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Ron Copley founded Copley Investment Management (CIM) in 1985. Prior to that, Ron served in the 5th Special Forces Group in the US Army from 1966 to 1969 during which he received the Bronze Star Medal for valor as an infantry officer in Vietnam. After his military service, Ron pursued his... More
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  • Retirement Planning Using A Goal-Based Investment Strategy

    Case Study: Goal-based Investment Strategy

    A prior article presented an intuitive concept for financial planning before and during retirement-that of goal-based investing. This month's column presents a case study of how a couple, Bob (66) and Sue (60), can use goal-based investing when planning their future.

    What is goal-based investing?

    Goal-based investing employs the simple idea of investing in a bond with a maturity matching the timing of your goal. If, for example, your goal is to have $10,000 five years from now, you would invest in a riskless US Treasury Inflation Protected Security (NYSEARCA:TIP) bond maturing in 5 years. Because the bond is risk-less and because the principal of the TIP grows with inflation during the 5-year interim, you are assured that the money will be there when you need it and that you are protected against inflation.

    An important aspect of goal-based investing is that it views risk as the consequence of not meeting a future goal. This view is quite different from the traditional view of risk as the volatility of returns. Pension funds have been using this asset/liability matching principle for years, although it is relatively new to individual investors.

    Bob and Sue's Monthly Income and Expenses

    Bob (66) is drawing Social Security (SS) benefits of $2,500 per month. Sue (60) is still working and earns $3,000 per month before taxes; she intends to retire in 3 years. When Sue retires at age 63, she is planning on drawing reduced SS benefits based on Bob's benefits until she reaches full retirement age of 66 at which time she will switch to her own benefits based on her work history. She estimates that her reduced benefits will equal $1,000 per month at age 63 and increase to $1,800 per month at age 66. Bob and Sue have a 25-year planning horizon.

    Table 1. Bob and Sue's Monthly Income and Expenses


    Sue (age 60)--today

    Sue (age 63)

    Sue (age 66)

    Bob: SS benefits1

    $ 2,500

    $ 2,814

    $ 3,075


    Sue: Wages1

    $ 3,000

    $ -

    $ -


    Sue: SS benefits1

    $ -

    $ 1,000

    $ 1,800


    Pre-tax Combined Income

    $ 5,500

    $ 3,814

    $ 4,875


    Less: Taxes (Fed and State)2

    $ 1,650

    $ ($953)

    $ (1,219)


    After-tax Combined Income

    $ 3,850

    $ 2,860

    $ 3,656


    Less: Living Expenses3

    $ (3,000)

    $ (3,877)

    $ (5,828)


    Surplus (deficit) Income4

    $ 850

    $ (1,452)

    $ (3,103)


    1 Increase at the assumed rate of inflation of 3%.

    2 Fed and State taxes at 30% while Sue works, but drops to 25% when she retires at age 63.

    3 Living Expenses increase by $500 per month to cover Sue's health insurance when she retires at 63.

    4 Includes extra taxes paid on withdrawals to cover deficits.

    Table 1 shows that the couple's combined pre-tax income currently equals $5,500 per month. After paying taxes ($1,650) and living expenses ($3,000), their combined take-home surplus income of $850 per month is available for saving for 3 years until Sue retires at age 63.

    At age 63, Sue will lose her wages but gain SS benefits giving the couple a combined pre-tax income of $3,814 per month. After paying taxes ($953) and living expenses ($3,877) each month, they will be short $1,452 per month until Sue reaches age 66.

    At age 66, Sue's monthly SS benefits will increase to $1,800. After paying taxes ($1,219) and living expenses ($5,828), they will have to withdraw $3,103 per month for the remaining years in their 25-year planning horizon. Bob and Sue have no mortgage or any other outstanding debt. They pay off their relatively small credit card balances at the end of each month. Their two grown children live out-of-state and are financially independent.

    Health Insurance

    Bob has purchased a supplement policy (Medicare Part B) the cost of which he has included in their monthly living expenses. Until she retires, Sue is covered by her employer's health insurance plan. When she retires, Sue will have to purchase health insurance for 2 years at an estimated cost of $500 per month until she reaches age 65 when she will be covered by Medicare. Like Bob, Sue will purchase a supplemental policy (Medicare Part B) at age 65 at an estimated cost of $500 per month.

    Bob and Sue's Parents

    Bob's parents are both deceased. Sue's father is deceased, and her out-of-state mother is in failing health. Sue periodically visits her mother and helps some with medical bills, which she has included in their average living expenses. Sue does not expect to receive any inheritance when her mother dies; Bob received none when his parents died.


    Table 2 shows that Bob and Sue have total savings of $640,000 consisting of both retirement and non-retirement accounts. Of the $640,000 total, $425,000 (66%) is invested in the stock market and the remainder is in CDs or cash.

    Table 2. Bob and Sue's Savings Today


    Bob: 401k


    Stock Mutual Funds


    Bob: Bank


    Bank CD (near cash)


    Sue: IRA


    Bank CD (near cash)


    Sue: Retirement Annuity


    Stock Mutual Funds


    Joint Checking Account




    Total Savings



    Current and projected financial picture

    At this time, Bob and Sue are in good financial shape for a couple of reasons. First, as we saw in Table 1, they are living within their means. Their combined monthly incomes show that they can save for the next 3 years after which they will have to dip into their savings during their retirement years. The question now is, how should they invest their saving in order to safely generate withdrawals of $1,452 per month for 3 years followed by withdrawals of $3,103 per month for the rest of their lives? They have two major concerns: inflation and health care. For purposes of planning, the couple assumes that their incomes from SS, their living expenses, and taxes will all increase by the rate of inflation. While this assumption may not be accurate, Bob and Sue will build into their investment plan a margin of error that will allow for inaccuracies in their estimates.

    A goal-based investment strategy for Bob and Sue

    Bob and Sue have decided on a 3-phase investment strategy as shown in Table 3.

    Table 3. Bob and Sue's 3-Phase Investment Strategy1


    Phase I (Sue, 60-63)


    Phase II (Sue, 63-66)


    Phase III (Sue, 66-91)

    Saving (withdraw)



    Withdraw $1,452/mo


    Withdraw $3,103/mo

    Begin Value






    Ending Value






    1 All calculations in Excel Spreadsheet (not shown) assume savings increase at the annual rate of 3%.

    Phase I. Bob and Sue can save $850 per month while Sue continues her employment over the next 3 years. Their beginning saving should, thus, increase from $640,000 to $722,743 at the end of year 3.

    Phase II. When Sue retires at age 63, the couple will begin withdrawing $1,452 per month from their saving over the subsequent 3 years. Based on an ending savings value of $780,909, the $1,452 equals an annual withdraw rate of 1.7 percent. Since the withdraw rate is less than the assumed rate of return of 3 percent, the savings will continue to increase.

    Phase III. At age 66 when Sue begins drawing SS benefits on her own work history, they will have to withdraw $3,103 per month over their planning horizon of 25 years. Again, the withdrawal rate is less than the assumed rate of return, which means that their savings will continue to increase to $1,069,286 at the end of year 25.


    The above analysis suggests that Bob and Sue are currently following an overly aggressive investment strategy that exposes them to much more risk than they should be taking. With 66 percent of their savings invested in the stock market, they could lose up to 50 percent of their equity savings if the stock market were to fall in the future the way it did in 2008. If that were to happen, Bob and Sue could find themselves facing some serious trouble.

    A goal-based investment strategy views risk as the consequence of not meeting a future goal. Bob and Sue would be foolish to pursue an investment strategy oriented toward the stock market when investing in risk-less TIPs would allow them to meet their goals and still have sufficient funds to meet unexpected expenses.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

    Tags: retirement
    Jan 25 3:43 PM | Link | Comment!
  • How Clear Is Your Crystal Ball?

    "A blindfolded chimpanzee throwing darts at the Wall Street Journal could select a portfolio that would do as well as the experts." Burton G. Malkiel, A Random Walk Down Wall Street, 1973.

    How Clear is Your Crystal Ball?

    If you were to peek into your crystal ball when deciding on an investment strategy, it would be to see if the market has efficiently priced all stocks trading up to that moment. If the market is efficient, current stock prices fully reflect all information available from every possible source. If important information is not reflected in current prices, the market is an inefficient pricing mechanism and you have an opportunity to generate an abnormally high return by judiciously selecting a few stocks in a strategy to exploit the inefficiency. The issue of market efficiency is the most important factor to consider when creating your investment strategy. Although the academic literature strongly suggests that the market is highly efficient, non-academic studies often suggest otherwise. So, how clear is your crystal ball?

    What strategy should I follow if the market is efficient?

    Given an efficient market, any guidance about the future you may attempt to gain from studying historical price patterns and previously published financial reports is a waste of time and effort. The implication is that you have no advantage in predicting returns because you do not have access to information not already available to everyone else. Future prices are not predictable but random (cloudy crystal ball), and no actively managed stock selection strategy can be successful. Hence, your investment strategy would be to construct a broadly diversified portfolio to hold for the long term.

    What rate of return should I expect if the market is efficient?

    Based on historical evidence from 1926 to 2011, Morningstar reports that a broadly diversified portfolio would have generated an average return of approximately 11 percent per year. Today, the investment vehicle for such a strategy would be a mutual fund like the Vanguard 500 Index (MUTF:VFINX) or an Exchange Traded Fund (NYSEMKT:ETF) like the SPDR S&P 500 (NYSEARCA:SPY). Because 11 percent is an average annual return, the actual return in any specific year would be higher in some years and lower in other years. In addition, some of the individual stocks within the portfolio performed better than 11 percent and some lower. Historical experience also suggests that the longer you hold the diversified portfolio (more than 5 years), the greater the chance becomes that you achieve the average of 11 percent. By following a full diversification strategy, your objective would be to accept the average return offered by the market with no attempt to beat the market.

    What strategy should I follow if the market is inefficient?

    If the market is inefficient, following a non-diversification strategy based on selecting a few stocks for the purpose of hitting a homerun is your best bet. With such a strategy, you are betting that you can correctly time the buy and sell decision, and that you have the ability to process publicly available information more efficiently than all the other investors in the market. This assumes that your crystal ball is clear.

    What does processing publicly available information more efficiently mean?

    By whatever technique you use, it means that you are a step ahead of the market. It could mean that you are better at analyzing financial statements and macroeconomic data than other investors. It could also mean that you know more about a specific firm's products and services, or that you have greater insights into global politics than anyone else. Staying a step ahead of the crowd is not easy, but if you can do it you have an advantage that you can exploit. Keep in mind, however, that you are competing with professional investors who have more training, experience, and resources than you.

    What kind of inefficiencies have been discovered in the past?

    Several studies on "market anomalies" suggest the existence of a few market inefficiencies. One is the "January effect", where stocks generate abnormally high returns in the first two weeks of each year. Other anomalies include a "weekend effect", which says that stock returns are unusually negative over weekends, and a "size effect", which says that small company stocks consistently earn higher returns than large company stocks. These anomalies are so called because empirical studies suggest they exist; if the market is efficient, they would not exist. Developing a strategy based on these anomalies is easier said than done. If all investors are aware that anomalies exist and, therefore, attempt to take advantage of them by buying heavily in late December, selling late in the day on Fridays, or making large purchases of small company stocks, these anomalies would most likely quickly disappear as a result.

    Can I, an amateur investor, compete with professional investors?

    Actually, you can, if you carefully select the game in which you want to compete. Just like playing baseball, you would have no chance competing against Derek Jeter and his Yankee teammates, but you would have a chance competing against your friends and neighbors who have backgrounds and experiences similar to your own. Just like professional athletes, professional investors have resources and training that you don't have. Knowing the game that professional investors do not play is the game you want to play. Because they control large amounts of money, professional investors usually restrict their attention to large, publicly traded stocks like Apple, IBM, and Exxon. Investing large amounts of money in small stocks is usually a game they cannot play. The small-company game is where you have a chance to compete on a level playing field since this is where your competition is other amateur investors.

    How can I recognize small-company stocks?

    Three financial metrics are important when identifying small-cap stocks: market capitalization, trading volume, and the percentage of institutional ownership. While no absolute rule exists when using these metrics, a few guidelines will help. First, market capitalization below $500 million will put you in the ballpark of small companies. Companies with market-cap between $500 million and $1 billion are mid-cap, and companies with market cap greater than $1 billion are large cap. Small companies have average trading volume of less than 100,000 shares per day. Large companies like Apple can average 20 million shares traded per day. Finally, institutional investors like pension funds and insurance companies rarely own more than 15 percent of the shares outstanding of small-cap stocks.

    What alternatives do I have if I don't want to spend the time and effort to conduct the requisite research for picking stocks?

    If you are not willing to spend the time and effort necessary to the conduct requisite research or if you are not comfortable doing this type of research yourself, you should consider a diversification strategy. Investing in an index mutual fund or ETF is quite easy. Even if you hire an investment adviser, you still need to have a view on the strategy you want your adviser to follow. It all depends on how clearly you can see the future in your crystal ball.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

    Oct 30 5:09 PM | Link | Comment!
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