Volatility is your friend when young, but an enemy in retirement

Volatility is a word that is thrown around quite a bit on CNBC and other financial news networks, usually as a way to get people watch and drive ratings higher. However, volatility comes in a lot of forms, and can be a good or bad thing, depending on where you are in your financial life.

The basic definition of volatility is the tendency for stocks and bonds to jump up and down on a daily, weekly, monthly and yearly basis - and most people prefer the "up" version to the "down" version. Generally, stocks exhibit more volatility than long term bonds, which in turn are more volatile than short term bonds or cash - with the higher volatility assets usually (but not always) putting up higher returns over a long (10+ years) period of time. Also, a more diversified portfolio can generate a higher return for a given amount of volatility than any one asset class. This is why diversification is called "the only free lunch in finance."

Young accumulators - pray for a crash!

However, volatility can often work with you. This is especially true when you are younger and building up your portfolio - this is known as the "accumulation phase." Since younger investors generally have a stock-heavy portfolio, it bounces around quite a bit. Assuming our young professional invests an equal dollar amount every month, s/he buys more shares of stock when the market is down, and fewer shares after a strong run. Over time, this little advantage can add up. Taking the concept one step further, a 20-30 year old should be rooting strongly for a punishing bear market, so she can buy as much low-priced stock as possible. This is also known as "dollar cost averaging."

Take the following example. Jane Smith invests $10,000 per year into a 100% stock portfolio that returns 7% per year for 20 years, with 15% standard deviation of returns (which is a common measure of volatility - about 68% of returns will be between -8% to +22% in any given year, and 95% of returns between -23% and +37%. This is a pretty wide range, but that's what she wants.

Contrast Jane's strategy with her friend Joe's portfolio. Joe spent a lot of time researching investments, and built a magical portfolio that returns exactly 7.3% per year, no more, no less. It is absolutely a magical portfolio, because it is impossible to find such investments at this time. (Back when interest rates were much higher, one might have been able to invest in a 30 year zero-coupon treasury bond at a 7.3% rate and hold it to maturity, but inflation was also much higher at that time, and current 30 year bonds only yield about 3.1%.) Joe looks at that magically smooth return and figures out that a $10,000 annual investment would leave him with a $1 million portfolio after 30 years. Not bad!

Fast forward 30 years, and Jane's portfolio did pretty well, although it got off to a horrible start. However, it still fell a little bit short of Joe's, and only returned 7.1% per year on an annual basis. The following chart shows the two portfolios as they progressed.



So, one would assume that Joe is a lot happier at year 30. That assumption would be wrong. Although Joe definitely hit his goal of a $1 million retirement, Jane actually ended up with more in the bank - $260,000 more, in fact - despite having a lower overall return and a much bumpier ride. Note that her investments didn't do anything for the first 10 years - how would you have handled that?  The next chart shows their comparative wealth over time.



Why did Jane accumulate more wealth over time? By investing a constant dollar amount, she was able to accumulate more shares than Joe in the early part of her accumulation period than Joe, who bought fewer and fewer shares as his portfolio increased in value like clockwork.



Of course, this doesn't mean that Joe had a bad strategy - in fact, there are a lot of advantages to knowing exactly how much money you will earn every year. Joe could precisely plan out his future, because he knew returns were guaranteed. However, like I mentioned above, a guaranteed 7.3% per year return for 30 years is not possible in this day and age, so Jane's scenario is much more realistic. In fact, given where stock market valuations and interest rates sit at the moment, a 7.1% return (with volatility) is probably optimistic. Jane would have definitely fallen short if her ultimate return only amounted to 4%.

However, this shows why it's okay - and even preferable - to shoot for a higher risk profile when you are early in the process - and also why you should actually want lower returns early on, so you can "buy low."

Retirees - Volatility is not your friend, especially early in retirement

However, the situation is much different in retirement. In this case, volatility can be extremely corrosive to a portfolio when the retiree is selling equal dollar amounts every year to support his/her spending budget. In this case, instead of buying more shares when stocks are lower in price, and buying fewer shares when stocks are higher, the retiree is selling fewer shares when stocks are expensive, and selling more shares when stocks are cheap.

Let's revisit Joe and Jane. For simplicity's sake, we will assume that they both start out with exactly $1 million at the start of retirement (Jane paid for her three kids' college with the extra $260,000). Since they both expect another 7%+ annual returns, both Joe and Jane think that withdrawing $57,000 per year is a prudent amount, since there is a nice "safety margin" between the 7%-plus annual return and the 5.7% initial withdrawal rate. In Joe's case, he is exactly right, but, in Jane's case, she couldn't be more wrong. (And, for reasons that I will cover in a future post, an initial 5.7% withdrawal rate is too risky in almost every situation).

By some miracle of nature, history repeats itself for both Joe and Jane. Joe earns a perfectly smooth 7.3% per year return, and withdraws $57,000 per year, while Jane earns a bumpy 7.1% annual return (with the same underperformance in the first ten years) and also withdraws $57,000 per year. The following chart shows the stark contrast in performance. Even though Joe spends $57,000 annually, his estate totals over $2 million after 30 years. Jane's retirement goes much differently. She still manages her $57,000 annual spending budget, but comes very close to running out of money.



Jane "eats her seed corn" early in retirement, because her portfolio struggles and she has to "sell low" to maintain a constant spending budget. Meanwhile, Joe has to sell fewer and fewer shares as his portfolio increases like clockwork. The last chart shows both retirees' shares over time.



Although Jane's portfolio made a heroic comeback in the last 20 years of her retirement, she didn't have enough left to make up for the initial erosion of the portfolio.

This concept is known as "sequence of returns risk," and it is very important for a retiree to understand. A huge initial drop in your portfolio can do a lot of future damage, while a bull market early in retirement can put you in a very favorable position. However, you can't count on a bull market.

There are a number of ways to mitigate sequence of returns risk. Unfortunately, all of them will most likely reduce your future returns. However, as the example shows, "smooth" returns that are lower can provide an advantage to "bumpy" returns that are higher in the long run. In future posts, I will explore them in more detail. Some of them include the following:

1. Choosing a conservative spending rate for the chosen level of risk.
2. Reducing risk in the early stages of retirement (uber-planner Michael Kitces calls this method pitching a "bond tent")
3. Using some combination of bond ladders, immediate annuities, deferred annuities and social security to build a "floor" of lower-returning but guaranteed cash flows to fund essential spending, while investing more aggressively in a higher-returning but more volatile "upside" portfolio to fund discretionary spending.
4. Constantly adjusting the withdrawal rate to account for actual portfolio performance by putting in "guardrails."
5. Purchasing insurance to pay for unexpected large expenses, such as Long Term Care.
6. Some combination of #1-#5.

Although this sounds like a cliche', there is no one size fits all strategy. It depends on the available resources and goals of each retiree.