Wall Street investors often say “diversification is the only free lunch”, meaning that having a diverse mix of assets in a portfolio can reduce volatility while still producing acceptable returns. Volatility is often equated with risk, reasoning that a more volatile asset or asset class will have more significant variations in price than an asset with less volatility, and therefore be more risky.  Combining assets that are not correlated with one another into a portfolio can therefore be desirable to reduce or manage risk, as long as the returns of the uncorrelated assets are acceptable.

For example, while bonds are generally believed to have lower volatility and to be less risky assets than stocks, a modified portfolio of 75% bonds and 25% stocks is less risky than a portfolio of 100% bonds due to diversification and the lack of correlation between stocks and bonds, the two asset classes in the modified portfolio.  The modified portfolio of 75% bonds and 25% stocks produces a higher return than the portfolio of 100% bonds, though, due to stocks’ historically higher returns relative to bonds.

Similarly, an investor who is OK with the risk of a 100% bond portfolio can enhance overall returns by assembling a portfolio of 50% bonds and 50% stocks, which has roughly the same risk as a portfolio of 100% bonds but substantially higher returns.  Increasing the percentage of stocks further results in even higher returns, but with a risk or volatility greater than the risk of the bond portfolio alone.

These examples illustrate how combining two assets, or asset classes, results in returns that are an average of the returns of the proportionate asset classes, while risk can be reduced to less than that of any one of the combined asset classes alone.  This only holds true for assets or asset classes that are not strongly correlated, though, as it should be no surprise that combining two portfolios having similar volatility and returns that are 100% correlated with one another simply produces a bigger portfolio with the same volatility and returns as the constituent portfolios.

The funds in the model portfolio presented here therefore desirably represent asset classes that are not strongly correlated with one another.  For example, a portfolio of energy, natural resources, energy services, and precious mineral funds or ETFs would be expected to have significant overlap, and strong correlation in price movement between the funds.  The current model portfolio of housing, biotech, and emerging markets dividend stocks does not have any such obvious correlation between asset classes, and is likely to have lower volatility than any of the constituent funds alone.

Because the return of an evenly weighted portfolio of uncorrelated funds is the average of the return of the independent funds, we can therefore produce a portfolio having a return that is the average return of the individual funds while experiencing lower volatility than the average volatility of the individual funds.  Average returns + lower than average volatility = Free Lunch!  The task for the investor remains choosing few enough funds for the portfolio to produce the expected higher returns of more favored asset classes or funds while having enough uncorrelated funds or asset classes represented to reduce risk to acceptable levels.

For the model portfolio, that’s three to four funds not strongly correlated with one another held at any one time, depending on whether four diverse asset classes having expected high returns can be found at the same time.

Now that we know we’re seeking a return greater than 7% per year (and hopefully much greater), and can bear the volatility imposed by market cycles that typically last around seven years given the relatively long retirement horizon, we’re left to construct a portfolio that pursues high returns while managing volatility. We know that stocks have returned 11-12% per year on average, and bonds have returned an average of 5.5% over time.  We will therefore seek a diverse mix of stocks, bought using mutual funds and ETFs to reduce transaction costs and research needed to maintain a diverse portfolio.

High volatility is often associated with high returns, but we will seek to pursue high returns with a diverse mix of mutual funds or ETFs (which are themselves typically each less volatile than stocks due to the diversity of stock holdings within a fund) to manage volatility, being careful to spread assets among three or four high-performing funds that are desirably not strongly related or correlated with one another.  The relatively small number of funds reduces the risk of diluting returns from strongly performing funds with poorer performing funds, while diversity among funds helps reduce volatility of a portfolio that may have only a few relatively narrow asset classes represented.

Funds are sorted based on a few criteria – no sales loads or excessive fees for selling within a few months of purchase, and recent performance over the past year.  Preference is given to funds that have stronger performance over recent months, in an attempt to identify funds that are near the beginning of a positive cycle rather than near the end of a cycle of outperforming the market.  We therefore use a weighting of 1, 3, 6, and 12 month returns, similar to what is employed in the No-Load FundX newsletter, with additional attention given to diversity among funds, market conditions and events, and other factors.

Milton Friedman noted that “Inflation is the one form of taxation that can be imposed without legislation”, while polar opposite Vladimir Lenin observed that “The way to crush the bourgeoisie is to grind them between the millstones of taxation and inflation”.  Inflation is simply the result of increasing the supply of money, such that things cost more in the future than today.  While this seems entirely undesirable on its face, governments print money and willfully cause some inflation to stabilize declining economies, to reduce the cost of paying back previous debt, and for other such functions.  But, this comes at the expense of the average taxpayer, who loses some percentage of the value of their dollar-denominated assets every year to inflation.

Even a modest 3% inflation will eat away a quarter of a dollar’s buying power every ten years, or halve its buying power every 24 years.  Although the Federal Reserve has only two mandates, the first of which is to control inflation and the second to minimize unemployment, we’ve seen double digit inflation twice in my lifetime – from 1974-1975 and from 1980-1981.  The Fed’s stated target of 2-3% inflation target therefore cannot be considered a guarantee, or even a likelihood, given our tremendous debt and faltering economy.  The temptation to cut the cost of our debt in half by inflating the dollar 100% is strong, and politically more palatable to many politicians than raising income taxes, although the net result is similar.

Is the standard 3% assumption a reasonable one?  I sure hope so, but it may be too low.

We know that our estimated 7% yearly return in retirement minus 3% inflation gives us about 4% per year to withdraw as retirement income using the standard model, and have discussed whether 4% is reasonable for income, but what about our estimated 3% for inflation or 7% for returns?  This example shows that inflation is just as relevant to the effective value of retirement income in present-day dollars as rate of return or amount withdrawn per year.  If one guesses that inflation may average a percent or two above 3%, as I believe is possible, this must be reflected in either a rate of return higher than 7%, or a rate of withdrawal lower than 4%.  I’ve already determined that 4% withdrawal per year is unlikely to be a high estimate, which leaves me chasing returns higher than 7% per year.

We’ve determined that our goal is to save enough to withdraw at least 4% of retirement savings per year in retirement, while maintaining approximately the same standard of living.  Although average returns in retirement are often estimated at a conservative 7% rather than 4%, this includes an estimated 3% inflation per year.  In determining whether the same dollar amount per year in retirement is reasonable for my situation, it makes sense to consider other factors that may affect income or expenses:

Taxes: I fully expect my taxes will be higher by the time I retire, whether income is 70% or 150% of what it is now.  The government seems to have no shortage of ideas on how to spend my money, and I expect this problem will likely define our government for the next 30 years, much as we are starting to see in Europe. One can dodge some of this by paying taxes now using a Roth IRA or Roth 401(k) – more on this later.

Expenses: My two biggest expenses are currently my home mortgage, and saving for retirement.  These will both be gone once I retire, along with other significant expenses, such as my student loan.  Related costs such as property tax, insurance, utilities, and the like will not go away.  Some expenses like transportation and food are likely to remain similar to current levels as well, but may vary with the cost of resources.  Other expenses are likely to rise in retirement, such as money spent on travel, hobbies, and medical care.

Other Income: I already have enough work history to qualify for social security on retirement, and if I work until my mid 50s, I should receive noteworthy social security income at 67 (or whenever I elect to take social security).  I do not expect to work in retirement with the goal of generating income, but some hobbies on the horizon may produce modest income, reducing the burden on my retirement savings.

Lake home, boat: I’ve always thought this sounded like a nice way to retire, and if it’s economically feasible I’ll likely try to find a place on water to live in retirement.  I may downsize, but expect that with transaction costs, property taxes, etc., such a move will not be inexpensive.

Conclusion?  My expenses in retirement will not likely be significantly below what they are today (adjusted for inflation), and are likely to be similar if not somewhat higher.  I’m therefore saving to replace my entire income, and trying to save more to give me some additional freedom to live near water.   So, using the hypothetical current income of $100,000, my goal is to have an income of greater than $100,000 per year in retirement.