The Underlying Investment Risk Of Modern Retirement -Action Economics

Here’s the conventional “wisdom”. The conservative safe investing playbook: Invest 10% of your income into a 401K with 60% going into a total stock market index fund and 40% going into a total bond market fund. Retire at 65 and withdrawal 4% of the starting portfolio balance every year until death. Don’t invest in anything else because it is too risky. Individual stocks, crypto, and real estate? Might as well put it all on black at the Roulette Wheel. Sound about right? Here is why that advise is dead wrong.

Investing Blindly:

Investing in total stock market and total bond market funds is essentially throwing your money across a wall and hoping some of it sticks. You indiscriminately buy the winners and the losers.

What’s worse than investing blindly? The entire population of a country doing so. Think about it. If we give the exact same advise to everyone, then every person who invests in our country will effectively be buying the exact same assets. This causes the valuation of those assets to increase.

One metric of stock valuations is the price to earnings ratio, or the P/E ratio. The PE ratio of the S+P 500 is currently 28. That means that the value being assigned to the stocks in the S+P 500 is 28 times what those companies earned in the past year. If you invest $1,000 in the S+P 500, the earnings from the companies in it is only $35.71. If you had $100,000 invested it would only be $3,571. The underlying earnings of companies matters, but we get away from this with vast institutional buying when everyone is buying the exact same stocks indiscriminately every month.

We can see the valuation increase. on a historic PE ratio chart we can see this spike clearly. The first index fund was started in 1976 and most employers were offering 401Ks by 1983. Between 1976 and 1983 the PE ratio of the S+P 500 was roughly 9. With stocks trading at 9 times their earnings, this meant that investing $1,000 would represent ownership of stocks that earned $111. If you had $100,000 invested the underlying earnings would be $11,111.

This means that from the dawn of the mass investment of index funds until today, the valuations have increased 311%. This is not sustainable. With the standard advice to everyone being to lock step invest in total stock market index funds we will likely continue to see valuations grow.

The 4% Rule:

I’ve written about the 4% rule before. It is ultra, ultra conservative. The 4% rule was based on the observation of every 30 year period in the modern stock market that someone with a 75% stock 25% bond portfolio could withdrawal 4% and index for inflation with 100% success (success meaning at least $1 at the end of a 30 year period.)

This means that someone who retired right at the onset of the great depression would have been able to completely ignore the reality around him, still take out 4% based on his original retirement number, and not run out of money for 30 years. NOBODY would do this. This is like the joke in that episode of the Simpsons where Mr. Burns checks his stock ticker and you see his face get long and go “Oh no, Oh no, Oh nooooo! SMITHERS! Why didn’t you tell me about this market crash in 1928? “Well sir it was 25 years before I was born.”

The joke is of course how ridiculous it is that Mr. Burns hasn’t checked his stock holdings in 50+ years and was completely ignorant to the great depression occurring, while continuing to live his opulent lifestyle.

The next conservative part of the equation is that it is based off of a 30 year retirement, when the average American retires at 62 and has a 20 year remaining life expectancy. a 50% margin is a pretty darn good one.

Combining High Valuations With The 4% Rule:

Now let’s combine the two. We are supposed to take out 4% per year…But the actual earnings are only 3.5% per year. This is not sustainable. It only works if other people are buying blindly as well at higher valuations. Then we run into demographic problems and socio-economic problems.

We have fewer young people than older people. Birth rates have been falling and we have older people living longer who also stayed in the workforce longer than expected, and those people are staying in higher paying roles. Millennials and Gen Z have earned far less than Boomers at the same career stages and the costs of housing, further education, and child care have all increased dramatically, far outpacing inflation. The final result is there are not as many buyers of stock in the pipeline coming up as we have people who have been in the pipeline and will start selling off assets to fund their retirements.

Without enough net new buyers and with more of the older generation who does own the wealth retiring and starting to spend down their 401Ks, valuations will likely fall. We have effectively ONLY had people in the accumulation phase for the entire existence of the 401K. It has NEVER been balanced. Sure people have retired with 401Ks, but not the majority and NOT people who have contributed for 40 years. The first people to contribute to 401k plans for 40 years total would have retired at the EARLIEST in 2018, and that was a small percentage of employees at the time.

What About Dividends?:

It is also surprising that so many people invest without any actual return of income. We all talk about the price of the asset, but not about the income of the asset. We are reliant on selling shares to a willing buyer at a future price. Not only are the earnings of the S+P 500 very low for the price, but the fraction that is returned to the shareholders is even smaller. The S+P 500 dividend yield is only 1.2%. So the total earnings is 3.6% and only a third of that gets returned to shareholders while the rest gets reinvested in the business.

Think about this as a small business you would buy:

The business earns $12,000 per year, the owner gets a dividend draw of $3,000 per year, and it costs $336,000 to buy. I would run from that deal!

The problem with a lack of return on capital is threefold:

The corporate governance which is largely influenced by Vanguard, Black Rock, and State Street, do not want to pay out dividends, because they are not the *actual* shareholders, just the share voters. Returning capital to the shareholders does not advance their interests. Keeping the money in the company does because it is under their control. How does this work? These large companies hold the 401K assets of most Americans and when those Americans don’t vote for things like corporate board seats, these 3 big companies vote their shares for them…And most people don’t vote their shares.
Increased valuations make it make sense to keep cash in the company: If all companies are being rewarded with 28X earnings valuations, it makes sense to reinvest any cash you can, because every $1 of earnings you produce is getting a $28 equity benefit. Look at how we evaluate multi-family real estate. Additional earnings leads to increased valuations, so owners and managers will do anything to increase the earnings. For my properties that trade at around a PE ratio of 10 (or CAP rate of 10) every $1 of earnings I can add increases the value by 10X. Being able to increase the value by 28X is absolute insanity. Switch all common lighting to LEDs and save $250 a month = $3,000 a year on the bottom line and increases my valuation by $30,000. A publicly traded company in the S+P does this and their valuation increases by $84,000. Valuations being this high actually lead to malinvestment, where companies will reinvest cash outside of their core missions and reinvest in things that don’t produce a high rate of return, just to increase total earnings a little bit to greatly increase the valuation.
Dividends are not tax efficient: If stock is held outside of a 401K or IRA, dividends when issued create a taxable event for the owner. Qualified dividends are taxed at a lower rate than ordinary income, being taxed at the long term capital gains rate, but still, they force a taxable event when issued. This is another reason why many companies engage in stock buybacks over dividend issues.

Another concern here is that IF I am correct that valuations will eventually fall due to baby boomers selling off their assets, relying on future buyers purchasing your existing shares in retirement is not a good strategy. If valuations fall from 28X to 14X, that would cut the value of your shares in half, even though the earnings of the company stayed the same. If the company paid a constant dividend, then the stock price would be largely irrelevant from a retirement cashflow standpoint. In fact, with lower valuations a company would be more likely to increase their dividend, because every extra $1 of net income they generate only creates 14X more in enterprise value, compared to 28X more. The company would have to be more frugal about what it invested its capital in, and would be more likely to return earnings to shareholders.

As an example, Whirlpool stock pays a $7 dividend per share every year and has slowly been increasing its dividend every year. The price of Whirlpool stock has fluctuated greatly over the last 5 years from $78 to $253. Regardless of what price the shares were trading at, investors received their $7/share dividend.

Going into the Boomer Sell Off, Dividend Stocks matter.

Are Individual Stocks Risky?

Putting 100% of your money into 1 stock is certainly risky. But what if you researched heavily and had your money split between 10 stocks? Much less risky. It is also possible to have massive diversification across different industries with stocks. Index funds have a place, but it should not be 100% of everyone’s retirement portfolio. If we are saving 10% of our income to invest it, then that means we spend on average 4 hours per week working to save for retirement. If we spent even half of that researching our investments we would likely do much better than index funds.

What About Real Estate:

From the time I started with real estate invested, even up until now, I have had many people inform me that each purchase I make is incredibly risky. Many of the risks involved in real estate can me mitigated. Real Estate also has tons of advantages that the traditional 401K/IRA retirement system does not have. Like with stocks, the more real estate you purchase the LESS risky it gets. Having 1 rental house is incredibly risky, Having 10 greatly reduces every risk. I am not suggesting the average person buy 10 rental houses. Owning 2 to 4 rental units can make a massive difference in retirement for most people. With 1 house if the unit is vacant 100% of the income goes away. With 5 only 20% of the income goes away.

For me, the biggest advantage is control. When I buy a house for the most part I can decide several things about it. I can negotiate and get the price down when I purchase. (no negotiating on the stock market!) I can choose how much money I invest in it. I can “find a bedroom” to increase rents. I can cut the house into 2 apartments so instead of a 4 bedroom 2 bath house rented for $1,500 a month I can rent 2 1 bedroom apartments for $900 a month each. I can invest in furnishings and rent it as a short term rental. I can put solar panels on it to save on the electric bill. I can add laundry and storage to make it more appealing to tenants. I have a large amount of control, whereas with stocks there is no control. I strongly believe this control greatly reduces risk.

Leverage: Leverage is also a major advantage. With 25% down I can control a lot more real estate. Using leverage in the stock market is possible, but much more difficult. I bought a few properties early in my investing career with 15 year mortgages, They are now about halfway through that amortization. I bought them when I was in my earl 30s and they will be paid off in my mid 40s. Rental real estate is inflation resistant and can provide a solid source of income in retirement.

Tax Advantages: Tax advantages matter, especially in retirement. With rental income there is no social security or Medicare tax. Virtually all expenses are tax deductible. In many cases the rental real estate owner can count as a business and claim the 20% QBI tax deduction. Rental real estate benefits from the phantom “expense” of depreciation, where the total value of the building can be deducted over 27.5 years, meaning a $200,000 property would receive a tax deduction of $7,272 per year.

In order to have a solid retirement plan, it makes sense to incorporate individual stocks and real estate and not be 100% in index funds.

What do you think of the standard investment advise?