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SOLICITING RISK

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        Investor's Insight - Wednesday, April 12, 2006           
          "A Digest of Investment Opinion From the 
             World's Leading Financial Advisers"


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FINANCIAL PLANNING 2.0, PART 4: SOLICITING RISK
by Scott Burns

Financial Planning 1.0 -- what most of us encounter 
through advisers or on the Internet -- meet Financial 
Planning 2.0. This eight-part series of columns, 
written by Laurence J. Kotlikoff and me, explores the 
consumption smoothing approach to lifetime personal 
finance. While the idea has been developing for nearly 
a century, it has taken the power of today's personal 
computers to build the necessary tools. When we use 
these tools, we find that conventional planning is more 
likely to lead us astray than take us to financial se-
curity.

Prostitution is the world's oldest profession, but 
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Just ask today's college seniors, many of whom are dy-
ing to land a job on Wall Street. These jobs start in 
the 6 figures. They head north from there. With the 
right stuff, you can pull down millions within a couple 
of years. Take New Jersey Gov. Jon Corzine. His last 
private-sector job was running Goldman Sachs. In his 
25 years with the company, he amassed close to a half-
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Year after year we get conned into paying financial 
wizards to "beat the market," although only a handful 
do. Worse, we get sucked into deals where the financial 
institutions and advisers conveniently match our needs 
to the securities they're peddling.

It starts by getting us to define our needs -- our 
retirement spending targets -- at levels that are far 
above what we can safely afford. Then they assume we 
will spend this amount regardless of what we actually 
earn on our investments.

Finally, they add a professional gloss by using Monte 
Carlo simulations to determine the probability of suc-
cess -- of our being able to spend at the targeted rate
through our lifetime. The last step allows them to show 
us that we can increase the probability of success by 
using higher-return (and higher-risk) assets that just 
happen to involve higher fees and expenses.

End result: We assume more downside risk; they collect 
higher fees.

Take, as an example, a single 60-year-old named Joe. He 
has $500,000 in assets. Assume Joe will live to age 95. 
Assume also that he faces no taxes of any kind.

If he chose a smooth and risk-free consumption path by 
investing only in TIPS -- Treasury Inflation Protected 
Securities yielding 2 percent after inflation -- he 
could spend $20,413 a year for life. He would have a 
100 percent probability of success.

Now suppose he visits a financial service firm and asks 
for retirement investing advice. They'll ask him what 
his retirement spending goal is. He'll pick one he likes. 
Suppose he picks a spending target of $30,000 per year.

What's Joe's probability of meeting his target if he 
invests in TIPS? 

It's zero.

Spending $30,000 a year will drive Joe broke for sure. 
The only way to make the plan succeed is to die early, 
a route few people want to consider. 

But suppose Joe invested in large-cap stocks instead? 
Since 1926 the real return on large caps has averaged 
9.16 percent on an annual basis. Were Joe able to earn 
this return, he'd be able to spend $48,264 per year. 

But large-cap stocks are volatile. Prices go down as 
well as up. Even so, there's a 67 percent chance that 
Joe will be able to spend $30,000 per year. 

So when the financial service firm uses a standard Monte 
Carlo portfolio analyzer, the TIPS route fails completely. 
But investing in stocks will meet his goal two-thirds of 
the time. Joe may view this as a pretty good bet, given 
the way the investment outcome information is being pre-
sented.

But suppose Joe has the misfortune of investing all his 
assets in large caps at the end of 1998. He experiences 
the losses of 1999, 2000 and 2001 -- namely, minus 12.1 
percent, minus 13.2 percent and minus 23.9 percent, res-
pectively. 

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Will Joe continue to spend $30,000 per year and remain 
in the stock market, given that his wealth after three 
years has dropped from $500,000 to $217,583?

Probably not.

In fact, Joe may switch to holding just TIPS. He will be 
forced to live from that point on at only $9,469 per year, 
kicking himself for the rest of his life. 

The real culprit is the advice he received. It never add-
ressed sustainable consumption. It focused his attention 
on the chance of plan success. It glossed over the precise 
nature of the downside.

Which well-known financial institutions engage in this 
type of risk solicitation?

Wrong question.

The question is which don't? 

This professional advice is the conventional targeted-
spending approach to financial planning. It differs fund-
amentally with the economic approach, namely consumption 
smoothing. Consumption smoothing entails adjusting your 
spending, saving, insurance and asset holdings on an on-
going basis to secure a relatively stable living standard. 
It's a spending standard that's as high as your wages, 
current assets and other economic resources permit.

To smooth their consumption, people need to see the range 
of actual living standards they may experience in sticking 
with a particular portfolio. If Joe had been shown that in 
holding stocks he could quickly end up living on less than 
$10,000 a year, he'd have thought twice about holding 
stocks.

Financial institutions aren't our friends. Rather than 
address the question of sustainable lifetime consumption, 
they put a pretty face on risk and sell it. They do this 
for their benefit, not ours, because their fees rise with 
risk. 

Next: Part 5 -- Maximizing Your Living Standard

ON THE WEB

Laurence J. Kotlikoff's Web page: 
http://people.bu.edu/kotlikoff

ESPlanner software Web page: www.esplanner.com

"The Coming Generational Storm" (at MIT Press): 
http://mitpress.mit.edu/catalog/item/default.asp

"The Coming Generational Storm" (at Amazon.com): 
www.amazon.com/gp/product/0262112868/002-5379885-1560022

(Questions about personal finance and investments may be 
sent to Scott Burns, The Dallas Morning News, P.O. Box 
655237, Dallas, TX 75265; or by fax: (214) 977-8776; or 
by e-mail: scott@scottburns.com 
Check the Web site: www.scottburns.com. 
Questions of general interest will be answered in future
columns.)

(Investor's Insight reflects the opinions of experts. It does 
not recommend any specific investments, and no endorsement is 
implied or should be inferred. For more information, contact 
the individual firms cited).

COPYRIGHT 2006 UNIVERSAL PRESS SYNDICATE

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