In the last few posts we’ve been considering the subject of risk in investing. As we’ve seen, the financial services industry’s definition of risk as investment volatility is not necessarily the most useful definition for the average investor. At least as useful, if not better, is the concept of shortfall risk: the possibility of falling short of one’s financial goals. While stock market volatility may contribute to shortfall risk, it is not the only aspect of investing that may cause you to come up short of your financial goals. At least equally important is the possibility that you will earn long-run returns that fall short of expectations, and even short of inflation. If you earn less than the rate of inflation, then the price tags on your financial goals—be they a college education for your kids, a new house, whatever—will rise faster than the value of your savings. Your investments will actually lose, not gain, purchasing power. As a result, you will have to either increase your rate of savings (or, if you are retired, reduce your spending)—or give up on achieving your goals and dreams.
So, you have a lot riding on your shortfall risk! For example, if you have virtually no chance of coming up short of your goals, you can rest easy. But if you have, say, a 9 out of 10 chance of coming up short, then you need to take action to improve those poor odds! That action might include saving more, changing your portfolio, or revising your goals—or maybe a bit of all three—but clearly you need to do something.
However, before you can even think about what changes to make—or if you need to make any changes at all—you will first need to estimate your shortfall risk. How do you do that? This is the question we will be addressing over the next few posts. At the outset, I want to emphasize that there is no perfect answer. At best, we can only get a rough estimate of our shortfall risk. But having even a rough idea of whether or not you are on track to meeting your financial goals is better than saving and investing blindly. Risk can only be managed and mitigated when you have some clue as to how much risk you face; the blind approach to dealing with risk is a formula for disappointment.
As I hinted at in last month’s post, the tools you need to estimate your shortfall risk are right at your fingertips. Certain retirement calculators, available to you, for free, on the internet, can be used not only to estimate your “retirement number” (the amount of money you need to save for retirement) and your risk of running out of money; they can also be used to estimate your risk of coming up short of any financial goal you might have. This month, we’ll work through an example to show you how you can use one of my favorite retirement calculators, FIREcalc (which you can find at http://www.firecalc.com/), to estimate the risk that you will fall short in a particular savings goal. Then, starting next month, I’ll explain why FIREcalc is vastly superior to most of the other retirement calculators available on the web.
Before we get started, you may want to play around a bit with FIREcalc, by using it for its intended purpose—as a tool to assess the risk of outliving your money in retirement. In the following example, I’m going to assume you’ve already gotten a bit familiar with FIREcalc, and are ready to learn how you can “trick” it to estimate the shortfall risk for any financial goal you have.
Let’s suppose that you would like to save $50,000 over the next ten years, in order to be able to fund something you want. It doesn’t matter what the “something” is—it could be a down payment for a house, it could be a trip around the world, it could be a solid gold telephone (like the one the phone company representative gave the Cuban dictator Fulgencio Batista in the movie The Godfather II*)—whatever turns you on. We’ll also suppose you’ve already saved $10,000 towards your $50,000 goal. You’ve invested the $10,000 in a portfolio split 60 percent stocks and 40 percent bonds. You plan to save $3,000 per year towards your $50,000 goal. What are the odds that you will come up short of your goal?
To answer this question, make sure you are on the “Start Here” page of the FIREcalc website (the tabs for the different pages appear just below the green-colored banners at the top of each page). Scroll down about a quarter of the way, and along the right hand side of the page you will find a small box labelled “Start Here.” That box asks for three inputs from you: “Spending,” “Portfolio,” and “Years.” Normally, if you were using FIREcalc to assess your risk of going broke in retirement, for “Spending” you would enter the amount of money you plan to spend in the first year of retirement to cover your living expenses. However, since in our example we are using FIREcalc to estimate the risk of coming up short of a savings goal, enter a zero for spending. Next, for “Portfolio” enter 10,000—the amount of money you’ve saved so far towards your $50,000 goal (normally, for “Portfolio” you would enter the amount of money you hope to have saved for retirement by the time you retire). Finally, since you plan to have reached your $50,000 goal in 10 years, enter 10 in the “Years” box.
Next, click on the “Other Income/Spending” tab, and then scroll down to the bottom of the page. Here you will see three lines where you can enter either a pension income or off chart spending. Since we are in effect tricking the calculator to estimate shortfall risk for a savings goal, not a retirement plan, we are going to use the pension income option to input our planned annual savings. FIREcalc will add the savings amount to our portfolio for each of the ten years. So, on the first line, click on the “Pension Income” option, and then scroll over to the box on that line and enter 3000. Then, enter the current year (2016) in the next box, since we plan to start saving $3,000 per year beginning now. Finally, uncheck the inflation adjustment box at the end of the line. (If we were planning to increase the $3,000 savings amount by the rate of inflation in each year, we would leave the inflation adjustment box checked.)
Next, go to the “Your Portfolio” tab. In the check boxes along the left-hand side, you should see that the “Total Market” option has been checked. Inside this option (bottom center) you will find a box showing 75 (indicating that 75% of the portfolio will be invested in stocks). Since in our example we are using a 60% stock portfolio, change the 75 to 60.
Finally, go to the “Investigate” tab. Make sure that the first option (“Display the results of the retirement plan”) has been chosen. Then, for this option, check the box to “optionally provide data and formulas in a spreadsheet format.” Then, scroll down to the bottom of the page and click the “Submit” button.
You should then be taken to a page that shows your results (or, if you aren’t automatically redirected to the Results page you should get a flashing tab that will redirect you to that page if you click on it). Now, ignore the results given on this page—they are based on the assumption that you are using FIREcalc for retirement planning. Instead, find the option to “Open an (unformatted) Excel spreadsheet…” (in the fourth paragraph of the writeup). Click on that option (NOT the second option, which is for a different spreadsheet), and open the spreadsheet.
What you will find, in the first column (Column A) of the spreadsheet is a list of years, beginning in 1871 and ending in 2006. What FIREcalc has done is calculate the growth of your savings as if you had started saving and investing in each of these 136 years. For example, go the row representing 1953 (Row 83, with “1953” in the first column). In the next column (Column B) of this same row, you should find the number 13329, which represents $13,329, the value to which your savings will have grown by the end of 1953. What the model has done is add $3,000 to your initial savings of $10,000, and then it increased this amount by 2.53 percent—the total returns a portfolio split 60 percent large cap stocks and 40 percent bonds would have earned in 1953 (based on actual stock and bond return data for that year). The next column over (Column C) shows the value of your savings and investment returns at the end of 1954, after you’ve added another $3,000 in savings and grown the resulting total by your investment returns for 1954. The subsequent columns show the growth in your savings for 1955, 1956, 1957, etc., until, by the last column (Column K), you find the final value of your savings after 10 years. In this last column you should see 73092, meaning that if you had started saving and investing in 1953, by 1962 you would have a total of $73,092. Since this amount exceeds your $50,000 goal, you would count it as a success.
Now, what you want to do is scroll down the last column (starting from the first row, through to the last row), and find all the rows where you fell short of your $50,000 goal. I find ten such rows, representing the following years for when you started saving: 1881, 1884, 1885, 1886, 1887, 1905, 1923, 1966, 1999 and 2000. These represent the time periods when you would have failed to meet your $50,000 goal. Now, there are 136 rows filled in with numbers, representing 136 rolling ten-year time periods that FIREcalc has tested for your savings plan. So, your estimated shortfall risk is 10 divided by 136, or 0.074. In other words, we estimate that you have a 7.4 percent chance of coming up short of your $50,000 goal, based on the past history of stock and bond returns going back to 1871.
This result is based on the assumption that you will keep your portfolio split 60 percent stocks and 40 percent bonds for the entire 10 years. One simple way to improve your odds would be to spend your money as soon as you reach your $50,000 goal, rather than wait the entire ten years. This is in fact what you would probably do. To estimate the improvement in your shortfall risk resulting from this approach, you should go back to each of the rows where you failed to reach your $50,000 goal by year ten, and see if you would have reached this goal in an earlier year. I find that two of the rows—the ones for an 1884 start year and a 1923 start year—would have hit the $50,000 goal prior to the tenth year. For example, in Row 53 (for a 1923 start year) you would have reached a total savings amount of $58,066 by 1928—only six years in to your savings plan. So, assuming that in 1928 you would have pulled your savings out of the stock and bond market and bought that new house (or that gold telephone), the 10-year period stretching from 1923 to 1932 would now count not as a failure, but a success. (And, by the way, do you know why you would have hit your goal in 1928, only to then drop back down below it had you kept your money invested until 1932? That would have been due to a little event known as the 1929 Crash—the worst stock market crash in history.) Since there are two periods in which you would have reached your goal before 10 years only to slip back below the goal by year 10, then your total number of failures would be 8 (the original 10 minus 2), and your odds of falling short of your goal would be 8 divided by 136, or 5.9 percent—in other words, there is a 6 in 100 chance of coming up short of your goal.
And so, voila, you’ve just tricked one of the web’s best retirement calculators into estimating your risk of falling short of a 10-year, $50,000 savings goal! You can now use the same approach to estimate the shortfall risk for the real savings goals you have, whatever those goals may be. All you need to know is your total savings goal ($50,000 in our example), the amount you’ve saved towards that goal so far ($10,000 in our example), the amount you plan to save annually ($3,000 in our example), and the number of years by which you want to reach your goal (10 in our example). If the resulting shortfall risk you estimate using FIREcalc is not to your liking, you can then test different mixes of stocks and bonds, different annual savings amounts, different lengths of time to reach your goal, etc., until you come up with a savings plan and investment portfolio that yields an estimated shortfall risk more to your liking. And then, as you implement your plan, you can return to FIREcalc on a regular basis (say, once every couple of years) to re-estimate your shortfall risk, and re-optimize your savings amount and portfolio mix.
The example we just worked through to estimate shortfall risk raises a couple of questions. First, is the 5.9-percent risk of coming up short of our goal an acceptable level of risk? Or, more broadly, how can we decide what is an acceptable level of risk for any particular financial goal? And second, why is the historical approach to estimating risk used by FIREcalc superior to the methods used by most other retirement calculators? Check back for next month’s post on July 5, when I’ll begin to answer these questions.
*A scene that was based on a true event, by the way—although the real phone Batista received, for approving a phone rate increase, was gold-plated, not solid gold.