“Some religiously stick to buy-and-hold. That's ok over 30 years if you can do it. It's not ok if you get run over by a 50% market correction if you are a pre-retiree or retired.” – Steve Blumenthal
A few weeks ago we wrote a post entitled The Economics of Loss discussing the importance of reducing volatility and managing exposure to large drawdowns in your portfolio, especially as you near retirement. Not only are large swings in investment value hard to deal with emotionally given The Cost of Being Human, but they can be detrimental to the mathematical sustainability of a long-term retirement plan.
As a new way of illustrating this concept let’s take a look at a hypothetical retiree (we’ll call him “David”). Using our financial planning software, we’ve built out a very simple profile for David, who happens to be 62 and newly retired. Years of disciplined saving has netted David a $1,000,000 retirement portfolio which serves as his only source of cash flow outside of his early social security benefits of just under $2,000 a month. Given David’s monthly spending budget of $5,000 a month, his portfolio has to cover a monthly cash shortfall of roughly $3,000 before taxes.
In order to make cash flow projections we next need to make an assumption about what rate of return the portfolio is likely to produce. As a starting point let’s plug in 7.6% per annum, which happens to be the annualized total return of the S&P 500 over the past twenty years. (NOTE: We would always be more conservative than this in actual retirement planning.)
As the chart below shows, at a 7.6% rate of return David’s portfolio growth is projected to outpace his annual cash shortfall, and in fact the portfolio is projected to continue growing on an inflation-adjusted basis over time. So far so good.
The problem with stopping the analysis here is that even if the portfolio is projected to average 7.6% over time we know the results will vary quite a bit from year to year. So our next step is to “stress test” the retirement plan by running a Monte Carlo analysis that processes 1,000 iterations of the same cash flow projection inclusive of some variability in the rates of return. In order to guide the level of variability we have plugged in a standard deviation of 15% to coincide once again with actual S&P 500 results over the past twenty years. This stress test reveals a 75% probability of success, meaning that 25% of the time the “sequence-of-return” risk described above caused the retirement plan to fail in the Monte Carlo simulations.
While this in and of itself is not a horrible starting point, it is probably not quite comfortable enough for most people as they head into retirement.
Now, let’s change the underlying assumption to reflect a similar long-term expected rate of return from the portfolio, but with half the volatility (standard deviation set at 7.5%). If we re-run the Monte Carlo analysis we see that the probability of success has now jumped to 88% - a materially better result.
Keep in mind that everything else in David’s retirement plan stayed exactly the same, but by merely compressing the range of potential outcomes in the portfolio the sustainability of the plan was increased dramatically. This is why we put so much emphasis on volatility reduction and downside protection. Successful risk management can have enormous long-term impact on someone’s financial future.
Admittedly, at some point these exercises can merely be “fun with numbers”. The underlying question is to what extent volatility and downside risk can actually be managed over time. We obviously believe there is tremendous value to be added in this regard. Our philosophy of Diversification 2.0 (going beyond just stocks and bonds) is the first layer of risk management that reduces the concentration of client portfolios in any one or two particular asset classes. Then on top of that MarketVANE for Stocks and Hard Assets provides a mechanism of tactically using cash to preserve value in major bear markets.
While we can’t predict the future or know in what periods our disciplined approach will or will not add value, we can predict with certainty that the future holds a wide variety of different economic and market environments. As such, we will continue working hard to construct portfolios with the highest likelihood of remaining durable and moving our clients in the right direction with as much consistency as possible.
Author David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.
Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.