Many investors are aiming at a target level of wealth, say for a retirement fund; I for one am. However, what's true in the public sector can also be true in investing; targets can create problems as well as solve them.
The first problem with targets is that they can make us vulnerable to money illusion. Let's say you think you'll need £500,000 if you were to retire today; such a sum would buy a 65-year-old man an annual income of £30,000. How much would you need in 20 years' time? The answer is more than £500,000 because £500,000 won't buy you as much in 2032 as it does today. In fact, if inflation hits the Bank of England's 2 per cent target, prices will be 49 per cent higher in 2032 than they are now. This means that to get the same real living standards as £500,000 would buy you today, you'll need around £750,000. And if inflation averages 3 per cent instead of 2 per cent, you'll need £900,000. The power of compounding is our friend with investment returns, but it's an enemy with inflation.
It's not just inflation that affects what our target should be. If we're investing for retirement, annuity rates also matter. If annuity rates stay at present levels, then £750,000 will buy you an annual income of £45,000 in 2032, equal to £30,000 in today's money with 2 per cent inflation. But if annuity rates fall by one percentage point, you'll need a pension pot of £900,000 to get such an income.
Luckily, though, annuity risk cuts both ways. Annuity rates can rise as well as fall. If the Asian savings glut diminishes and/or quantitative easing stops - which are reasonable possibilities sometime in the next 10 years - then gilt yields would rise, pushing up annuity rates. A one percentage point rise in such rates would allow you to reduce your target wealth by 14 per cent.
A further problem is that targets can affect our appetite for risk. If we're a long way below them, it's tempting to take more risk; prospect theory tells us that people have an urge to get even.
To some extent, this is no bad thing. Low share prices often mean high expected returns, so taking more aggregate equity risk after the market has fallen needn't be a disaster. The investor who, in early 2009, responded to a shortfall in his wealth from his target by raising equity exposure would have done a lot better than the one who threw in the towel then. In this sense, an apparently irrational urge - 'I've lost money so I should double up' - can actually yield quite sensible results, as long as it's not pushed too far.
Instead, the problem can come in response to gains. In principle, if our wealth is around or above our target, we should reduce risk to ensure staying at the target. But there is a tendency to ratchet the target upwards in good times; 'we could do with a bigger house for when the kids visit'. This can cause us to stay in an expensive market. Of course, this is not an issue now, but it could become one sometime.
These issues matter because there are big risks to long-term targets. Let's say we expect total real returns on shares to average 5 per cent a year in real terms, with annual volatility of 20 per cent; these are, I think, reasonable round numbers. This implies that there's a one-in-six chance of shares making no money at all in real terms over the next 10 years. That's the bad news. The good news is that there's also a one-in-six chance of them making you a real return of 120 per cent.
For reasonable targets of wealth, therefore, there's a high chance of over- or under-shooting them.
And it's not just an under-shoot that is unpleasant. An overshoot carries a cost as well. It means you've saved too much and so deprived your younger self of consumption possibilities; some nice holidays or cars. It can also mean that you've worked too long or too hard.
Luckily, there are solutions to problems such as these, at least for some of us.
One is to be flexible about when you retire. You can make up for shortfalls from your target by working longer. This is a good reason why people start saving for retirement from an early age; having to retire at 60 rather than 59 is less painful than having to retire at 70 rather than 69.
There's another source of flexibility - in our tastes. If your wealth looks like falling short of your aspirations, there are two things you can do. The obvious one is to raise your wealth by working longer, saving more or taking more risk. The other one is to reduce your aspirations; do you really need such a big house or fancy car?
Financial advisors don't often recommend the latter, for the same reason that turkeys don't welcome Christmas. But it is the natural consequence of the economic crisis; lower GDP growth and the poorer investment returns it causes means lower growth in living standards, which requires us to adjust our expectations down. It's not obvious that doing this is more painful or more difficult than attempts to increase our wealth.
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Chris blogs at http://stumblingandmumbling.typepad.com