Warning for Investors: Sobriety Checkpoint Ahead

In an upward-trending market like the one we’ve enjoyed for much of 2019--and for the past decade, for that matter--checking your investment-account balances can provide a little bit of a thrill, or maybe just some well-deserved peace of mind about your financial future.

If you had $100,000 in a boring old balanced fund (albeit a good-quality one) 10 years ago, you’d have nearly $272,000 today--and that’s not factoring in any additional contributions you may have made. And if you had your whole $100,000 portfolio in stocks at this point 10 years ago, your balance would be more than $400,000. Seeing your account value grow from year to year is a strong motivator to stick with the plan and perhaps even bump up your contribution rate as your salary allows.

At the same time, enlarged portfolio balances may encourage perverse behaviors, or at least unrealistic expectations. Coasting on very strong recent returns, it can be tempting to use your larger nest egg as a reason to pull back on your savings rate, or let a too-aggressive asset allocation ride. It’s also easy to get blinded by the baseline total, losing sight of the factors that can erode the actual spending power of your portfolios--specifically, inflation and tax costs. (This is true in good markets and bad.) An amount that looks positively robust today may seem less adequate when it comes time to spend it.

If you’ve been watching your portfolio grow by leaps and bounds for the past decade, take a moment to congratulate yourself for your part in it: your contributions, your investment selections, and your perseverance through periods of market volatility. (Periods of turbulence, such as the debt ceiling "crises" of 2013 and 2015 and the fourth quarter of 2018, were short-lived, but we didn’t know they would be at the time; they felt bad while they were happening.) At the same time, acknowledge that luck played a role in your success, and be sure to not let your large balance lead you to any of the following four pitfalls.

1. Overspending/undersaving. Even though your long-term investment accounts are likely segregated from your spending assets, a larger total portfolio has a way of making you feel more comfortable with spending more. A more expensive vacation. More frequent meals out. A $6.50 latte versus your usual $3 drip coffee order. (That's me, raising my hand.) The periodic splurge can be money well spent if it keeps you sane and happy; the trick is to not have so many indulgences that they cut into your savings rate. Market history, expert forecasts, and current valuations suggest that the strong market that has prevailed since early 2009 will portend a less-impressive one over the next decade. If that's the case, you'll have to save more, not less, to grow your portfolio as much as you've been able to do recently. In other words, pick your financial indulgences carefully and make sure they don't cut into your savings, which will ultimately be the bigger determinant of your portfolio's bottom line than market returns.

2. Taking more equity-market risk. Relatedly, a sustained strong market can encourage excessive risk-taking. If you're a young investor with a long time horizon until spending, you absolutely should have a substantial allocation to equities for your long-term portfolio, and periodic market dips can be a good time to add to them. But if you're saving for shorter-term goals, be sure that you're not confusing confusing your risk tolerance, which may be high, with your risk capacity, which is lower because of your near-term spending horizon. And if you haven't been battle-tested by living through previous bear markets, whether the early 2000s, the financial crisis, or both, you may not be that great of a judge of your risk tolerance to begin with.

My midyear portfolio checkup suggests some benchmarks for setting in-retirement asset allocations. But if you're saving for a goal that's closer at hand, you might use a bucket approach to guide you to a sensible allocation; this article includes some model exchange-traded fund and mutual fund portfolios for short- and intermediate-term goals. The latter have a bit of equity exposure, but not much; the short-term portfolios have none.

If you're closing in on retirement, you have even more of an incentive to not let your fattened portfolio distract you from de-risking your portfolio. The market environment you encounter in your retirement is the luck of the draw; it's down to timing, and most of us don't have as much control over our retirement dates as we might wish to think. If a bear market materializes early in your retirement, your portfolio is positioned too aggressively, and you don't dramatically rein in spending, that can permanently impair your portfolio's sustainability. This video discusses asset-allocation considerations for younger retirees and/or people who are considering retirement within the next five years.

3. Underestimating the role of inflation. Inflation is stubbornly low right now--so low, in fact, that the Federal Reserve would like to nudge it higher to prove that the economy is healthy. Yet the enlarged portfolio balance you see today doesn't reflect where costs will be when you get around to spending it, one reason why big milestones in your retirement account balance can be illusory.

While it might seem tempting to ignore inflation when determining the viability of your retirement portfolio, rising costs can be an enormous swing factor, as discussed here. Portfolios that properly anticipate the role of inflation could be hundreds of thousands of dollars larger than those that do not. It's also worth remembering that healthcare outlays have historically been a larger share of the outlays of retiree households than for working folks, and it's likely to stay that way. Thus, even though the headline inflation rate is low, your own inflation experience could be quite different.

4. Forgetting that it's really not all yours. Also in the category of "Objects in your portfolio are smaller than they appear," it can be easy to forget about how taxes can lower your take-home return. Making pretax contributions to a 401(k) or other company retirement plan can give your portfolio a real boost. But the tax collector needs to take a cut at some point, and for traditional 401(k) and IRA contributions, that point is when you begin taking withdrawals in retirement. Taxes will also reduce your take-home amount for retirement assets held in a taxable account; even though you've already paid taxes on the amount you've invested, you'll still owe taxes on most income and all dividend distributions, as well as capital gains over your holding period. If you don't factor those taxes into your retirement planning, you could face a standard of living that's dramatically below what you thought it would be.

Say, for example, you're adhering to the 4% rule for your retirement portfolios. Assuming a $1.5 million starting portfolio and a 4% withdrawal in year one, you could tap your portfolio for $60,000. But that's a gross number--it doesn't incorporate that at least some of that money will be taxed, and the tax treatment will differ depending on where you're holding the money. If all of it is in a tax-deferred account like a Traditional IRA or 401(k), all the contributions that you didn’t pay tax on, as well as any investment earnings, will be taxable upon withdrawal. Assuming you're in the 22% tax bracket, your take-home withdrawal shrivels to less than $50,000. If you were withdrawing from taxable accounts or better yet Roth accounts, the tax collector would take a smaller cut of the withdrawal.

My point isn't to discourage you from saving within tax-deferred accounts like 401(k)s and IRAs, even though you'll take a haircut when you make withdrawals from them. Rather, it's to underscore the importance of factoring in taxes when determining the viability of your retirement plan and deciding whether you have enough. If you're using an online calculator to see whether your retirement portfolio is on track, you'll want to make sure it is segregating your retirement assets by their tax treatment. If it's not, it's too simplistic a tool to be useful. Also bear in mind that tax rates could realistically go up in the future. Because you don’t know what tax rates will be when you pull the money out in retirement—either secularly or your own personal tax rate—I’m a believer in using multiple silos for retirement savings. Traditional tax-deferred accounts may well be a key part of your retirement-savings portfolio, but it can also be smart to build assets in Roth and taxable accounts as well. You won’t get the same instant gratification (higher initial withdrawals/faster growth of pretax contributions) from those accounts that you will from tax-deferred accounts, but you’ll be grateful for them when it comes time to pull the money out in retirement.

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