Monday, 12 May 2014

Why Retirees Need to be More Concerned about Portfolio Volatility

Whether or not retiree investors have a more cautious attitude, often termed lower risk tolerance, the fact is they should look to build a portfolio that is less volatile. Why? The reason is something termed sequence of returns risk, the chance that the year by year order of portfolio returns may have significant downside early on during retirement, even when over the long term returns are strongly positive.

To demonstrate, let's have a look at some simple examples, comparing i) a retiree making annual withdrawals from a portfolio, ii) another investor in savings mode putting in an annual contribution and, iii) a third investor who invests a large lump sum, perhaps an inheritance, and leaves it to grow. We'll use identical returns across various sequences of returns to see how dramatically the end results can differ.

The Returns and Investor Scenarios
  • Retiree: Starts with $100k retirement portfolio and withdraws $20k a year
  • Accumulator: Starts at zero and puts in $20k per year
  • Inheritor: Receives $100k and invests it, making no further contributions or withdrawals
  • Five years, combining 20%, 0%, 20%, 15% and minus 5% with the negative year being either at the beginning the middle, or the end. 
  • As a variation we change the 15% and minus 5% to 21.38887% and minus 10%, keeping the other three years the same. 
  • Our sets of numbers all correspond exactly to a smooth equal compound annual return of 9.485546% (spreadsheets are just as easy for making numbers precise as approximate).
Inheritor - This situation is simplest, since there is absolutely no variation in end value, no matter what the sequence of returns turns out to be. Any order of returns gives exactly the same end result, $157,320 after five years. Volatility doesn't matter to such an investor. Unfortunately, most investors live in a different more complicated world with either contributions or withdrawals.

Accumulator and Retiree - For both these types of investor, the end value varies, but especially so for the retiree. Building a similar table to the one above, we have summarized the results in the chart below, which shows how much after five years the end value of the portfolio varies from the simple case of smooth constant annual returns of 9.485546%. The worrisome situation for the retiree is under-performance at the beginning of withdrawals and it is most worrisome when the drop is larger, even when it is followed by large gains afterwards. As is often said, taking money out a portfolio when it has endured a market value loss can permanently damage it.

In contrast, the accumulator doesn't suffer nearly as much. Intuitively that makes sense since he/she doesn't yet have much money at stake.

How to counter these damaging effects?

Reduce portfolio volatility by diversifying
Holding a number of types of assets whose returns move as little as possible in sync is the most powerful method for reducing the overall volatility of a portfolio. We recently illustrated this idea in analyzing the Permanent Portfolio's reason for success, discussed how to do it directly last year in a post on how to minimize portfolio volatility and compared the volatility of several model portfolios in this 2013 post.

Retirees to avoid the problem of volatility by a bucket strategy?
A more controversial, though often used, strategy is for retirees to keep enough non-volatile cash or short term bonds to fund several years of retirement spending and thus avoid having to sell volatile assets like equities after a market drop. Noted retirement researcher and finance professor Moshe Milevsky doesn't think much of this approach calling it a financial placebo and dangerous mirage, while financial planner Michael Kitces writes that it more or less works out to the same as a conservative asset allocation. One technique that works for sure, because it takes some of the investment funds and leaves them inside the portfolio to work like the lump sum investor's experience, is for the retiree to reduce spending in down market years.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

1 comment:

Anonymous said...

Portfolio volatility can be reduced by increasing the allocation to bonds. You can also sidestep the sequence of return problem using a percent of portfolio withdrawal strategy, something like the Bogleheads VPW method.