Living Standard Risk
How to tie your investment risk to your spending
Is your lifestyle at risk? Not the paragliding, Everest climbing, adrenaline at historic levels, risks to life, but the risk to the style of life and investment risk that most of us share. Households save for a home, retirement, or a child’s education and choose how savings are put to work. How to allocate assets consistent with a household risk profile was the subject of last week’s book installment, and this week’s installment follows how investment risk is transformed into lifestyle risk. Every household has its magic number, captured by its optimally determined, sustainable size of discretionary spending. Experienced readers of PFE know there are Nobel laureates behind this application to personal finance, and today’s extension of Chapter 6 is one of the more exciting outcomes of economics-based financial planning. Informed by the range of prospective living standards for more risky asset allocations, panic or, more likely, comfort will settle in. Knowing more about investment risk will keep the Tulsa couple, Roger and Jan Peterson, and their Golden fed.
Today’s installment shows how to project your investment risk to better understand the risk to your standard of living. For the Petersons, the chart above traces their living standards from today forward. Four lines offer the Petersons their annual discretionary spending cap for a sustainable future, distinguished by two distinct asset allocations for their existing financial assets. A lower-risk alternative invested 80% in the Total Bond Index and 20% in the Total Stock index, and a higher-risk alternative places 100% of retirement assets into a Total Stock index fund. Context matters and Peterson’s entire case study is included in this week’s installment to illustrate how you can fold in your asset allocation to understand your spending caps.
Today: In a 1997 talk, “Financial Planning in Fantasyland,” the great financial economist William Sharpe expressed concern that financial planning software output was long on graphics and short on a discussion of risk when projecting future retirement accumulations in defined contribution plans. He stated, “We need to devise software that recognizes that investment returns are not certain, that conveys risk/return tradeoffs in ways that are relevant and understandable by the user, and that projects mutual fund characteristics as carefully as possible.” That sounded reasonable thirty years ago, and it sounds reasonable today. Sharpe’s ideas have been extended, and projections of living standards embodying investment projections are now mainstream. Living standards and discretionary spending outcomes with percentile ranges allow a household to make a better investment decision. In the book, we try to go short on graphics and long on discussion to help readers learn. Paid subscribers can directly message me with their questions, too.
Excerpt:
