In the investment world, a number of false statements are constantly propogated by financial professionals and media alike. These statements are nothing more than investment myths. And they are rarely caught out by investors. This is because they are sold extremely well and present an overly optimistic view of things. But believing these myths invariably sees investors end up achieving the wrong outcomes with their money. So in today's post, I will bust a few such myths by throwing light on the facts that are contrary to each myth.
Myth : Equity as an asset class is guaranteed to beat inflation over the long term (say 10 years or more)
Fact : No market linked asset class offers any form of a guarantee. And this is no different with equity. Therefore this statement requires a much more mature interpretation. Over 10 or more years there is a reasonably high probability that equity as an asset class will at least match or beat inflation. But there is also a material probability that it will fail to beat inflation. Allocating upto 60% of portfolios for long term goals simply gives us the best possible chance to beat inflation.
Myth : Investing 20-30% of post tax annual income is sufficient to build an adequate corpus for retirement.
Fact : If things were this easy, retirement planning would not be the kind of challenge that it is. Retirement planning essentially looks to replace lifestyle costs of the individual post retirement. One look at the aspirations and lifestyles of most individuals today is enough proof of the size of the challenge on our hands. Therefore a savings rate of 20-30% of annual post tax income is nowhere close to enough.
The concept of zero real returns shows that the average individual must invest at least 50% of their annual post tax income (more than 50% in most cases) to adequately provide for retirement. The formula for the required retirement corpus as per the zero real returns method is as follows.
Required retirement corpus = Current annual expenses * (90 - age at retirement)
For more on the concept of zero real returns refer my earlier article, Zero Real Returns : Seemingly Zero Logic, Definitely Very Real
Myth : One can completely retire at age 45 with a corpus worth 25 times their annual expenses at age 45 (a play on a thumb rule popularly known as the 4% rule)
Fact : The 4% rule is based on research conducted in America in the 1990s. The research was based on a 50:50 asset allocation between stocks and bonds. It assumes a retirement age of 60. Life expectancy post-retirement is assumed to be 30 years. India’s average retirement age is coming increasingly closer to 55. Life expectancy of today's Indians is expected to be around 90. Therefore, a corpus lasting 30 years post retirement may not always be adequate to retire completely. Asset allocations of retiree portfolios may vary from the 50:50 allocation between stocks and bonds assumed by the research study. Also, inflation in America has historically been a lot lower than in India.
A corpus worth 25 to 30 times annual expenses at age 45 may be enough for the individual to consider semi retirement. This implies that the individual continues to work in a more flexible, lower stress job or role. It would invariably allow the individuals to earn enough to cover their monthly and annual expenses. This would need to continue for 10 to 15 years.
Complete retirement at age 45 with a corpus worth 25 to 30 times annual expenses makes no sense. Complete retirement implies cessation of work without dependence on an earned income. Therefore the corpus required would be much larger. Assuming a life expectancy of 90 years someone wishing to retire completely at age 45 would require a corpus worth 45 times their annual expenses. Therefore only a trivially small number of people can truly afford complete retirement at age 45.
Myth : Higher investment returns can adequately compensate for a low savings rate
Fact : Individuals may try to make up for not saving enough by allocating more to risky assets like equity. This may increase expected returns from the portfolio. But a subsequent market crash and/or prolonged bear market can decimate the portfolio. Most individuals may not be able to psychologically cope with such an eventuality. They may then reduce their equity allocation. They are therefore likely to generate lower investment returns over the long term. Therefore there is no plausible way to work around not being able to save enough for our goals. The only solution in such cases would be to extend the time horizon of the goal or downsize it.
Myth : Systematic Withdrawal Plans (SWPs) from hybrid mutual funds are ideal to structure withdrawals from a retirement corpus.
Fact : There are two major issues here. First, the equity exposure in the hybrid fund means that returns from hybrid funds would also be volatile. Second, it must be understood that SWPs are entirely different from Systematic Investment Plans (SIPs). The investor's biggest advantage in case of an SIP, becomes their biggest disadvantage in case of an SWP.
An investor doing an SIP would stand to benefit from market volatility. This is because the investor would buy more units when the markets are low, and fewer units when markets are high. But an investor doing an SWP would do the exact opposite. They would redeem more units when the markets are low and less units when the markets are high. SWPs are therefore not a viable strategy for withdrawals post retirement. Withdrawals must only be made from non volatile and highly liquid products in the corpus. Savings deposits, liquid funds and money market funds therefore become ideal avenues from which to make most of our withdrawals post retirement. Money parked in market linked assets must be moved to these avenues a few years before the withdrawals fall due. Then the withdrawal may safely be made.
Myth : Withdrawal rates are an effective means to quantify withdrawals in retirement
Fact : Adherence to withdrawal rates implies that we withdraw a fixed percentage of our portfolios, after adjusting for inflation in during each year of retirement. But in reality, our spending needs may change from year to year. In fact, our spending in retirement may follow a phased pattern. During the first phase of our retirement (say until age 65), we may spend more from our corpus. This can usually be put down to discretionary expenses such as travel.
During the middle phase of retirement (say between age 65 and 75) we may slow down physically. Therefore we may tend to spend relatively less from our corpus during this phase. During the late phase of retirement (say age 75 onwards), long term cognitive and lifestyle issues are likely to kick in. This would lead to an increase in spending owing to healthcare expenses. We are therefore likely to withdraw more from our corpus during this phase. This means that our spending patterns throughout retirement are likely to resemble a smile shaped curve. This is borne out by the concept of the Retirement Spending Smile as shown in the graphic that follows.
A possible way around the use of withdrawal rates may be to define an upper limit to portfolio withdrawals for each year in retirement. This can be done as shown in the illustrative example below.
Available retirement corpus = Rs 7,00,00,000
Current age = 55
Life expectancy = 90
Years in retirement = 90 – 55 = 35
Withdrawal limit for the current year = 7,00,00,000/35 = Rs 20,00,000
This shows that portfolio withdrawals for the year should be capped within Rs 20,00,000. It does not mean that the individual cannot exceed the spending limit during a particular year. It only means that if ever the limit is exceeded, the individual may have to curtail spending for some years in the future. This calculation can be repeated year after year. It would define each year’s upper spending limit and maximum withdrawal amount.
Myth : Investment costs are inconsequential. The alpha (incremental return) generated by the product would adequately justify the costs involved.
Fact : Just as returns compound, so do costs. And while returns vary from year to year, costs remain constant. Investment costs commonly constitute a percentage of the value of the portfolio, or the amount invested.We must also realise that markets around the world are progressively becoming more efficient. Therefore the scope to generate alpha would keep diminishing.
This means that it is extremely hard to beat the market over the long term. Therefore costs incurred on products and strategies that claim to beat the market cannot be adequately justified. All they do is significantly eat into an investor’s long term returns. It is therefore vitally important to be cost conscious when selecting products and building portfolios.
That completes this discussion on popular investment myths and the facts that prove each of them wrong. Understanding these facts and their implications would help us make more realistic and prudent investment decisions. This in turn would improve our chances of achieving optimal outcomes with our investments.
Excellent and crystal clear article