When Risk and Returns Really Start to Matter

Forbes wrote a nice profile on financial planner and blogger Michael Kitces last week. In the piece, I thought Kitces made a very important point about how the need for financial planning can vary based on where you’re at in your life-cycle:

When you’re young, don’t obsess over investment returns. Worry about career and saving instead, and buy a few low-cost index funds, including Vanguard Total Stock Market (VTSMX). Ten years before retirement, get serious about asset allocation. “The amount of return you get then actually starts to matter a lot, but the risk you’re taking matters a whole lot more, too.”

There are obviously exceptions to this rule as there are some young people who hit it big and find themselves in need of more financial guidance. But in general, the importance of financial planning ramps up as you get closer to retirement. Wealth accumulation is actually much easier to advise people on than wealth preservation.

I get questions from young people all the time when it comes to retirement planning. Usually these questions are very vague and rarely do I get much follow-up after my initial advice. My basic advice is always the same — save as much money as you can in a tax-deferred retirement account, invest in yourself so you can earn more money and never carry a credit card balance. Start there and you’re doing better than the majority of your peers. But young people don’t want to hear this kind of advice, so it’s much easier for them to ignore it and assume they’ll start planning for retirement at a later date.

It’s once you start closing in on retirement age that people really get serious about financial planning. I get plenty of questions from this group too, but you can tell they mean business because they ask very specific questions: What’s my ideal asset allocation in retirement? Best withdrawal strategies for distributions? Tax deferral options? Will my portfolio last in retirement or should I keep working? Do I need my mortgage paid off before I retire? When should I start taking Social Security?

This is why it’s funny to me when people say that robo-advisors are going to take over the financial planning business. I say that’s nuts without a number of actual financial advisors available for people to talk to when all of these baby boomers retire or start to think about retirement.

Giving long-term asset allocation advice to young people is the (relatively) easy part, which is an under-served market that the robo-advisors have smartly tapped into. Young people need a simple solution and no one has ever really paid attention to that demographic when it comes to investment advice. But once you approach that 10 year mark that Kitces talked about? That’s the point when people really start to worry. They need someone to talk to along with a strong financial plan.

Kitces also brings up a very important point about when your returns start to matter (a topic I covered a few weeks ago, as well). What most people fail to understand when thinking about compound interest is how important it becomes later in life after you’ve built up a decent-sized nest egg. Life never plays out exactly as it does on a spreadsheet, but let’s take a simple retirement calculator example to see why those later years are often so important.

Let’s say you start saving at 30, at which time you stock away $500 a month. Each year you increase that amount by 3% to keep up with inflation. Miraculously — because this is a fake retirement calculator scenario — you earn an even 7% annual return on your money each year. By age 60 you have roughly $830,000. Not bad. But let’s say you don’t want to retire until age 65. By then you’re portfolio would grow to more than $1.2 million. That means around 35% of your ending value at age 65 would come from the last 5 year’s worth of portfolio growth. The pressure at that point can be intense if you’re not sure what you’re doing.

Since real world markets don’t give reliable returns year-in and year-out out like they do in retirement calculators, risk management and your investment policy become critical to your success in those later years. If you don’t have a solid financial plan in place or a legitimate financial advisor to keep you on track it could be nearly impossible to recover from a huge mistake at that point. At that stage in your life there’s not as much time to make up for a poor investment decision and your human capital is basically tapped out, so new savings aren’t going to bail you out.

Thousands of baby boomers are retiring every single day in the coming years. Color me bullish on the financial planning business over the next couple of decades.

The New Money Masters: Financial Planning Guru Michael Kitces (Forbes)

Further Reading:
Four Questions
Do Young Investors Need a Financial Advisor?

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Discussions found on the web
  1. Gregory commented on Jun 25

    It is a paradox: index/passive investing is about buy and forget but there are more and more products and articles like this one so You can spend a lot of time to study them. And a lot of people don’t have enough time, interest for this not mentioning the willpower like in a bear market. What’s more everybody has an unique life that is changing. Due to these a lot of people need a good advisor. Passive investing is easier said than done.

    • Ben commented on Jun 25

      Agreed. Some people can do it on their own, but not many. Even doing nothing most of the time requires a plan. The tough part is finding a good one, but I think more and more people need someone to help them these days.

  2. Steve commented on Jun 25

    Many investors end up working with brokers from the big firms as they invest over the years. When retirement comes around, they will be stuck in a long term relationship,with their broker, who calls himself a financial advisor, or Sr. VP. They won’t get the financial planning advice they need. There really needs to be a clear distinction between salesmen (broker) and true financial advisors. Look how difficult it has been to get a fiduciary standard applied to the brokerage industry.

    • Ben commented on Jun 25

      It’s getting better, but you’re right that it can be very confusing for individuals who don’t work in the finance industry to tell the difference. Hopefully something gets passed on this soon.

  3. Hurrow commented on Jun 25

    I think the worry is that a lot of young people aren’t taking the advice about investing in low cost funds or saving as much as you can in tax deferred accounts, are instead just spending the money. And if they continue doing that, then the conversation they have with ten years to go till retirement is a lot less pleasant because instead of talking about the most appropriate asset allocation or structure it’s that they instead have to start saving some enormous amount of money each year that they wouldn’t have to if they had been regularly saving much smaller amounts. I think this is where the robo-advisers are really going to help, by helping people who probably wouldn’t otherwise be investing to do so.

    • Ben commented on Jun 25

      Me too, which is why I don’t think so many advisors should be worrying about the robos. They are hitting an under-served market. Eventually the ones that do manage to put away a decent amount will need more tailored advice. That’s when they’ll switch to a traditional advisor.

      • Hurrow commented on Jun 25

        I think the difficulty for traditional advisers will be that the robo advisers will almost certainly start to employ their own advisers for investors with higher balances or those who are closer to retirement and they will have a big advantage in keeping/winning those clients. That being said, there is probably plenty of room for traditional advisers still for all those who don’t use robo advisers when they are young, hit the ten years to retirement mark and start going “Oh my god I have no savings what am I going to do?”.

  4. Keith G commented on Jun 27

    This really hit home. For years I did well with my investments selling high, buying low, staying diversified and keeping my emotions in check. Now that I’m a little more than a year from retirement, things have changed a lot.

    First of all their are taxes to worry about it, which is something I never worried about. Which I’ve spent hours understanding the implications and laying out a withdraw plan.

    Then there is whole different level of emotions because the game becomes more serious. If you make a mistake, it’s hard to make up without future contributions. I find my self always stress testing my portfolio. High inflation, low inflation, economic growth, economic contraction. Always trying to keep my expectations in check and remind myself, I’m not invulnerable.

    As always, great article.


    • Ben commented on Jun 27

      I think you hit on the worries that many have in that stage. The good thing is you already have good habits in place. Honestly I think 80% of it is just having a plan you can stick with. Obviously there will have to be changes mde along the way and some trial and error but for the most part just having a contingency plan and understanding your spending habits will help.

  5. Matt commented on Jul 02

    Young people do face asset-allocation issues when including the value of their human capital, student loans, and mortgage balances. In my case, I am continuing to rent so I can pay down my graduate student loans as fast as possible (earning an effective ~6% return), while an economist would argue I should smooth my consumption over my lifespan, pay down the loans slower, and instead purchase a house and lock in a mortgage now. How does a young person decide to allocate across a 401K, Roth IRA, student loans, and a mortgage? I don’t think this is an easy question to answer.

    • Ben commented on Jul 02

      Great question. This could be a topic for an entire blog post. You have to balance not only the financial considerations but also the psychological ones. Which would you regret more: Paying off your loans early or missing out on potential stock/real estate gains? I like the question and I’ll try to do a write-up on this soon.

  6. When Risk and Returns Really Start to Matter | Tamma Capital | Personalized Investing for Your Future commented on Oct 05

    […] Ben Carlson highlights a Forbes article on financial blogger Michael Kitces (who I also follow) in which Kitces touches on the following point, "Ten years before retirement, get serious about asset allocation. “The amount of return you get then actually starts to matter a lot, but the risk you’re taking matters a whole lot more, too.” Carlson goes on to give a good example of Kitces point below; […]