By: Frank Armstrong
*As seen on Forbes
Portfolio failure, meaning you run out of money during retirement, is directly related to volatility. As volatility goes up, the expected failure rate of a portfolio taxed with making withdrawals rises almost exponentially. Unfortunately most retirees don’t appreciate the link between portfolio volatility and running out of money while still alive, and many don’t even have a good idea of their portfolio’s volatility.
Even if a portfolio’s expected average rate of return is comfortably above the withdrawal rate a few random bad years might wipe it out if the volatility is high.
Almost all advisors define portfolio risk or volatility as Standard Deviation. Without getting into the math, you can think of Standard Deviation as a relative risk rating: Low Standard Deviation = low volatility = low risk.
In the absence of a perfect crystal ball we must guesstimate both future portfolio risk and returns based on past performance. Then using those guesstimates we can forecast the probability of potential failure rates using a simple spreadsheet simulation tool called Monte Carlo analysis.
Monte Carlo analysis is a neat tool to help us evaluate the probable outcomes of various possible strategies. Like any other computer tool, it’s subject to the garbage in garbage out rule. We just ask a computer to construct a random pool of numbers approximating a given rate of return and a given standard deviation. Then we ask the computer to draw numbers from that pool randomly to simulate a single future theoretical return sequence. Then we ask it to do it again 1000 or 10,000 times to see what the distribution of failure rates might look like. Even primitive laptops can do this in the blink of an eye.
For instance, purely as a thought experiment, we run the tests using a pool of numbers with an average 10% rate of return but a standard deviation of 10%, 15%, and 20%. We will illustrate a withdrawal rate of 6% per year.
If there were no volatility this story would always have a happy ending. You could take out more than most financial advisors deem prudent and every year your account would grow by 4%. You would never face the prospect of depleting the account or running out of money. Your heirs would receive a windfall.
Alas, there are no risk free 10% returns. Zero risk assets yield about zero real return. In order to get anything over a zero return you must accept some level of risk. But, any volatility in the portfolio during withdrawals introduces the possibility of portfolio failure. So, you must minimize the risk in the portfolio to its lowest possible level to achieve an acceptable return.
After 30 years of simulation at various risk levels, only 1% of trials fail at 10% Standard Deviation, but 23% fail at a Standard Deviation of 20%. Failure rates soar with the higher volatility!
The simulation reveals a clear link between volatility and survival of the portfolio at any given time horizon. So that anything we can do to reduce portfolio volatility (given the same rate of return and withdrawal rates) will significantly enhance the chance that a retiree’s nest egg will survive.
All ten percent returns are not equal. It’s pretty easy to construct portfolios with a guesstimated 10% average return. We could imagine millions of possible combinations that would do that. But, many of them might have risk far higher than 20% Standard Deviation. On the other hand, I’m not very optimistic that any 10% return portfolios might have a Standard Deviation at 10% or lower. But, at least for planning purposes we can get pretty close in a properly diversified global portfolio.
The take away from our little thought experiment is that the higher the risk, the higher the probability of portfolio failure during a withdrawal period. So, investors facing a lifetime of withdrawals must do everything possible to moderate their portfolio risk to generate a secure and prosperous retirement.
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