The Fallacy of Investing Your Way Out of Excessive Spending
One of my favorite mantras comes from my partner, Mike Tallman, who argues, “There are no logical decisions. They are all emotional.” And he’s right. In the end, every choice we make is an emotional one. However, by learning to skillfully apply logic, we can gently coach our emotions into making the right decisions.
Over the years I’ve learned some of the tricks our emotions use to circumvent logic. One of the most common is a logical fallacy known as hasty generalization. Hasty generalization, by definition, is asserting a position based on insufficient data or drawing a conclusion without considering all variables.
I see an example of hasty generalization being used by retired investors on a regular basis. It starts with wanting to spend more than their resources can sustain. Their emotional side presents the following false argument:
“Our current portfolio strategy cannot sustain 6% distributions, so we should simply invest more aggressively to get higher returns.”
It sounds simple and brilliant. Invest aggressively, make a return higher than the desired rate of distribution, never spend-down the wealth, and live happily ever-after.
“Explanations exist; they have existed for all time; there is always a well-known solution to every human problem – neat, plausible, and wrong.” –H.L. Mencken
When emotion presents this argument, the mind wants to believe it! But Mencken was right. This simple, seemingly logical solution is, in fact, dead wrong. It’s actually one of the most dangerous things an investor’s emotional side will ever try to talk them into doing.
The primary flaw in this strategy is the failure to consider the most important variable: range of results. Historically, equity (stock) investing (as opposed to fixed-income) has produced the best returns over long periods. But the devil is in the details. Along with higher average returns, equity investing produces a wider range of returns.
Why is range of returns just as important as averages? Think of it this way: I’m writing from Kennewick, WA where the average annual temperature is 65F. The average for San Diego, CA is within 4 degrees (69F). If you only concern yourself with averages, you will come to the conclusion that the climates are nearly identical; remaining oblivious to the fact that temperatures in Kennewick can dip to as low as -9F, while the coldest day in San Diego can reach as high as +41F. Range matters!
The S&P500 Total Return (S&P500 with dividends reinvested) has a 15-year average return of 7.15%. On a year-by-year basis, how high or low can you expect to deviate from that average? The index has a standard deviation over that period of 14.85. This means, if you invest for 15 years, you can expect 1-year losses worse than -7.7%, 16% of the time. An investor who assumes they can combine a high rate of distribution with losses of that magnitude and come out even is sorely mistaken.
The illustration above compares two hypothetical portfolios, one being 50/50 stock and bond, the other being 100% stock. Each paid out monthly distributions that increased 2% per year to provide inflation adjustment. In the first year, these distributions were 7% of the portfolio value. As you can see, over the past 15 years, the 100% stock portfolio achieved nothing over the blended portfolio, all while exposing the investor to over twice the risk (standard deviation of 14.85 vs. 7.37). It’s like watching an impatient driver racing from stop light to stop light, taking greater risk but never getting ahead.
Viewing this single example in isolation, we might come to the conclusion that no harm has been done. The returns are similar and, though the stock portfolio experienced higher highs and lower lows, they both ended up in essentially the same place. However, if we reexamine this scenario using rolling 15-year periods over the past 25 years, it is revealed that 20% of the time, the 100% stock portfolio completely ran out of money. The 50/50 mix never did.
The bottom line is this: higher rates of distribution require a more conservative (and hence lower expected return) investment strategy. You can’t have your cake and eat it too.
Aggressive investing as a strategy to facilitate excessive spending is not a recipe for success. While our emotions may attempt to will our portfolios into providing beyond their capacity, it’s imperative we use logic to coach those emotions back to a prudent choice. If you are unsure whether your distributions and investment strategy are long-term compatible, your best choice is to consult with a qualified financial advisor.
Ben Messinger, CFP®