8.2 The “old” investor Part 1 – Avoiding bad luck
Before I launch into a discussion of the “old” investor, recall that the “old” investor is not just retirees. This category includes anyone who intends to spend invested money relatively soon or regularly during the remaining investment period. Nonetheless, much of the investment research and data out there are based on retirement scenarios, and I will often use the term “retirement” as a short-hand example. With that in mind, let’s examine mindful investing for the “old” investor.
We have seen that investing in stocks is relatively safe for time periods greater than about 5 to 10 years (Article 8). So, when you are less than a decade away from starting to spend some of your invested money, it makes sense to adjust your investments. As we have seen, the timing of a market downturn makes no mathematical difference to the end result. However, this is only true if you are not withdrawing funds during the investing period. When funds are routinely withdrawn, the timing of downturns can have a big impact on the growth of your portfolio. This is sometimes called “sequence of return” risk. Here is a graph presenting an analysis like the one in Article 8, but with regular spending withdrawals added into the mix.
In this case, I’ve assumed a starting nest egg of $1,000,000 and a constant annual withdrawal rate of $40,000 per year (or 4% of the starting portfolio value). This represents one reasonable retirement scenario. All other assumptions are the same as before, including the 30 year investing period, a 50% market decline at three different times in the investing period, and a 5% constant annual growth rate of stock value. When regular withdrawals are included, we see that the timing of a large market decline can indeed cause very different outcomes. The early decline scenario runs out of money by year 26, while the late decline scenario still has about three quarters of the original investment at year 30.
“Old” investors clearly need to pay more attention to short term stock market volatility than “young” investors. As discussed in Article 6.1, this is where the difference between a “temporary loss” and a “permanent loss” becomes reality. Because “old” investors need some of the investments for spending, they enter a vulnerable period where temporary losses can materialize into permanent losses all too easily. This is the real risk we are trying to avoid, as opposed to routine market volatility. But no one can predict whether a steep market decline is likely a few years after you decide to retire. What realistic options do “old” investors have to avoid bad luck causing permanent losses?
Avoiding bad luck
Many researchers, websites, and books address minimizing permanent losses while investing near or in retirement and unfortunately, opinions vary. Most recommendations for retirement involve moving some “risky” stock investments into other assets that are less volatile, like bonds and cash. These other assets usually (but not always) decline less during stock market routs, which cushions the impact to your overall portfolio. This is the “ballast” function of bonds and cash that I discussed extensively in the Article 7 series. Of course, the price you pay for the relative safety of more ballast is lower long term returns. The question boils down to selecting the right balance of stocks and ballast during the vulnerable time just before and early in the spending phase.
Descending glide path – Probably the most commonly cited rule-of-thumb for finding the right balance of stocks and ballast is to adjust the percentage of bonds in your overall portfolio based on your age. According to this rule you should hold a percentage of stocks equal to 100 minus your age. So, if you are 60 years old, this rule says that 40% of your portfolio should be in stocks and the rest in bonds. As you get older the percentage of stocks in your portfolio would further decrease. As a result, this rule falls into one category of retirement allocation called a “descending glide path” for stocks.
Rising glide path – In contrast, Michael Kitces and Wade Pfau have recently concluded that a “rising glide path” approach, where stock exposure increases with age, may better minimize the chances of running out of money in retirement. However, an examination of their results indicates the case for a rising glide path approach is not very clear. Among other measures, they examined the “success rate” (cases where the portfolio did not run out of money) for different expected future return scenarios assuming 4% of the portfolio value (inflation adjusted) is withdrawn annually for 30 years. For two of the scenarios they evaluated, key results were:
- Expected returns Scenario A (consistent with “MoneyGuidePro” software)
- Descending glide path (Start 100% stocks, End 20% stocks): Success Rate = 64%
- All stocks (Start 100% stocks, End 100% stocks): Success Rate = 66%
- Gently rising glide path (Start 70% stocks, End 100% stocks): Success Rate = 70%
- Steeply rising glide path (Start 30% stocks, End 80% stocks): Success Rate = 74%
- Expected returns Scenario B (future returns lower than historical average)
- Descending glide path: Success Rate = 64%
- All stocks: Success Rate = 64%
- Gently rising glide path: Success Rate = 65%
- Steeply rising glide path: Success Rate = 60%
The first thing you’ll notice is that the success rates are pretty closely grouped, even though they involve pretty widely diverging strategies. From a mindful perspective, this is our first clue that the differences in glide path approach may be a less important to success than unpredictable future market conditions. That is, you could pick the glide path with the highest percentage for the future market scenario you think is most likely. But if future market conditions turn out different than the expected scenario, you could get a worse outcome than if you had picked one of the lower percentage approaches. This story should sound familiar, because we found something similar with the whole question of diversification in general in Article 7.3.
More specifically, under Scenario A assumptions, the success rate for a stock rising glide path was better. However, for Scenario B assumptions (lower future returns), simply maintaining a 100% stock allocation performed better than a strongly rising glide path and about the same as a gently rising glide path. As I detailed in Article 6.2, the most likely scenario moving forward is for historically lower returns, although there are large uncertainties. Given this outlook, the Kitces and Pfau analysis suggests that a rising glide path approach may be no better than static allocations, like simply holding 100% stocks throughout retirement.
Static allocations – The merits of a static allocation are highlighted by another study by Javier Estrada that examined 110 years of data from 19 countries. Estrada concluded that “both an all-equity [stock] portfolio and a 60/40 stock/bond allocation are simple and very effective strategies for retirees to implement.” That is, looking at factors such as success rate and ending portfolio value, he found that these static allocations performed slightly better than or similar to either the rising or descending glide path approaches. However, once again the results can easily flip-flop depending on which historical periods and countries are used in the analysis.
Other approaches – There are other variations on this theme. For example, elsewhere Michael Kitces recommends a “bond tent” approach. This entails increasing your ballast in the decade leading up to retirement and then spending down that ballast in the first half of retirement (e.g., over about the first 10 to 15 years). The idea is that you maximize ballast in the vulnerable period when dramatic stock market declines are most likely to cause permanent losses. After that, you end up focused again on mostly stocks. Kitces presents calculations that show some of the benefits of the bond tent, but again much of his analysis assumes some range of future market conditions, which we know are highly unpredictable.
Overall, we have some evidence from recent studies that increasing ballast around the time retirement starts may have the potential to minimize permanent losses and the resulting impacts to portfolio growth. But reasonable variations in unpredictable future market conditions could cause a 100% stock portfolio to do just as well or even better, particularly if substantial stock declines don’t occur in the vulnerable period just after retirement. What’s a mindful investor to do?
Going back to Article 2, a mindful investing approach is built upon rationality, empiricism, patience, and humility. The above rational review of the empirical data and studies leaves us uncertain. That means we should turn to patience and, particularly humility. Specifically, although we can take certain steps to avoid permanent losses, we should patiently accept the uncertainty involved in this decision and with humility have no expectation of picking the “right answer”. We will need to be further patient and accepting as we move through the spending phase, because it’s likely our actual results will be less than perfect when viewed in hindsight.
In Articles 5 through 7 I showed how the mindful perspective supports a stock heavy approach to investing. Accordingly, you might assume I would end up recommending a 100% stock approach for the “old” investor, because the studies reviewed above are equivocal. However, I think the math behind the early stock decline scenario is highly objective and essentially irrefutable, like all math. When you are in the spending phase, it is always true that an early draw down will do more damage to your portfolio than a late draw down of similar magnitude. This math applies to any market situation and does not depend on assumptions about unpredictable future market or economic conditions.
Further, we have seen in the Article 6 series that stocks are expensive right now and are expected to have low returns in the foreseeable future, like around 5% annual average return without inflation adjustment. We also know that the stock market hardly ever moves in a calm consistent fashion. To achieve a mere 5% annualized average return over the next 5 to 10 years, it’s likely that stocks will undergo dramatic variations possibly including a significant stock market decline or two.
Consequently, converting some stocks to ballast and holding that ballast shortly before and early in the spending phase appears to be a mindful investing approach for the “old” investor. Article 8.3 delves into the details of a mindful ballast approach