Retirees should focus on whether or not the stock market and their portfolio is likely to deliver needed returns over a specific time period, which happens to be the first 10 years of their retirement.
The table below is a simple illustration of a 30-year retirement scenario where the portfolio is valued at $1 million during the first year of retirement is there is a payment of $50,000 (5% of $1 million). Portfolio is growing at 10.43% each year and the payment to maintain lifestyle with inflation which is assumed to be 5.38%. Therefore, the absolute return is 5.05%.
There seems to be little risk that the retiree would run out of money with the withdrawal growing with inflation. Retirement withdrawal during year 1 of $52,690 grows to $240,833 during year 30 with the initial $1 million portfolio growing to $4,183,628.
But what if the scenario is different? The table below shows that the portfolio still earns the same average annual return of 10.43% over 30-year period like the above example. Inflation is following the actual yearly change in CPI for the 30-year period starting from 1966.
Even though this portfolio has the same average portfolio return and inflation rate for the period as the first table, the results are startling with the value of portfolio decreasing in value after year 15 of retirement. By year 20, portfolio value fell to $632,508. What do you think the 60 year old retiree who is now 80 years old be thinking when their projected value in year 21 was supposed to be $2.79 million dollars but is actually $589,000?
This is a very good example of how one calendar year where portfolio delivered a negative return can blow up in year 25 of the retirement plan. It is the order of the return, not the magnitude of the return that matters. Because the retiree experienced less than expected returns in the early years of his retirement, the retirement plan was doomed to fail even though the returns for the last 20 years of retirement was outstanding. You may never be able to retire by using buy-and hold-investment strategies in bear market.
However, the biggest risk an investor can make is to not own stocks, because stock market offer investors the highest real, or inflation adjusted, rates of return over long periods of time, typically over 10 to 20 year time periods.
Investors will feel they are a genius in a bull market where asset values are rising during these highly profitable periods. Investors should avoid buying overvalued assets. Overvalued assets will not deliver average annual returns to investors in a time horizon that is short enough to help them achieve their financial goals.
There are two unbreakable rules of managing risk, diversify and don’t buy overvalued assets.
These two rules are simple, but investors don’t find it easy to follow and using them to construct their portfolios. The problem with diversification is correlation. A well-diversified portfolio has assets that have a low correlation to one another so they don’t move during the same time in one direction.
The problem with valuation is that market valuation is a poor market-timing device. Markets tend to “overshoot” their fair values both to the downside and upside, making valuation a difficult tool for investing for any time frame other than the intermediate term which is 7 to 10 years.
Be a tactical investor rather than a strategic investor. Tactical investors believe in both diversification as well as fundamental assessments of market values as the best means to manage risks.
No comments:
Post a Comment