Posted January 2009 – John Spitzer & Todd Houge
In our view, “what is your objective” is probably the most important question you need to answer in order to maintain a solid grip on your financial future. In particular, we believe that one of the biggest mistakes you can make is to adopt “maximize my wealth” as your objective, even though some financial advisors advocate doing exactly that.
In this section we start by showing why this way of phrasing the question will likely lead you astray (a flawed question), and the pitfalls of using maximize my wealth as your objective. We then offer an appropriate objective for retirement, discuss liquidity and another objective many people have.
We conclude the section with a quick look at additional objectives and our views regarding the hierarchy of the objectives.
A Flawed Question
“What is your objective” is actually a flawed question, and flawed in a way that can do serious harm to you. Phrased as “what is your objective?” the question presumes that there is a single objective that can provide all the guidance you need. The better question is “what are your objectives?” Very few people have only one objective, and to try to cover all the various objectives with one statement leads to trouble.
Maximize My Wealth?
Now let’s consider whether your set of objectives should include “maximize my wealth” or whether that might be a big mistake. It seems logical to want to maximize one’s wealth and, indeed, many financial advisors endorse this objective. We have read: “Your objective, of course, is to maximize your wealth.” But we’re in the other camp – we believe that trying to maximize your wealth will likely be a huge mistake for you.
So what is wrong with “maximize my wealth” as an objective? First, it is utterly impossible for anyone to attain that objective. There is no possibility that, in later years, you will be able to look back and say “I did it – I made every right decision I could have made and there is no way I could have attained more wealth than I have.” At the end of the day, objectives that are unattainable often lead to feelings of regret, angst, or failure. Who needs that? We like objectives that are attainable.
Another serious problem with the “maximize my wealth” objective is that it gives no guidance concerning how much risk you should take. One of the axioms of finance is that higher return goes with higher risk. Always. If someone says they have an investment with high returns and low risk … run. And if you have an objective to maximize your wealth, you will almost inexorably be drawn into higher risk investments, because that is the only way you can increase your return. The risks may be small, but the direction is one-way – this objective will never lead you to choose the least risky investment.
We can illustrate this principle with a true story, related to one of our directors. Marv was retired and had a comfortable financial situation, yet he lost his house and his life savings through a scam. Why? Because he just wanted more. One can’t be certain, but we’re pretty sure it would have helped him to realize that “maximize my wealth” was a very unwise focus for him to take. So, if you were thinking that “maximize my wealth” is a good objective in wealth management, we really hope we have changed your thinking. We think it’s a terrible objective, and one that can cause you serious financial harm.
An Appropriate Objective for Retirement
So what is an appropriate objective? We strongly suggest that you include “Don’t be Poor in Retirement” as a primary objective. Consider the two criteria we’ve noted above – attainability and guidance for taking risk. First, “don’t be poor in retirement” can be attained. Second, this objective will lead you to take the risks you need to take in order to avoid poverty (i.e., don’t put all your savings under the mattress) while, at the same time, it will lead you to avoid taking unnecessary risks that are not necessary for your well-being in retirement. Perhaps most importantly, we would argue that you cannot have financial security unless you are able to avoid being poor in retirement.
Another important objective is to have the ability to meet unexpected expenses. We characterize this objective as “having sufficient liquidity.” Indeed, some financial planners say that having a financial cushion to cover emergencies is the most important of the objectives, and recommend that you build a liquidity cushion before you allocate funds to your retirement account. In general, financial planners recommend that you establish a fund that is sufficient to cover 3 to 6 months of living expenses, and we agree.
The liquidity objective is a good illustration of why it is important to recognize that you have several objectives and to manage the funding for those objectives separately. For the liquidity objective, you invest in liquid assets – savings accounts, money market mutual funds, and the like. These investments usually provide a return that is close to the rate of inflation, so the real return (the return after adjusting for declining purchasing power) on these investments is pathetic. But that’s OK – your objective here is to provide liquidity, not to make a large return. Meeting your liquidity objective provides you with the peace of mind to know that you can handle the temporary financial emergencies that come along from time to time.
You also need ready access to the liquid funds, so they need to be outside your tax-sheltered accounts (401k, 403b, and IRA accounts that impose a penalty for early withdrawals). In contrast, since you don’t need the “don’t be poor in retirement” funds until you actually retire, it is very useful to have those funds in tax-sheltered accounts.
Another Common Objective
Many people also have another major objective: “the chance to hit it big.” If you have any doubts about whether people actually have such an objective, just consider the ever-growing gambling industry, and the size of the state lotteries. This objective may be a mix of wanting the thrill of a wild ride (independent of actually seeking a big payout), just wanting some hope that “the ship will come in,” and actually thinking that “I can beat the market.” Whatever. It’s absolutely all right for you to have this objective. The important thing, however, is to keep this objective from interfering with the “don’t be poor in retirement” and the liquidity objectives. It’s also perfectly all right to have a set of objectives that does not include the chance to “hit it big” – it’s your choice.
Then there are other objectives that may fit your situation. Here are some examples: Provide a quality education for the children. Accumulate enough money for a home purchase. Accumulate enough additional wealth to move beyond the “don’t be poor” level. Leave an estate of sufficient size for specific distributions to heirs and charities. We believe it is important to explicitly identify these as separate objectives if you have them.
Hierarchy of Objectives
As you have probably surmised, we think there is a useful hierarchy among these objectives. We would rank “don’t be poor in retirement” as number one, with “maintaining adequate liquidity” as a close number two. The others, with one exception, depend upon your desires and circumstances. That exception, as you have guessed, is the “chance to hit it big” – we recommend putting that at the bottom of your priority list, which means only allocating funds to it after you have attended to all the other objectives.