By Jack Forehand, CFA, CFP® (@practicalquant) —
One of the things I have tried to do with my articles is to use them as an opportunity to learn. Throughout my career, my focus has always been on investment management and specifically using factors to build equity portfolios. In that world, the goal of building portfolios is often to generate the best long-term returns possible.
But I recently passed the CFP exam and have been spending a lot of time learning about the intricacies of the world of financial planning. One of the big changes in that world from the one I am used to is the focus on building optimal portfolios that can not only grow, but also sustain consistent withdrawals.
Optimizing a portfolio that money is being withdrawn from is a very different animal than managing a portfolio with long-term returns as your only primary goal because the order in which your returns occur becomes a primary consideration in the portfolio construction process.
To illustrate why that is, let’s look at a simple example. Let’s say that the returns of the market over a five-year period are the following:
For an investor who is not withdrawing money from a portfolio, the order in which those 5 returns occur will not matter. They will have the same annual return in all possible sequences of the returns. But for an investor who is withdrawing money from their account, the order of the returns matters a lot. The reason is that money withdrawn when the market is down never has the opportunity to compound when it goes back up. So for an investor in retirement who is withdrawing money, their path will look very different if they are unlucky and see the worst returns first. That sequence of returns risk is something that has to be managed. In retirement planning, when returns occur can be just as important as what returns are.
The Balance Between Drawdowns and Withdrawal Rates
So how does this translate into actually building a portfolio? It does so through a concept that has always been counterintuitive to me, but that is clearly backed up by the data. The concept is that the best way to build portfolios that can sustain high withdrawal rates is typically not to only focus on generating the highest long-term returns. Instead, the goal is often best accomplished by focusing on managing drawdowns. It would seem on the surface that if I want to sustain the highest withdrawal rate possible on a portfolio, I should just invest it 100% in stocks so I generate the highest long-term returns. But that turns out not to be true.
Rather than trying to explain why that is conceptually, though, I think the easiest way to explain it is to look at a few examples.
Since the goal of retirement planning is to maximize the percentage chances of achieving a specific goal, one of the best tools to utilize is typically a Monte Carlo simulation. Monte Carlo simulation just looks at a range of potential outcomes by running a large number of tests and varying the data in each one. So for example, if I wanted to see if a specific portfolio can sustain a 4% withdrawal rate without running out of money, I could take the historical returns of the asset classes it is invested in and run thousands of simulations where I stress test it by reordering actual historical results in many different ways. This can give me a rough estimate of the odds that the portfolio might run out of money in the future.
Monte Carlo is also a good tool to help us understand why drawdowns are so important for a portfolio that has cash coming out of it. To illustrate this, let’s look at 3 portfolios and examine the long-term withdrawal rates they might be able to sustain. Let’s examine a portfolio invested 100% in stocks, a portfolio invested 60% in stocks and 40% in bonds and a portfolio that adds a small position in gold. To analyze them, I will use Portfolio Visualizer’s Monte Carlo simulation tool.
Before we look at the results, it is important to keep in mind that this simulation covers the period from 1978 to today (the longest period Portfolio Visualizer has data for all the asset classes). The majority of that period has been very good for both stocks and bonds. So the goal here isn’t to suggest that the withdrawal rates we come up with will work in the future (they very likely will not), but instead to look at how they change as we add uncorrelated asset classes and reduce drawdowns.
Starting with a portfolio of 100% US stocks, the safe withdrawal rate that works in 90% of potential simulations is 3.9%. The maximum drawdown for the market over that period is 58%. But for an investor using the standard 4% rule and withdrawing 4% of their assets each year, that drawdown rises to 100%, indicating that the investor ran out of money in more than 10% of potential simulated outcomes.
Now let’s introduce bonds into the equation to see what happens. For a 60-40 portfolio, the withdrawal rate that can be sustained 90% of the time rises to 5.6%. The reduced drawdown of the combined portfolio led to lower sequence risk, which in turn allowed for greater withdrawals. The maximum drawdown for this new asset allocation fell to 26%, and when cash flows are included it fell to 34%. So even though bonds had a lower return over the period than stocks, the fact that they are not correlated with stocks and reduced drawdowns led to a big increase in the safe withdrawal rate.
If we add a 10% position in gold to the portfolio, the results also improve. The safe withdrawal rate of that portfolio rises slightly to 5.7%, even though gold returned less than stocks and bonds did over the period.
|90% Confidence Withdrawal Rate
|Max Drawdown with Cash Flow
|Stocks & Bonds
|Stocks, Bonds & Gold
The Balance Between Risk and Return
None of this is meant to suggest that a certain mix of asset classes belongs in any investor’s portfolio. That is a personal thing that changes based on everyone’s personal circumstances. It also isn’t meant to suggest that the 5%+ safe withdrawal rates that this simulation came up with are realistic going forward. Given today’s low bond yields and high equity valuations, they very likely are not. The most important point here is that in a portfolio that has cash coming out of it, return cannot be the exclusive focus, even for investors that can stay the course through all the market’s ups and downs. For portfolios with regular withdrawals, drawdowns also must be a major focus.
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.
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