A significant number of people (perhaps you are among them) don’t invest their savings, instead keeping their money in cash or bank CDs. These people share certain feelings about investing and the market that explain why they choose not to invest. In most cases of non-investing, the individual chooses “peace of mind” over wealth enhancement. These people are willing to forego potential growth of their assets in return for not having to worry about the safety of their money. Unfortunately, the “peace of mind” gained from knowing you will not lose money, at least not on paper, can cost you huge sums over the long run.
Similar to the non-investor, there are also many people who do invest, but are overly conservative, perhaps completely avoiding riskier assets such as stocks. The analysis below also applies to them, although the actual numbers will not be quite so extreme.
How much does peace of mind cost?
Using the financial modeling software that we employ for our clients’ wealth projections, we can estimate approximately how much a hypothetical married couple (John & Jane Doe) would sacrifice for peace of mind over the course of their retirement. This software incorporates specific information about a client’s situation (assets, income, spending, desired estate size, etc.) and runs one thousand simulations to estimate the odds of reaching your goals. For each simulation, the software randomizes the annual performance of each asset type in your portfolio and calculates how much your portfolio would be worth at the end of each year, taking into account all income, spending, taxes and inflation. It then repeats this process 999 more times.
This technique, known as “Monte Carlo simulation,” was developed during WWII to model complex systems whose actual behavior is unknown; creating 1,000 simulations helps ensure that the full range of possible outcomes are accounted for. In one simulation, for example, your investments do remarkably well, enabling you leave far more than you expected to your heirs. In another simulation, you live through two or three more bear markets like we had in 2008 and run out of money 15 years early. Your “success rate” is the percentage of simulations that enable you to reach your goals. Research has shown that a success rate between 75% and 90% is sufficiently high to provide confidence that your plan will succeed.
Running the Numbers
We made the following assumptions about the Doe family:
- John is 52 years old, Jane is 51, and both plan to retire in 11 years (when John is 63)
- John lives 43 more years (to age 95) and Jane lives 47 more years (to age 98)
- They both currently earn $150,000 per year and contribute the maximum to their 401k plans (plus an employer match of 3% of salary). This is their only savings.
- John and Jane will each collect the maximum in Social Security starting at age 66
- The couple currently has $1.5 million in liquid assets ($1 million of that in their 401k plans) and wants to leave $500,000 to their heirs
- Inflation averages 3% per year over the remainder of their lifetimes
We calculated the Doe’s success rate under two different scenarios:
Scenario #1: They invest their savings in our “aggressive portfolio” (mainly equities) during their working years, and switch to our “balanced” portfolio (about 54% equities) during retirement. Note: We included a 1.5% annual investment management fee in this scenario.
Scenario #2: They invest only in “safe” US Treasury bills and bank CDs for the rest of their lives. Note: No investment management fee was included in this scenario.
We targeted a success rate of 90% (high enough for near certainty) by adjusting the couple’s spending during retirement until each scenario reached a 90% chance of success. Not surprisingly, we found that if the Doe’s choose to pursue a non-investment strategy, they will have to sacrifice greatly in order to avoid running out of money, not to mention meeting their long-term goal of leaving $500,000 to their heirs.
The Price of “Peace of Mind
Here are the results:
Scenario #1: If the Doe’s choose to invest aggressively now and moderately during retirement, they would be able to spend $119,000 a year during their 37-year retirement.
Scenario #2: If the Doe’s choose to invest only in Treasury bills and CDs, they could spend only $82,000 a year during retirement.
You can see that the Doe family (whose assets and financial goals are similar to many of our clients) would have to give up $37,000 a year in spending, or $1,369,000 over the course of their retirement, for the privilege of not having investments to worry about. If you ask me, that’s an awful lot to pay for a good night’s sleep! How much are you willing to pay for “peace of mind?” (Of course, one could invest less aggressively prior to retirement and still be able to spend a lot more than a non-investor; we used a relatively extreme example to illustrate our point.)
Note that while there’s almost zero chance of a non-investor running out of money completely, the investor in scenario #1 does have a 5% chance of running out of money when Jane is “only” 91 years old (but they’d still have Social Security). The Doe’s could reduce the chances of running out of money early to less than 1% by spending only $102,000 per year, still $20,000 pear year more than the non-investor gets to spend. It comes down to how much you’re willing to pay for certainty.
For our clients, we spend many hours considering every aspect of their financial lives in the simulations so we can be as precise as possible. We then explain their results and test alternative scenarios. (What if we wanted to spend $10,000 per year traveling? What if our daughter went to an Ivy League school instead of state school? Etc.). While we cannot offer this level of detail to non-clients, we would be happy to input basic values such as your assets, income and expected retirement spending so that we can show you the impact that not investing would have on your retirement. Call or email us if you are interested.
Why do people choose not to invest?
Many people believe that the market is no more than a big casino, an idea that we discuss in an upcoming blog post. Perhaps even more common, many people are so risk averse that they cannot consciously make the decision to invest and put their hard-earned money at risk when they can stash their money in a “safe” alternative such as a bank, because the prospect of loss is so frightening. However rewarding a +10% gain is for this group, a loss of similar magnitude is felt much more strongly. Those who study behavioral economics have developed a gauge, called the “coefficient of risk aversion”, which measures how much more painful a loss feels compared to the pleasure of an equal gain. For most investors, that number is 2.5x, meaning that to offset the pain of a $10,000 loss, one must make a $25,000 gain, or 2.5 times the amount of the loss. Although the individual in this example is $15,000 better off, the pain from the loss was so intense that the much larger gain is needed to return the investor to emotional square one.
What you can’t control
Many things that affect the growth of your wealth are under your control, such as the mix of your investments, and your spending and saving habits. There are also externalities like inflation that you can’t control, but they can dramatically affect the outcome of your financial plan. In the example above we used a 3% inflation rate, but what would happen if inflation averaged 4% during the Doe’s lifetime? Their spending power would be far less under this scenario:
Maximum amount the Doe’s can spend and still succeed in 90% of simulations:
3% Inflation 4% Inflation
Investment Portfolio: $119,000 $102,000
Bank CDs: $82,000 $66,000
Clearly, inflation can have a huge impact on your retirement. With clients, we typically create scenarios with different inflation rates to see how robust their financial plans are. In addition, we periodically recalibrate our wealth projections, particularly as the economic environment and personal financial situations change, in order to provide the most accurate projections possible. Not infrequently, adjustments to the plan are necessary (often in a good way). Whether you are an investor or a non-investor, your future will be less scary and uncertain if you spend some time planning and make changes that raise your chances of long-run success.