Sunday, January 13, 2008

Retirement Planning and Risk, Uncertainty, and Profit

Frank Knight, as I mention in the book, was an economist, who seeking out a subject to do his thesis on, choose profit. In today’s terms, this topic would have little significance. We all know what it is and how it is created. In its simplest form, it is the difference of price between the cost of making a good and the price a consumer is willing to pay for it.

But when Knight decided on profit, economists had yet to understand the nature of the corporation fully or its impact on what was about to become one of the most significant changes in economics. (The other was the development of economics as an exact science, one that shared the field with mathematics and physics – in other words, it was about to become abstract.) What Knight found was a system that, prior to the turn of the century, was built on the notion that someone could make money, but only if the capitalist was willing to take the risk.

The system was set up like this: Men used money that they had, hired workers as they needed them and paid rent for the land or buildings they used. They did borrow money to begin these enterprises but that seed cash was the result of sacrificing the financial and often, the managerial side of the business to the banker or trading company. Those two entities became the dominant partner and often one that stifled the very businesses they were funding.

But things were changing. Competition was beginning to exert a force on the business model. His book Risk, Uncertainty, and Profit was published in 1921 and changed the way we looked at randomness and why it was important in making risk work.

Knight suggested that a businessman’s paycheck was not profit but merely a contract interest. He writes that, “Even Adam Smith and his immediate followers recognized that profits normally contain an element which is not interest on capital.” One of the first recognizable references to this change came from a French author J. B. Say. In his fourth edition of Traité he noted that income was once the best way to reward risk-taking but because of shift away from what the capitalist had previously accrued, the reward was now the province of the entrepreneur.

There have been numerous instances where the subject of risk requires a definition. I can’t begin to tell you how often I alone have tried to explain the topic, using a wide variety of analogies to explain that some risk is good because it increases the likelihood of reward. It is almost as if the topic is fluid and cannot be contained by simple words.

I have explained that risk needs to account for inflation, taxes and a whole variety of other distractions including the most problematic element – which I describe in my “Investing for the Utterly Confused” book as the mental maniac inside all of us. But it persists in what it can provide for the investor - and take away and yet, we are all seeking the right level, the perfect balance, and the prize that awaits the person who can.

Mr. Knight also pointed out a flaw in the current thinking about work. Trying to look at how men act rationally, he pointed out that it was “superficially natural to assume that a man will work more – i.e., work harder and more hours per day – for a higher wage than for a lower one.” Calling this assumption incorrect, suggesting instead, that they will in fact divide their time “in such a way as to earn more money, indeed, but to work fewer hours.”

Encouraging risk taking among the youngest members of our society is unfortunately difficult. You can explain the rule of 72 (Divide 72 by the annual interest rate you are receiving on a simple account, and you will be able to pinpoint when that money will double – 72 divided by 6 percent=12 years. Other cool rules at the bottom.).

Risk comes from deduction, which is the use of probabilities to guess how things will turn out for a specific investment or induction, hat is commonly referred to as behavior. You know deductions as forecasts, something all of us make at one time or another based on what we know that could influence what might happen.

Induction is backward looking. How something performed might offer an indication of how it might perform in the future.

Risk can be, more or less quantified, understood or even predicted with a certain degree of accuracy. But behavior is what drives uncertainty both in the marketplace and in your retirement planning portfolio. We second guess ourselves despite knowing the consequences of doing so – lack of savings, inadequate retirement goals, etc. and that creates more uncertainty than is needed.

As I write in the book: “Risk provides the investor with innumerable opportunities. Problem is, we rely on the past to point the way.”

Suppose you want to calculate the inflation rate and the effect of that rate on that dollar in your pocket. This is important for two reasons, saving too little will create a gap in what your money was actually worth and what is actually is. For instance, suppose the inflation rate was 3%. (This is higher than the current rate.)

Your money will be worth half as much 23 years from now. So that dollar you stuffed under the mattress would only be worth 50 cents. To determine the time for money's buying power to halve, we use the “Rule of 70” dividing 70 by the current inflation rate. See why that rate is so important to the Federal Reserve.

Fees play an important role in our financial decisions and it is important that we know how they impact our savings and investments. Fees usually come with investments such as mutual funds (which have both fees and expenses) and variable universal life insurance policies (loading and expense charges). To calculate the impact of those fees, divide 72 by the fee.

Simply divide the number 72 by the fee to determine when the policies value will be cut in half compared to an investment without fees.

You can use the “Rule of 72” provides a good approximation for annual compounding, and for compounding at typical rates but those approximations become less accurate at higher interest rates – above 10%.

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