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The Financial Myth of Risk = Reward
By Jeffrey W. Kirshner, CPA*, PFS, MBA
I hear it all the time as I’m sure you have had as well: In order to grow your wealth, you need to accept financial risk; the greater the risk, the greater the reward. Is this a true statement? I don’t believe so. In fact, I believe you can get ahead without putting everything you’ve worked so hard for at risk.
The Traditional Financial Formula
Traditional financial planning often attempts to satisfy a stated future financial goal or target (such as your retirement) by using the following simple formula:
Target = Money X Time X Rate of Return
This is a simple algebraic formula which states if you know your future target, then you can “back into” a financial strategy if you know 3 of the 4 other variables. For example, if a person needs to accumulate $2,000,000 of assets by retirement (the Target), and the money won’t be needed for another 30 years (the Time), and if money is assumed to grow by 10% per year (the Rate of Return), then it can be calculated that this person must save about $11,050 each year in order to hit the goal.
Sounds pretty simple, doesn’t it?
The truth is that there are a number of problems with this approach to financial decision making, and these problems have contributed significantly to many people getting way behind in their wealth building and financial planning endeavors. The solution, believe it or not, has nothing to do with asset allocation.
What are some of these problems?
Your true cost of living
So many people ask me, “Why do I feel like I’m not getting anywhere financially? I make a good living, but I feel like I’m just treading water.” Well, there are many forces working against you and your money. These include, but are not limited to, rising taxes, inflation, product wear and tear, planned product obsolescence, desire for improved lifestyle and unexpected life events. If your personal balance sheet is not growing, then these factors will likely be magnified.
The strategy of hoping for a 10% rate of return is not the optimal solution. For many, the past 15 years have produced some good returns in the market, but the past 15 years have also produced some very disappointing years as well, and these disappointing years have impacted the personal balance sheets of so many individuals and families. The cost of living factors mentioned above do not cease to exist just because of poor market conditions. On the contrary, they seem to tighten their grip on household finances during these down years.
The traditional formula deters savings.
Unfortunately, most financial planning platforms don’t take into account the multiple factors that impact your true cost of living. Using the simplistic formula, many people can justify saving less because they anticipate that the future market performance will create the desired outcome.
Why is this? Quite simply, there is abundance of marketing pieces that show attractive long-term results if a person stays invested. However, while all of the fine print states that “past performance is not indicative of future results” and that there are no guarantees, this is just not what most people hear.
Let’s return to my example above. If a person only realized a return of 5% instead of 10% during the same 30-Year time horizon, then $11,050 of annual savings would create just $771,000, which is a shortfall of over 60%! Hey, what happened to my 10% and $2,000,000?
Using the same formula, though, we can easily determine that $2,000,000 is still a reachable goal with only 20 extra years of work assuming, of course, that the annual savings of $11,050 continues and returns of 5% are achieved. Sure, the math works, but is this reasonable? Hardly. Who really wants to or can work an additional 20 years? Unfortunately, this is what happened to so many people who planned on retiring around 2008.
Learn to Save.
Today, far too many people invest in market –based assets and never save in accounts with guarantees. This approach can lead to inappropriate levels of risk, and it can sometimes lead to a lack of liquidity at times when liquidity is needed in order to respond to an unexpected life event. Parent Care, natural disasters, and medical emergencies are but a few examples of unexpected life events that can be devastating, especially without sufficient liquid savings.
The real key to building wealth is having enough new money reach your personal balance sheet each and every year. It can be easily proven that the level at which you save is more important than the rate of return you hope to receive. With that said, it almost doesn’t matter where you save your money as long as you are saving enough, and this means you can take less risk with the money that you are saving.
To gain more control of your financial future, you should be able to systematically save 15% - 20% of your gross income into wealth building endeavors. And, as your income goes up, you should continue to save at the same rate in order to limit the risks that come along with an ever-expanding lifestyle.
So, going back to my example again, if the person has an income of $200,000, he or she should NEVER be told that it is OK to save $11,050 per year. Instead, the savings rate should be at least 15%, or $30,000 per year. Over our 30-year time horizon and an assumed return of 5%, this would produce a result of nearly $2,100,000. If the person in our example could save 20%, or $40,000 every year, this would yield nearly $2,800,000. And all of this with half the risk as the person in our original example!
Saving this money may seem like a difficult task, but it is doable with the correct strategies in place. Lowering your taxes, managing your debt, owning a home that is affordable, selecting the right mortgage and living within a budgeted lifestyle are all ways to achieve savings goals.
When I hear people say that it’s very difficult to save this much money, I tell them I understand and that saving this much money is like trying to lose weight. Losing weight, generally speaking, is quite simple. Eat less and move more. Saving money is kind of the same. Spend less and save more. Yes, both may be difficult, but neither is impossible, especially with the right discipline and game plan.
Some Proven Strategies
Protect yourself first. You have likely worked very hard for everything you have, yet it can all disappear in a moment if you don’t have the right protection in place. Implement the best financial protection at the lowest cost.
Reduce taxes. Identify the multiple different taxes that impact you today and over time, and implement strategies and products that reduce the impact of these tax liabilities over time.
Manage debt. Avoid credit card debt at all costs. Choose the right mortgage, and don’t let your monthly mortgage payment consume your income. Generally speaking, a mortgage payment should not exceed 15% of your income.
Save 15-20% every year. Saving enough money every year allows you to protect yourself against the factors that impact your real cost of living, reduce the risk you take with your money and have a better chance at achieving your wealth building potential.
Create a budget. Creating a budget is one thing, but sticking to it is quite another. To save more, you will need to get organized so you understand where your money is going. Once you have a good grasp of your cash flow, it then becomes easier to figure how to get to your savings goals.
Jeffrey W. Kirshner, CPA*, PFS, MBA
Jeffrey W. Kirshner is a Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS). OSJ: 5080 40th Street, Suite 400, Phoenix, AZ 85018, (602)957-7155. Securities products and advisory services offered through PAS, member FINRA, SIPC. Financial Representative of The Guardian Life Insurance Company of America® (Guardian), New York, NY. PAS is an indirect, wholly-owned subsidiary of Guardian. KIRSHNER & KLARFELD FINANCIAL GROUP, LLC is not an affiliate or subsidiary of PAS or Guardian.
*Not Practicing for Guardian or any subsidiaries of affiliates thereof
The views and opinions expressed herein are solely that of the author and do not represent the views or opinions of The Guardian Life Insurance Company of America, or its subsidiaries or affiliates thereof
2015-10882 Exp 9/17