Both the stock and bond markets have been pretty rocky over the past couple weeks reminding us all that volatility still exists, even if we haven’t seen much for a while. So how does this affect financial planning, and the achievement of financial goals? The answer is more significant than you might think.
Imagine back at the end of the 1990’s that you saved one million dollars and you were ready to retire. Your plan was to invest the money in the stock market, the S&P 500 in this case, and withdraw $50,000 at the end of each calendar year. You’d use that $50,000 to live on (or to supplement other income such as a pension or social security). At $50,000 a year it seems logical that you should be able to get a least 20 years of withdrawals. Seems reasonable, right?
Well, if you had done that, you would have run out of money years ago[*].
With a steady withdrawal rate, the high volatility of the stock market, including two major corrections (2000-‘02 and 2008-‘09), left you with a zero balance by the end of 2018.
Ok, you say. But I wouldn’t have planned to take a fixed $50,000 out each year. Rather, I would have followed the more traditional approach and taken a fixed percentage of the balance out. That way I could never go broke, right? Right. Well, sort of. [†]
[*] The calculations of the S&P 500 with a fixed $50,000 taken out each year are available at valuemonitoring.com/volatility.[†] The calculations of the S&P 500 with a fixed 5% taken out each year are available at valuemonitoring.com/volatility.
As the graph illustrates, the results are somewhat better. The two big bear markets of the 2000’s still hurt, but because you were flexible with your withdrawals, your account never reached zero. In fact, it climbed back to the million-dollar mark by 2021. But how flexible did you have to be with your withdrawals? Well, the answer is “very”. [‡]
You may have been planning, or at least hoping, to withdraw around $50,000 each year. In reality, that is not what would have happened. Because of the volatility of the investment, your first withdrawal at the end of 2000 was about $46,000, and it dropped from there, reaching a low of ~$20,000 in 2008. True, your account recovered, as did the withdrawal amount. But if you had been counting on $50,000 a year but instead had to make do on $20,000, that’s some pretty lean years.
So, what is a person to do? Well, one answer is to diversify. (And it’s a classic because it is rarely proven to be wrong!) You can also find a manager with expertise in low-volatility investing. Let’s go back to our original example. But now we’re going to create a “diversified investment,” including a low-volatility strategy. For this we will put 50% of the account into the S&P 500. The remaining 50% will go into a hypothetical, actively managed high-yield bond strategy[§], a low-volatility system similar to what VMI does for its clients. With this new diversified approach things look quite different.
[§] The hypothetical low volatility system used here was created by comparing the daily price of BlackRock High Yield Bond Portfolio Institutional Shares (BHYIX) with an eighteen-day exponential moving average (EMA) of its price. An EMA is a type of moving average that places a greater weight and significance on the most recent data points. An EMA reacts more significantly to recent price changes than a simple moving average, which applies an equal weight to all observations in the period. 100% of the account value was used to buy shares of BHYIX each time the price of the mutual fund first exceeded its 18-day EMA. 100% of the shares were sold for cash each time the price of BHYIX first crossed below its 18-day EMA. Trades were recreated historically using prices adjusted for dividends of the BlackRock High Yield Bond Portfolio Institutional Shares (BHYIX) mutual fund. A 2% management fee was included. The specific calculations used are available at valuemonitoring.com/volatility.
Whereas the undiversified approach ran or nearly ran out of money, the diversified low-volatility portfolio never dropped below 70% of the initial account value. And, courtesy of the recent extended bull market, the account is well into new highs, all despite regular withdrawals. And if you had withdrawn 5% of the diversified account each year, you would have had just a few years below the $50,000 mark, and the rebounded account value is even more impressive with annual draws now in excess of $80,000, and an account value well over $1,500,000.[**]
[**] The calculations of the amount of the annual withdrawals using 5% of the account balance for the diversified low-volatility portfolio taken out each year are available at valuemonitoring.com/volatility.
So, what is the upshot of all this? Simple really. Volatility is not your friend when you are living off your assets. Even in a generally upward trending market, dramatic price swings can rapidly deplete your retirement accounts. And the solution? Diversification and other low-volatility investment strategies really do matter. If you have even a decent mix of holdings, a decline in one asset class can be offset by appreciation in another. Or you can use a low-volatility strategy like the one we specialize in at VMI. Whichever way you decide to proceed, reducing fluctuations in your retirement account assets is an important consideration, and can substantially increase the probability of meeting your financial goals.
Jim, Mark and Dave
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