The Three Most Important Criteria
The importance of low volatility can be
demonstrated by looking at the most recent performance in the stock
market.
In 2008, the S&P 500 lost over 37% of its
value1. Many investors who were allocated
primarily to equities lost similar amounts or more. As
demonstrated by the chart below, if a client portfolio declines
40%, the return necessary to recoup the loss is 66.7%. As the
losses increase, the amount of return needed to recover increases
exponentially.
If a portfolio begins at $1, and loses 50¢, the amount needed to
recover to $1 is 50¢ or a 100% return. Adding onto
the exponential loss dilemma is the psychological impact of an
extreme loss in a portfolio. If we look back at the end of
2008 and beginning of 2009 when the markets were extremely volatile
and investors were panicking, there were countless articles
published in newspapers about people abandoning their 401(k)s and
moving all assets into stable value funds and extremely low-risk
investments such as CDs and savings accounts. Equity mutual
fund redemptions were at an all-time high2. An
investment loss of 20%, although uncomfortable, seems much more
palatable than a loss of 40% and therefore much less prone to lead
an investor to make a rash decision. Studies have repeatedly
shown that the best way to profit consistently from the stock
market is to remain invested for long periods of time rather than
trying to time the market as it rises and falls3.
Consistent cash flow in the form of dividends from stocks and
interest payments from fixed income is vital to a retirement
distribution portfolio. Each year, a retiree's portfolio may
be paying out as much as four percent or more to cover living
expenses. If a substantial percentage of the monthly payout to the
retiree that can be made from dividends and interest, then the
amount of principal value that must be withdrawal decreases.
If a hypothetical portfolio yields 3% in dividends and interest,
and the withdrawal rate is 4% per year, in the first year 75% of
the payouts needed will come just from dividends and
interest. Even after ten years of average inflation and zero
portfolio growth, 50% of the retiree's payout is coming directly
from the dividends and interest.
In rapidly fluctuating markets as well as in flat markets, by
keeping more of the principal invested, the investor will reduce
the need to sell investments at a loss and therefore recover faster
when the markets improve. Keeping more principal invested
also has an effect of investor psychology. If a large amount
of a payout needs to come from principal during a down market, the
idea of "locking in losses" may appear in investors' minds.
Investors may therefore more be apt to make radical changes to
investment philosophy and that would adversely affect their
probability of success.
The final factor of capital appreciation affects probability of
success due to the purchasing power erosion caused by long-term
inflation. Assuming an average 3% inflation4, the
cost of goods and services doubles once roughly every 25 years.
That means if a worker retires at 60, by the time he reaches 85,
the cost of living will have doubled. The payouts from his
account, therefore, will have to be increased proportionally over
his lifetime. (See below.)
If a retiree tries to rely on a portfolio of just fixed income
and cash, the likelihood of running out of money is significantly
greater than if he has a diversified mix of stocks, bonds and
alternatives to allow for some growth as well as
income5. Understanding that a pay raise will be possible
in later years of retirement can be a comforting realization for an
investor.
It is finding the balance of these three factors: low
volatility; consistent, predictable cash flow; and capital
appreciation that is essential in maximizing the probability of
success in retirement.
1. Source:
Standard and Poors
2. Source: Morningstar
3. Source: Blackrock
4. Source: US Bureau of Labor Statistics. Inflation varies
regularly. Many sectors of the economy inflate at different
rates. 3% is the generally accepted overall inflation
rate.
5. Source: Financeware
Next Section: Sub-Par Market Performance over 10
Years
