Sometimes referred to as “the butterfly effect” in popular culture, chaos theory is actually the science of surprises — a highly interesting and popular area of study that deals with randomness and unpredictability, and how these concepts affect complex systems like extreme weather and the stock market.
One key principle of this theory states that the smallest alteration in a process can create a massive shift in the outcome.
So what does that have to do with your retirement strategy?
As it turns out, quite a lot.
While accumulating wealth is generally a linear process, what happens when you are actually living on that money is non-linear and adds some spicy chaos that’s very difficult to plan for.
Your rules of portfolio management need to adapt if you’re going to create a safer, more effective strategy for post-retirement.
The chaos factor is actually the key to simplifying and personalizing your financial plan to achieve the best results.
In this first part of an ongoing series, I’ll begin to explore the sharp difference between returns in accumulation and distribution as well as the principles inspired by chaos theory to help you better navigate this landscape and thrive in retirement.
Transforming Classical Portfolio Management
It’s simply not possible to calculate all possible future possibilities when it comes to retirement, as inputs and outputs are no longer proportional once the nonlinearity of withdrawals is introduced.
In other words, think about saving versus spending. Working hard, saving money, and investing your funds following traditional rules of financial planning, such as “committing this amount with this targeted rate of return equals X profit.” That’s just math.
But when someone is retired and on a “fixed income,” i.e., focused on the preservation of capital and controlling spending, there will definitely be shifts in risk and psychology. There will be costs and events you can’t forecast, and times when it makes sense to spend rather than save.
The predictability of robo-advisors and set-it-and-forget-it 401(k)s don’t play well with powerful non-linear and chaotic influences during distribution, such as health issues, inflation, and unforeseen occurrences. Conventional wisdom doesn’t always apply, and more innovative solutions and an active approach are needed.
Talking heads tout the (wrong) idea that portfolio management is nothing but maximizing returns and minimizing fees, and therefore paying for customized investment advice isn’t worth the cost. But it’s the exact opposite that’s true.
Partnering with an advisor who understands how a chaos-adaptive distribution theory will influence your retirement income is crucial for protecting your assets in an uncertain environment.
An agile and innovative retirement planner realizes it’s much more beneficial to prepare rather than predict.
In 1962, philosopher and Doctor of Physics Thomas S. Kuhn published a book titled The Structure of Scientific Revolutions, which introduced the now-ubiquitous term “paradigm shift.” His unique insight caused something of an uproar in stuffy academic circles back then, and the conversation continues, especially when it comes to the evolution of portfolio management thinking.
His thoughts on chaos theory disrupted the belief that we live in a predictable world. And when it comes to your retirement, predictability goes right out the window. There are many unknown variables, and it makes sense to transform your perspective on living longer, get out of the fixed-income mindset, and embrace flexibility.
According to James B. Sandidge, JD in his recent article for Retirement Management Journal, “retirees should be skeptical of any media that makes blanket recommendations around investment strategies without distinguishing between wealth accumulation and distribution.”
Savvy advisors should challenge every assumption when it comes to working with retired clients, and focus on beating the index in negative return years instead of depending on overconfident advisors and passive strategies.
The choices today are remarkably different for those about to retire than they were in the recent past, and in this volatile and ever-shifting economy, those on the edge of retirement should throw off the old stereotype of a stagnant and change-resistance existence.
Today’s retirees are leveraging opportunities like pivoting to more fulfilling part-time or freelance work to supplement their income and taking a more active role in getting the maximum benefits from their assets.
Chaotic, constantly changing, and actively managed are principles for both the retiree lifestyle and retirement portfolio management.
Islands in the Storm
Most people prefer spending to saving, and while they love receiving income via an annuity (or Social Security), paying for these types of policies rubs some folks the wrong way. Discussing possibilities and expected returns is not much fun.
But these insurance products provide guaranteed lifetime income with much less risk than other investments flogged by unimaginative and overconfident retirement planners.
Unfortunately, losses are more dangerous financially and psychologically during the post-retirement decumulation phase. That’s why annuities are a perfect balance to your investment portfolio, as they offer a guaranteed stream of long-term income, offer certain tax benefits, and serve as a hedge against inflation.
There are different kinds of annuities, and not every type is right for every individual. Fixed, indexed, and variable annuities all have their pros and cons, so it’s critical to explore all of your options with your experienced financial advisor.
One massive advantage of utilizing annuity products is that they’re more flexible than other retirement planning and investment tools. Using a 1035 exchange, you can transfer funds from one annuity to another product of like kind without triggering a tax on investment gains, if the original contract or policy no longer fits your needs.
Variety is the Spice
“Chaos” doesn’t necessarily sound like a good thing when discussing your assets and retirement outlook, but embracing some of the tenets of this theory actually helps you weather unpredictability during retirement immensely better than flying on autopilot.
There are many potential positive and negative impacts of even the smallest adjustments to your portfolio. And in uncertain times with volatile markets like we’re seeing now, taking a passive approach can have disastrous consequences.
The smartest way to prepare for the unknown is to work with a knowledgeable financial advisor who’s laser-focused on tailoring your asset management plans to your specific habits and needs.
It’s also important to keep an open mind, go with the flow, and enjoy an active role in controlling your destiny once you become one of the more than 47 million retirees in this country.
Stay tuned for the next installment in this series on chaos and how it affects your retirement income — and if you’re ready to discuss building your wealth and finding financial freedom, reach out today!