“Financial Advising is a prescriptive activity whose main objective should be to guide investors to make decisions that serve their best interests.” Daniel Kahnemann
This regular update is intended to be used as talking points with clients.
While there are many reasons for chasing returns, from a practical perspective, assets are useful only as a means to be converted into income at a later date. For many of our clients, the date which the bulk of these assets will be converted into income is far in the future even if there is an immediate income need. For most, the overwhelming majority of their money has a long time horizon.
We can quantify the time horizon over which assets are expected to be converted into income by interviewing the client and putting together a financial picture. For example, if the client plans on retiring in 5 years, and he believes,
Then his simplified minimum Target Return is 3.8% (75,000/2,000,000). An achievable target. Based on these assumptions, we would begin putting together a Retirement Spending portfolio for the client beginning 3 years before his retirement. At retirement, we would fund the Retirement Spending Portfolio with 3 years of spending needs, or $225,000. This is the short-term bucket. The remainder of his assets would be directed to the Long-Term portfolio.
Volatility can be an investor’s best friend or worst enemy. When cash flows are positive and contributions are coming into an account volatility can help the accounts grow and compound. On the other hand, when investors are withdrawing, volatility can destroy the long term income producing potential of their asset base. In an analysis done in 2002 by Metlife, investors can clearly see how downside volatility can be extremely detrimental to the income producing potential of e portfolio.
In the analysis, a hypothetical investor retires in 1983 with $1,000,000. This investor chooses to withdraw 7.5% off the portfolio for income in the first year, and then increases that withdrawal by 3% each year to keep up with inflation (for example 1,000,000 X 7.5% = $75,000 in the first year, then $75,000 X 1.03% = $77,250 in the second year). The table below depicts the outcome of the hypothetical investors experience using the ACTUAL S&P 500 Composite Index returns from 1983 to 2002.
As you can see a long streak of positive returns for stocks from 1983 to 1999 helped ensure a highly successful retirement for our hypothetical investor. At the end of the period he has withdrawn over $2 million out of his assets and has $5 million left. But what if returns were not so rosy?
By flipping the years, and using the returns starting in 2002 and working backwards to 1983 the story of our hypothetical investor changes dramatically. At the end of the period our investor has withdrawn only $1.5 million out of his portfolio as he runs out of money during year 17. And instead of finishing the period with $5 million left over our hypothetical investor is in debt. By year 4 our investor has less than half of the total assets he started with.
But what would happen even in this poor return scenario if our hypothetical investor was not withdrawing off of the portfolio? We’ve thrown in our analysis to see.
Despite the poor environment to begin with, our hypothetical portfolio has recovered quite nicely and finished with a total balance of almost $9 million!
Growth of an investor’s asset base is vitally important to maintaining income production. However, downside volatility can wipe out the income producing potential of any portfolio very quickly ESPECIALLY when withdrawals are being made. At Global View, we combat this by splitting up the short term and long term assets into separate buckets, the Long Term Portfolio (LTP) and the Retirement Spending Portfolio (RSP). This help us insulate client portfolios where withdrawals are being made from heavy downside risk, while allowing the LTP room to grow, increasing its future income production potential.