Blog #35 Let’s Fuss over Asset Allocation

It’s time to face the elephant in the room: how to save enough to enjoy a well deserved, comfortable retirement in the future?

By any measure, this number is going to be a humongous sum because we are living longer and cost of living never seem to stop rising. Yet, for all its epochal significance, few people actually make the effort to quantify “THE NUMBER”.  Those who do it correctly will probably fall off their chair after seeing the mega amounts.

To give you a ball park figure, I’m going to assume that you are 30 years old, earning a $60,000 a year salary and looking to retire 35 years from now at age 65. The statistics say that current life expectancy of Singaporean is 83 and rising.  I will add a buffer to that and assume an RIP age of 85 for calculation purpose.  That means, you will need money to last for 25 years if you retire at 65. How big a retirement nest egg would you need?

This is a fairly complex calculation that hinges on many assumptions. My ball park answer is $3.8 million.  The calculations are in the spreadsheet listed below and I encourage you to tailor them to your preferred assumptions.

But for this blog and the next, I will fix $3.8 million as a future goal and proceed to solve the next challenge, which is how much one needs to save in order to hit the target wealth of $3.8 million in 35 years.

Required Savings Rate

Assuming you start saving now and grow your savings by 5% a year every year for the next 35 years, my calculations show that you will need to stash away 53% of your earnings as savings!

The key assumptions that lead to this unbelievable result rate are the following:

  • You start saving now
  • Your savings increase by 5% annually
  • Your savings earn a constant interest rate of 2% per year
  • You experience no major career disruptions that will jeopardize your ability to sustain your savings

I doubt there are few souls able or willing to sock away half their pay for an abstract future goal like retirement. You can certainly lower the required savings rate somewhat by changing some of the above assumptions). Suffice it to say that all things equal, unless you have a six-figure pay check at 30, your required savings rate will be no walk in the park. This is a compelling reason why we need to invest.

Asset Allocation

Let’s fantasize a little. Suppose the rate of return on your savings is not 2% but 6% because you’re taking higher risk for higher returns. With this change of assumption, your required savings rate drops to just 16.5%. This of course underscores the power of compounding money over long periods.

BUT, there is a substantive difference a 2% and a 6% return. I can easily get a 2% return by investing in high-quality bond. I cannot however, get a 6% return on average unless I venture into stocks or asset classes with equity-like returns. This is why investors must fuss over asset allocation, the way an investment portfolio is apportioned into different asset classes with complementary risks and returns.

Proper asset allocation is the second key challenge in retirement planning. Just as people tend to procrastinate in estimating THEIR NUMBER or are clueless on how to do it, most people also difficulties getting the asset allocation process right. A major problem is how to deal with uncertainty.

Put simply, when you have a 6% target return portfolio, you can’t just compound money at 6% every period the way you do with a 2% interest rate because risk means in some  years, your return will below 6% while in other years they will be above 6%. Visually, the wealth paths generated by a risky portfolio is not unlike mornings when you step out of your home with hair uncombed (see the portfolio hair diagram below).

Hair diagram.jpg

Each strand of “hair” in the above diagram represents a possible time path a risky portfolio can take. Paths that glitter are situated near the top of the value range. Paths that suck lie near the bottom. All paths are possible before the fact (i.e., before the end of your investment period). Prudent investors don’t wait until the end of investment period to balance risk and return. They do it at the start and at points that define key life stages (e.g., youth, middle age, close to retirement, in retirement). This is appropriately called life cycle asset allocation.

All my years, I have encountered only a few investors who take uncertainty in asset allocations seriously. Is this task too complicated for the average person?  Conceptually, I don’t think so. All one needs is a basic understanding of time value of money and an elementary knowledge of statistics. Is it too computationally hard to do?  Answer: I don’t know; my spreadsheet isn’t complaining.

Coming up in the next blog: Lifetime Asset Allocation on a Spreadsheet

 

Spreadsheet
Excel spreadsheet to estimate required savings rate in retirement planning.

 

 

 

 

 

 

 

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