There are two dimensions to math of loss. The first is the duration of the loss, which we covered in my previous article. The second part is the dollar amount of the loss, which leads us to asset allocation.
During the last century, markets exhibited random or “normal” behaviour (as it’s known in the Gaussian world) about 94% of the time. The remaining 6% of the time, markets were in a fractal (non-normal, extreme, non-Gaussian) mode, split evenly between up and down directions.
Classic strategies such as asset allocation and diversification work perfectly well when markets are in their random mode, but not so much during their fractal mode. This is when some clients will abandon their best-laid plans and bail out of their investments. The key to success is to adhere to plans even during fractal times, so that when normalcy returns, these strategies resume working for the client’s benefit.
To analyze both random and fractal market behaviour, we can look at actual market history, which we call “aftcasting” (as opposed to “forecasting”). Aftcasting displays the outcome of all historical asset values of all portfolios on the same chart since 1900. It gives a bird’s-eye view of all outcomes for a given scenario.
It also provides the success and failure statistics with exact historical accuracy because it includes the actual historical equity performance, inflation and interest rate, as well as the actual historical sequencing/correlation of these data sets.
The short-term impact of asset allocation
Let’s look at two hypothetical accumulation examples.
Chase, 30, has a portfolio worth $100,000. He believes that stocks are for the long run. He owns 100% equities in his portfolio, half in Canadian stocks (S&P/TSX) and half in U.S. stocks (S&P 500). He plans to add $4,000 to his portfolio every year. He has never been through an adverse market event and therefore his stated risk tolerance has never been tested.
Market history shows that in the worst case, Chase’s portfolio value dropped to $38,713 (in the starting year 1929), as depicted in Figure 1. This is after adding $16,000 to his portfolio ($4,000 per year for four years), and it represents a 61% loss.
Figure 1: Accumulation portfolio — Chase’s aftcast (100% equities)
Click here to enlarge the chart
The second hypothetical scenario is for Grace, who’s also 30. Like Chase, she has $100,000 in her portfolio and plans to add $4,000 every year. Unlike Chase, she prefers a far more conservative asset mix of 40% stocks and 60% fixed income after a rigorous risk tolerance assessment with her advisor.
Figure 2 depicts her aftcast. In the worst case, her portfolio dipped to $84,159 — a much smaller loss (16%) than Chase experienced (61%).
Figure 2: Accumulation portfolio — Grace’s aftcast (40/60 asset mix)
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The main risk for an accumulation portfolio is the client’s willingness to stay invested during adverse market events. Everything else being equal, Grace would be more likely to stick with the original plan than Chase.
The long-term impact of asset allocation
Let’s look at the impact of staying power, or the “behavioural risk,” for a 20-year time period. For that, we use the historical median portfolio values rather than the worst case.
After a year of agonizing losses, Chase changes his asset mix to 40/60. Grace is also unhappy with her short-term returns, but she tolerates the volatility.
Both median portfolios are depicted in Figure 3 after accounting for the initial loss.
Grace had the staying power. She was able to accumulate more assets than Chase, who did not know his risk tolerance and had to bail out after the first year and reset his asset mix. That one mistake cost him a lot of money — about $104,000 after 20 years of compounding — not to mention a significant loss of accumulation time totalling at least six years.
Figure 3: The value of knowing your risk tolerance in accumulation portfolios
Click here to enlarge the chart
What if Chase hadn’t panicked and instead maintained his original asset mix? His 100% equity portfolio would be worth about $260,000 at age 50, after accounting for the same initial loss, compared to roughly $236,000 after switching to a 40/60 mix as shown in in Figure 3.
We can now translate these findings into practical action steps.
Know thy risk tolerance: The most effective way for clients to increase their investment success is to know the limits of their risk tolerance. If this is not crystal clear, they should err on the side of lower risk.
Asset allocation during the early accumulation stage: Clients may want to keep portfolios conservative (40% equity and 60% fixed income) until the annual accumulation of dollar amount is less than 4% of the portfolio value. This may prevent clients behaving as Chase did and bailing out if volatility becomes too high.
Conservative portfolios also avoid the risk of clients feeling as though they’re feeding the losses after a downturn. This can happen in a multi-year bear market when the money flowing in only makes up for market losses — especially when the client knows the advisor is still making commissions.
Asset allocation during the mature accumulation stage: Once the annual additions are less than 4% of the portfolio value — and if risk tolerance permits — the client may proceed to a 60/40 mix, which can provide sufficient growth at a reasonable risk.
Asset allocation close to retirement: Ten years before retirement, clients may want to move the asset mix back to 40/60. Why? As seen in the previous article, one might need 10 years to recover after a nasty black swan event. Reducing the risk sometime between ages 60 and 65 can mitigate the damage.
Retirement income sustainability: Once the portfolio is switched from accumulation to decumulation, the math of loss flips on its head. Even if withdrawals are perfectly sustainable (say, 3% initial withdrawal rate) clients might never again see the pre-loss asset value of the portfolio after a seemingly minor correction.
Retirement income for essential expenses: If a client’s required withdrawal rate for essential expenses is over 3%, they want to consider guaranteed income such as annuities or segregated funds with lifelong guaranteed income. Why? Because a portfolio loss as small as 15% can significantly reduce the sustainability of income.
If the required withdrawal rate for essential expenses is under 3%, the client may want to choose between a traditional or a segregated fund investment, depending on estate planning considerations.
Retirement income for non-essential expenses where preservation of capital is important:
If withdrawals from the portfolio are for discretionary and non-essential expenses only, but preservation of capital is important, then segregated funds with guarantee of capital may be appropriate.
Retirement income sustainability when income is for non-essential expenses and preservation of capital is not important: If withdrawals from the portfolio are for discretionary and non-essential expenses only, and preservation of capital is not that important, then a traditional investment portfolio may work.
Keep in mind, this analysis is based on the market history of the last century and assumes that the current borrowing binge can continue indefinitely. During the last century, fixed income was the “safer” side of a portfolio; going forward, it might turn into the riskier side. We shall see. In the meantime, enjoy this recovery.
Jim C. Otar, M.Eng., is a retired certified financial planner and professional engineer; he founded retirementoptimizer.com.