I thoroughly enjoyed “How Much Money Do I Need to Retire?”. It offered a lot of new perspectives and presented the information in a clear and engaging format. This book takes you one step closer to mastering your personal finances and knowing how to invest and plan for retirement without a financial advisor.
I could write for days about the new knowledge I gained from this book. It’s so good that I had to include it in my Top 5 Best Books about Saving for Retirement. And this is coming from a guy who’s read hundreds of financial-related books. But for time’s sake, I’ll keep this post short and try to give you a brief overview of some concepts that the book touched upon.
Coming up with an exact dollar amount you need to retire sounds simple, but this book lays out all the intricacies. Most retirement books have a lot of the same content and usually relay the same message using the conventional retirement model. This book looks at retirement planning from the view of 3 separate models. Well, 2 models and 1 bit about better understanding the assumptions that go into the other models.
Essentially, this book is covering:
- A review of the conventional retirement planning process and why it doesn’t work the way people think it does.
- A deep dive into the assumptions that drive most retirement calculator equations and how a small tweak can completely change the entire outcome.
- The limitations of Monte Carlo simulations used by most financial planners.
- The difference between national inflation and personal inflation.
- Looking beyond the conventional asset allocation model of just stocks and bonds.
- How the first 7-15 years of retirement will make or break your portfolio
- New models to better plan for retirement
It takes a hard look at inflation and how most financial advisors take an average 2-3%. They then use that in their models to come up with how much money you’ll need to retire.
But did you know that the average annual inflation from 1965 to 1980 was 5.83%? And that the S&P 500 returned an average annual return of 5.56% during that same period? That means that most stock portfolios in that 15-year period actually lost purchasing power.
The author believes that inflation is the single biggest threat to your retirement and has a lot of evidence to back that claim up. How do you adjust your plan to take these risks into account?
Well, you need to buy the book to find out that juicy information. I feel like I might get in trouble if I just type out the whole book here…
There’s a lot I could cover, but I’m going to limit myself to just a few takeaways I got from “How Much Do I Need to Retire?”.
Plexus Asset Management Study
Something that I found particularly interesting in this book was a study from Plexus Asset Management. It analyzed the 10-year returns of the S&P 500 from 1871 to 2007. They took these returns and compared them to the S&P 500 Index price-to-earnings ratios (P/E Ratio). Also known as cyclically adjusted price earnings ratio (CAPE ratio) . The comparison happened at the beginning of holding periods.
Basically, if you invested a lump sum in 1953, and the CAPE ratio was 17 at the time, what would your returns over the next 10 years be? How about if you invested a lump sum in 1978, and the CAPE ratio was 11 at the time, what would your returns be over the next 10 years? Etc. etc. etc.
What’s cool here is that the data taught us that you can predict with reasonable certainty what kind of returns you’ll get from the S&P 500 index over the next 10 years by looking at today’s CAPE ratio.
If the CAPE ratio is around 22 then you can expect an average subsequent inflation-adjusted annual return of just 3.2%. On the other hand, if the ratio is at the beginning of your holding period is around 8.5, then you’re looking at average 10-year subsequent returns of 11% annually.
Therefore, the higher the CAPE ratio at the beginning of your investing horizon, the lower your 10-year annualized returns will be. Can you guess what the CAPE ratio is at the time of writing this?
… 23. Scary stuff…
How To Mitigate This Risk
Luckily for people who are approaching retirement during times of high P/E ratios, there’s ways of mitigating these risks. The author states that one way to reduce risk is to reallocate the bulk of your assets to rental real estate and bonds. As ratios start to fall back into more favorable levels, you can buy back stocks, as necessary.
P/E Ratio House Example
If you’re confused on how a price-to-earnings ratio could predict your investment return over a period, that’s okay. The author uses a helpful metaphor in the book to help clarify. Let’s say someone’s selling a house that rents for $1,000/month. Buying that house for $200,000 (price) and renting it out for $1,000/month or $12,000/year (earnings) would result in a P/E ratio of 16.7 (200,000 / 12,000). Alternatively, if you were to buy that house for $50,000 and rent it out for that same $1,000/month then your P/E ratio would be 4.2 (50,000 / 12,000).
With a low P/E ratio like in the scenario above, you could buy 4 houses for the price of the high P/E ratio house and make $4,000/month instead of $1,000/month. That’s just like how the stock market works. Low P/E ratios mean you can invest the same amount of money, but the stocks that you buy will be earning you a lot more money.
Another great piece of knowledge I gained by reading “How Much Do I Need to Retire?” has to do with sequence of returns risk and how it applies to the 4% rule. This topic eventually breaks down the difference between average and compound returns. It also expands on how you should only spend compound returns. The author goes into detail on how the first decade of your retirement makes or breaks your financial security.
I could go on and on about the new information I have rolling around in my head after reading this book, but I leave you with this: If you want to better prepare yourself for retirement, then buy “How Much Money Do I Need to Retire?” and start questioning some of the assumptions in your current plan. It will pay dividends in the future.