Saving and investing towards a future goal—a new house, early retirement, a dream vacation, whatever—usually involves a tradeoff between risk and sacrifice. You can reduce the risk that you will come up short of your goal, but to do so you may have to save more each year, or save over a longer time—thereby sacrificing your present consumption for your future goal.
But this tradeoff between risk and personal sacrifice works both ways. In other words, while we may have to sacrifice more to reduce risk, we can also reduce the amount of sacrificing we need to do if we’re willing to accept more risk. Suppose the initial plan you test using FIREcalc yields a shortfall risk estimate that is significantly less than the maximum risk with which you’d be comfortable. How would you optimize such a plan to reduce the personal sacrifice required, by increasing shortfall risk? This is the question we’ll tackle in this month’s post, and we’ll do it by tweaking our example from last month.
Let’s suppose that the $50,000 savings goal in last month’s example was needed not for a something you consider a necessity (such as your child’s college education), but for a luxury item (like, say, a trip around the world). In this case, you might be comfortable with a shortfall risk considerably higher than the 7.4 percent we estimated (using FIREcalc) for our initial savings/investment plan. Suppose, for example, you were willing to accept a 20-percent shortfall risk (that is, a 1 in 5 chance of falling short of your goal). In this case, by testing alternative savings and investing options, you would be able to reduce the sacrifices you need to make to fund your dream vacation and still keep your shortfall risk within your 20 percent or less comfort zone. The real beauty of having a method to measure your shortfall risk (using FIREcalc) is that you can use that method to either reduce the risk (using the options most palatable to you), or to reduce the amount of sacrificing you have to do to reach your savings goal.
Once again, we’ll start with a $50,000 savings goal to be met in 10 years or less. We’ll once again assume you’ve already saved $10,000 towards this goal, and you are planning to save $3,000 more per year. You plan to invest the savings in a 60/40 investment portfolio (that is, a portfolio split 60 percent stocks and 40 percent bonds). In the August post we tested this initial plan using FIREcalc, and estimated that you run a 7.4 percent risk of coming up short of your $50,000 goal. You have a number of options available to you to increase this risk, reduce your sacrifices, and optimize your savings/investment plan. You can:
- Change your savings goal (e.g. in our example, you could increase the goal from $50,000 to a larger amount, and fly first class in order to reduce the sacrifices to your comfort that flying involves);
- Change the amount of money you intend to save per year (e.g., reduce your annual savings from $3,000 to, say, $2,500);
- Change the timing of your goal (e.g., reduce the number of years you give yourself to reach your goal from 10 to, say, 8);
- Change your mix of investments (e.g., use a 20/80 portfolio instead of a 60/40 portfolio); or
- Make some combination of the above changes.
Once again, the first step in optimizing your plan is to rank the above options, from most to least palatable to you. Let’s suppose that you are having some difficulty saving $3,000 per year, and would really like to reduce this amount to $2,500 if at all possible. This, therefore, will be your best option, followed by reducing the number of years to meet your goal (the sooner you get to leave on your vacation the better!), increasing the amount you plan to save, and finally reducing your reliance on the volatile stock market to meet your goal.
The next step is to test the above options in FIREcalc, proceeding in order from most to least palatable. The August post explains how to use FIREcalc to test a savings and investment plan. Using the procedure outlined in that post I first tested a reduction in the annual savings amount from $3,000 to $2,500. According to FIREcalc, this savings option yields a failure rate of 72.6 percent. Since the estimated shortfall risk is calculated as 100 minus the failure rate, reducing savings to $2,500 would increase the shortfall risk to 27.4 percent. Unfortunately, we can’t reduce annual savings this much and still meet our 20 percent risk target. But we should still be able to reduce savings by a lesser amount. Therefore, as a next step I tried entering various savings amounts between $2,500 and $3,000 until I found the minimum amount that would yield a shortfall risk of 20 percent or less. The result is $2,661, which happens to yield a shortfall risk of exactly 20 percent.
Thus by increasing shortfall risk from 7.4 to 20 percent, we’ve reduced the required annual savings amount by 11.3 percent. Our savings plan has been optimized for the particular goals and preferences in our example. You can use the same basic approach to find the best balance between risk and sacrifice for your own savings plans, whether you are saving for a college education, an early retirement, a new house—whatever your financial goals and dreams might be.