In the past year, five of the 99 families we work with have sold their dental practices. As a result these clients contributed in total over $6,000,000 to their investment accounts with us. Along with their other savings, we are now using these funds to finance their monthly lifestyle costs. On average these clients are receiving $14,500 per month ($175,000 annually) after-tax. The most difficult question we face is deciding when we should invest the practice proceeds into their long-term strategy.
In 2000, our clients’ portfolios were down between eight and twelve percent. If you had sold your practice for $2,000,000 and contributed it to our retirement account in 2008 and we had just gone ahead and invested 100 per cent of the money, then you might have been down $240,000 in the first year. That is what keeps me up at night. The five dentists who sold their practices and contributed to their investment accounts this year have worked for over 30 years to build up that value. Just because they sold this year, does that mean it is the right time to put the money into the stock market?
Those of you who have read our book or articles on investing to fund your retirement know there is a difference between growing your portfolio and living off your portfolio. For example, if you invested in the Toronto Stock Market from 2000 to 2010 your average annual return would have been 8.06 per cent. If you invested in the bond market your average return would have been 6.16 per cent. So if you are growing your portfolio you would have made more money investing in the Toronto Stock Market. However, if you were living off your portfolio like the five families mentioned above, then your situation is different. You see, in 2001 the stock market dropped 14 per cent, and if you were like our five clients you withdrew $175,000. The next year the stock market also declined and again you would have withdrawn $175,000. When the stock market did recover to raise the average to 8.06 per cent annually, you had $350,000 less in your portfolio to participate in the increase. Surprisingly, if you were in a withdrawing portfolio you would have made more money investing in the bond market from 2000 to 2010 than in the stock market.
Knowing how sensitive your long range plan is to the short-term fluctuations in the stock market, how should you invest the proceeds of your practice sale?
First off, for most of you this will be the first place you withdraw money from to finance your retirement. Our five families who sold their practices and retired received $14,500 into their bank account the month after they retired. We need to sustain this monthly figure for the rest of their lives, which in some cases is over 30 years. And this figure needs to keep pace with inflation. So in order to finance $14,500 per month indexed for inflation, the return on our savings must outpace inflation. Inflation right now is averaging around two per cent. So if you were to earn two per cent you would simply be keeping pace with inflation, not outpacing it. Our plans require us to outpace inflation by three per cent in order to meet these retirement cash flows, so our target annual return to meet the monthly cash flow for these clients is five per cent. Conservative fixed income investments are currently only returning about two per cent, so we cannot invest in them to meet our return requirement. So what else should we invest in?
In order to outpace inflation, we will invest a component of the practice sale proceeds into stocks. According to Dalbar, a market research firm in the United States, stocks (as measured by the S&P 500, which includes the largest 500 companies in the US) returned an average of 8.19 per cent over the past 20 years. However, here’s the problem: Dalbar’s research also shows that the average investor only earned 2.11 per cent on an annualized basis for the past 20 years. Even bonds returned 5.34 per cent over the period.
The reason for this is that investors make poor decisions and are guided too much by their emotions. In 2008, the World Stock Market index dropped by 40 per cent. Most investors get nervous and sell out after a decline. When the stock market recovers, they buy back in. In other words, most investors sell low and buy high. That is why the average investor has done so much worse than the stock market as a whole.
How much should be invested into stocks?
To determine this we recommend using at least three years of lifestyle costs and setting this amount aside in risk-free assets. That way, even if you experience a substantial decline in the rest of the portfolio, you have the money set aside and can allow the portfolio to recover before you need it.
So out of all the investment alternatives, I would recommend putting the practice proceeds into stocks…just not right now. In other words, hold onto cash and revisit this at the end of the year. If there is no major correction in the stock market by December 31, then we begin a dollar cost averaging program to move the practice proceeds into stocks over the next 12 months. You’ve worked over 30 years to make this money, so don’t rely on luck. The likelihood your practice closing date is on the same day it’s a good time to invest in the stock market is very low. PA