As rising bull markets go on for a long time, I start getting questions from investors like “Why don’t we just invest in stocks and forget bonds and alternative investments?” Or, perhaps a reference to Warren Buffett’s advice (as a multi-billionaire who doesn’t think about the risk of high withdrawal rates) that all we need is an S&P 500 Index fund.
For some investors, stocks could possibly represent a complete portfolio, but it depends on the relationship of the size of your portfolio to the amount of income you need to take from it on an annual basis. For example, someone with $10 million to invest in a portfolio of high-quality dividend paying companies could easily generate $200,000 to $300,000 of income, and if they used a policy of never taking more than the actual income it wouldn’t matter if the value of the portfolio fell 50 percent, as it has twice in the last 17 years. Just keep spending the dividends and wait for the value of the portfolio to recover.
That same portfolio of stocks for an investor with $1 million would create $20,000 to $30,000 of income. This comparison illustrates an effect known as the law of large numbers. We all have our own definition of desired lifestyle, but it’s easy to see that the $10 million investor could have a really great retirement lifestyle with only the dividend income and their social security benefits, while the $1 million investor has a much more modest standard of living from dividend income and Social Security. When we consider that most retirees have portfolios less than $1 million, it is easy to see why they need more than just the current dividend income of 2 percent or 3 percent to maintain their lifestyle. Typically, they need to spend some of their principal value and invest in other investments that create higher levels of income.
The answer lies in what is known as “sequence of returns” risk.
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Once we start spending principal value, it is best to follow some guidelines related to safe withdrawal rates to make sure you don’t run out of money during your lifetime. Diversified portfolios that are rebalanced periodically have tended to achieve a higher probability of success over 20- to 30-year retirement periods, even though the average rate of return may be lower during that time than a portfolio of 100 percent stocks. How can a lower return portfolio possibly have a higher chance of failure?
The answer lies in what is known as “sequence of returns” risk. Let’s say you retire when times are good and the stock market has been doing well for several years. Remember the year 2000 or 2007? In this case, you likely will have high expectations for your retirement lifestyle and may set your portfolio withdrawals at say 5-7 percent of the total value annually, with most of your money invested in stocks. If in the first couple years after you retire the stock market drops 50 percent, which is extreme, but has happened twice in the last two decades, and you maintain the withdrawals, you will be taking 10-14 percent of your portfolio value each year. Chances are good your portfolio value may never recover because the withdrawals may consume all the value created during the recovery from the large decline.
A truly diversified portfolio may only decline 25 percent during a market event like described above. This is still a large decline, but means a big difference in the possibility of recovering your lost value. There are many factors and variables to consider. For those with less than several million dollars, a diversified portfolio is probably a better solution to protect against an extreme outcome.