If someone asked me to come up with the two defining characteristics of financial markets, my answer would be “opportunity” and “risk”. The opportunity to make a good return on an investment and the risk that an investment will diminish in value. Both have been well-illustrated in the past three years. Unchecked, opportunity and risk can take investors on a wild ride. Even with the best thought-out rules, rules that actually get followed, many investors will experience some volatility in their portfolios. But the right rules, followed and enforced, can make financial markets much more friendly. Breaking the rules almost always has consequences. Let’s apply this to planning for and funding retirement.
Financial market rules come in all shapes and sizes. Some are intended to encourage certain types of behaviour; some are intended to discourage other types of behaviour. Some rules are based on specific legal codes; some are mainly based on the scarcest resource of all – common sense.
Let’s spend a moment reflecting on some of the rules that were broken during the past three years – and the resulting consequences.
- Financial institutions (fortunately, not the ones in Canada) were lending money with no reasonable due diligence regarding credit risk, with the consequence of a slew of loans not being repaid and dire consequences for the lenders and borrowers. Securitization of these bad loans, followed by little or no transparency to the investors who purchased the securities, with the consequence of frozen credit markets and massive losses to investors.
- Sophisticated financial engineering intended to eliminate risk (which I believe is impossible) with the consequences of massive financial losses.
- Faulty risk assessment by credit rating agencies (essentially, assessment of the wrong risks in the wrong place) of supposedly sophisticated securities, again with the consequence of massive financial losses.
- Some governments running large annual budget deficits when they should not have been doing so, being less than truthful about the extent of these deficits, and trying to finance them essentially out of sight, with the consequence of a crisis around government debt.
The list could go on and on. But you get the point. All of these unfortunate consequences were the result of some rule or other being ignored.
What is interesting in this context is what happened to those who didn’t break the rules. One shining example is the Canadian banks, which successfully followed the quaint Canadian custom of checking potential borrowers’ credit ratings before lending them money and following a number of sensible strategies. The result? For a time, the values of their shares took a hit, an overflow from the real problems in other countries. But basically, they came through very well and are poised for the future.
There are some fundamental lessons here for the economics of retirement. Knowing the rules and following them is much more likely to result in a good outcome than a bad one. Establish a set of rules around saving for, investing for and living in retirement, and follow them. The outcome? A much higher probability of avoiding financial grief, a much higher probability of achieving financial goals.
I am suggesting half a dozen such rules. I don’t claim authorship of any of them. But, I think they constitute a set of rules that could form a corner stone for retirement planning.
There are many other rules that could be discussed here, but I think these cover the basics. Like the rules around financial markets, following them doesn’t guarantee that there won’t be bumps along the road. But they do make it much less likely that a personal retirement savings wipe-out will occur and most likely will result in a much better outcome than ignoring the rules. Of course to some, the rules I have outlined will seem bland and boring. They don’t have the excitement of a hot investment. But, they will promote the likelihood of actually achieving retirement income goals and reduce the likelihood of severe client stress along the way. In other words, they reduce the risk and raise the opportunity.