising that many are ringing alarm bells about potentially low rates of return in the future. It is not just CAPE, but a host of other measures including price/sales, Tobin’s Q, and Equity-Q are sending the same message.

The problem with fundamental measures, as shown with CAPE, is that they can remain elevated for years before a correction, or a “mean reverting” event, occurs. It is during these long periods where valuation indicators “appear” to be “wrong” that investors dismiss them and chase market returns instead.

Such has always, without exception, had an unhappy ending. 

Things You Can Do To Succeed

There are many ways to approach managing portfolio risk and avoiding more major “mean reverting”events. While we don’t recommend or suggest that you try to “time the market” by being “all in” or “all out,”  it is critical to avoid major market losses during the accumulation phase. As an example, the chart below shows how using a simple 12-month moving average to avoid major drawdowns can impact long-term returns. We used the same 10% savings rate as above, dollar cost averaged into an S&P 500 index on a monthly basis, and moved to cash when the 12-month moving average is breached.

By avoiding the drawdowns, our young saver not only succeeded in reaching their goals but did so 31-months sooner than our example of saving 50% annually. It doesn’t matter what methodology you use to minimize risk, the end result will be same if you can successfully navigate the full-cycles of the market.  

You Can Do This

Last week, we laid out some suggestions on what you can do to build savings. This week will add the suggestions for the investing side of the equation.

  • It’s all about “cash flow.” – you can’t save if you don’t have positive cash flow.
  • Budget – it’s a four-letter word for most Americans, but you can’t have positive cash flow without it.
  • Get off social media – one of the biggest impacts to over spending is “social media” and “keeping up with the Jones’.” If advertisers were getting your money from social media they wouldn’t advertise there.
  • Get out of debt and stay that way. No, you do not need a credit card to build credit.
  • If you can’t pay cash for it, you can’t afford it. Do I really need to explain that?
  • Expectations for future returns should be downwardly adjusted. (You aren’t going to make 6% annually)
  • The potential for front-loaded returns going forward is unlikely.
  • Control investment behaviors and emotions that detract from portfolio returns is critical.
  • Future inflation expectations must be carefully considered.
  • Account for “variable rates of returns” in your plan rather than “average” or “compound.” 
  • Understand risk and control drawdowns in portfolios during market declines.
  • Save money regularly, invest when reward outweighs the risk. Cash is always an alternative.

Lastly, remember that “time” is your most valuable commodity and is the only thing we can’t get more of. 

Just recently, CNBC ran a story discussing the “Magic Number” needed to retire:

“For many people who adhere to the mission, there’s a savings target they want to hit, at which point they will have reached financial independence, as they define it. It’s called their FIRE number, and typically, it’s equal to 25 times a household’s annual spending, invested in low-cost, passive stock funds. Many wannabe-early retirees aim to save between $1 million and $2 million.”

This was the savings level we addressed in part one, which is erroneous because it is based on today’s income-replacement level and not the future inflation-adjusted replacement level, as it requires substantially higher savings levels. To wit:

“The chart below takes the inflation-adjusted level of income for each bracket and calculates the asset level necessary to generate that income assuming a 4% withdrawal rate. This is compared to common recommendations of 25x current income.”

“If you need to fund a lifestyle of $100,000 or more today. You are going to need $5 million at retirement in 30-years.

Not accounting for the future cost of living is going to leave most individuals living in tiny houses and eating lots of rice and beans.”

The Cost Of Miscalculation

As noted in the CNBC article above, it is recommended that you invest your savings into low-cost index funds. The assumption, of course, is that these funds will average 8% annually. As discussed in Part One, markets don’t operate that way. 

“When imputing volatility into returns, the differential between what investors were promised (and this is a huge flaw in financial planning) and what actually happened to their money is substantial over long-term time frames.”

During strongly trending bull markets, investors tend to forget that devastating events happen. Major events such as the “Crash of 1929,” “The Great Depression,” the “1974 Bear Market,” the “Crash of ’87”, the “Dot.com” bust, and the “Financial Crisis,” etc. often written off as “once in a generation” or “1-in-100-year events.” However, these financial shocks have come along much more often than suggested. Importantly, all of these events had a significant negative impact on an individual’s “plan for retirement.”

It doesn’t have to be a “financial crisis” which derails the best laid of financial plans either. An investment gone wrong, an unexpected illness, loss of job, etc. can all have devastating impacts to future retirement plans. 

Then there is just “life,” which tends to screw up things without a tragedy occurring. 

Making the correct assumptions in your planning is critical to your eventual success.

Your Personal Returns Will Be Less Than An “Index”

One of the biggest mistakes made is assuming markets will grow at a consistent rate over the given time frame to retirement. As noted, there is a massive difference between compounded returns and real returns as shown above. Furthermore, the shortfall is compounded further when you begin to add in the impact of fees, taxes, and inflation over the given time frame.

The chart below shows what happens to a $1000 investment from 1871 to present, including the effects of inflation, taxes, and fees. (Assumptions: I have used a 15% tax rate on years the portfolio advanced in value, CPI as the benchmark for inflation and a 1% annual expense ratio.)

There are other problems with chasing an “index” also:

  • The index contains no cash
  • An index has no life expectancy requirements – but you do.
  • It doesn’t have to compensate for distributions to meet living requirements – but you do.
  • It requires you to take on excess risk (potential for loss) in order to obtain equivalent performance – this is fine on the way up, but not on the way down.
  • It has no taxes, costs or other expenses associated with it – but you do.
  • It has the ability to substitute at no penalty – but you don’t.
  • It benefits from share buybacks (market capitaliziaton) – but you don’t.

As an individual you have very little in common with a “benchmark index.” Investing is not a “competition” and treating it as such has had disastrous consequences over time. 

Financial Planning Gone Wrong

I know, you still don’t believe me.  Let’s use CNBC’s example and then break it down.

For instance, imagine a retiree who has a $1,000,000 balanced portfolio, and wants to plan for a 30-year retirement, where inflation averages 3% and the balanced portfolio averages 8% in the long run. To make the money last for the entire time horizon, the retiree would start out by spending $61,000 initially, and then adjust each subsequent year for inflation, spending down the retirement account balance by the end of the 30th year.”

Kitces Spending Drawdown 071116

This assumption on expanding inflationary pressures later in retirement is correct, however, it doesn’t take into account the issue of taxation. So, let’s adjust the chart and include not only the impact of inflation-adjusted returns but also taxation. The chart below adjusts the 8% return structure for inflation at 3% and also adjusts the withdrawal rate up for taxation at 25%.

By adjusting the annualized rate of return for the impact of inflation and taxes, the life expectancy of a portfolio grows considerably shorter. 

However, we must also consider the impact of variable rates of returns in retirement as well.

The Impact Of Variability

Over the last 120-years, the market has indeed averaged 8-10% annually. Unfortunately, you do NOT have 90, 100, or more years to invest. All that you have is the time between today and when you want to retire to reach your goals. If that stretch of time happens to include a 12-15 year period in which returns are flat, which happens with some regularity, the odds of achieving goals are massively diminished.

But what drives those 12-15 year periods of flat to little return? Valuations.

Understanding this, we can use valuations, such as CAPE, to form expectations around risk and return. The graph below shows the actual 30-year annualized returns that accompanied given levels of CAPE.

As evidenced by the graph, as valuations rise future rates of annualized returns fall. This should not be a surprise as simple logic states that if you overpay today for an asset, future returns must, and will, be lower.

Math also proves the same. Capital gains from markets are primarily a function of market capitalization, nominal economic growth plus the dividend yield. Using the Dr. John Hussman’s formula we can mathematically calculate returns over the next 10-year period as follows:

(1+nominal GDP growth)*(normal market cap to GDP ratio / actual market cap to GDP ratio)^(1/10)-1

Therefore, IF we assume that

  • GDP maintains, 4% annualized growth indefinitely
  • Which means recessions have been eliminated, AND
  • Current market cap/GDP stays flat at 1.25, AND
  • The current dividend yield remains at 2%:

We would get forward returns of:

(1.04)*(.8/1.25)^(1/30)-1+.02 = 4.5%

These are some “big” assumptions. If we assume inflation remains stagnant at 2%, as the Fed hopes, such would mean a real rate of return of just 2.5%. This is far less than the 8-10% rates of return currently being counted on in many of the financial plans I see regularly. 

Let’s take this a step further. For the purpose of this article, we went back through history and pulled the 4-periods where trailing 10-year average valuations (Shiller’s CAPE) were either above 20x earnings or below 10x earnings. We then averaged those periods and ran a $1000 investment going forward for 30-years on a total-return, inflation-adjusted, basis.

Not surprisingly, the starting level of valuations has the greatest impact on your future results.

If we apply the math of valuations to our example, a much different, and far less favorable, financial outcome emerges – the retiree runs out of money not in year 30, but in year 18.

With current valuations elevated, and total returns in excess of 300% over the last decade, planning on using the stock market to make up for a savings short-fall may be misguided. This is the same trap that pension funds all across this country have fallen into and are now paying the price for.

What Your Financial Planning Should Consider

The analysis above reveals the important points individuals should consider in their financial planning process:

  • Expectations for future returns and withdrawal rates should be downwardly adjusted.
  • The potential for front-loaded returns going forward is unlikely.
  • The impact of taxation must be considered in the planned withdrawal rate.
  • Future inflation expectations must be carefully considered.
  • Drawdowns from portfolios during declining market environments accelerates the principal bleed. Plans should be made during up years to harbor capital for reduced portfolio withdrawals during adverse market conditions.
  • The yield chase over the last 8-years, and low interest rate environment, has created an extremely risky environment for retirement income planning. Caution is advised.
  • Expectations for compounded annual rates of returns should be dismissed in lieu of plans for variable rates of future returns.

Investing for retirement, no matter what age you are, should be done conservatively and cautiously with the goal of outpacing inflation over time. This doesn’t mean you should never invest in the stock market, it just means that your portfolio should be constructed to deliver a rate of return sufficient to meet your long-term goals with as little risk as possible.

  1. Save More And Spend Less: This is the only way to ensure you will be adequately prepared for retirement. It ain’t sexy, or fun, but it will absolutely work.
  2. You Will Be WRONG. The markets go through cycles, just like the economy. Despite hopes for a never-ending bull market, the reality is “what goes up will eventually come down.”
  3. RISK does NOT equal return. The further the markets rise, the bigger the correction will be. RISK = How much you will lose when you are wrong, and you will be wrong more often than you think.
  4. Don’t Be House Rich. A paid off house is great, but if you are going into retirement house rich and cash poor, you will be in trouble. You don’t pay off your house UNTIL your retirement savings are fully in place and secure.
  5. Have A Huge Wad. Going into retirement have a large cash cushion. You do not want to be forced to draw OUT of a pool of investments during years where the market is declining. This compounds the losses in the portfolio and destroys principal which cannot be replaced.
  6. Plan for the worst. You should want a happy and secure retirement – so plan for the worst. If you are banking solely on Social Security and a pension plans, what would happen if the pension was cut? Corporate bankruptcies happen all the time and to companies that most never expected. By planning for the worst, anything other outcome means you are in great shape.

Most likely what ever retirement planning you have done is most likely overly optimistic.

Change your assumptions, ask questions, and plan for the worst. 

The best thing about “planning for the worst” is that all other outcomes are a “win.”

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