2023-08-28 06:30:00 ET
Summary
- Investment strategy determines the size of gains and frequency of losses in a portfolio, impacting retirement income.
- Different investment approaches have varying levels of risk and potential returns.
- Withdrawal rates and minimizing losses are crucial for retirees to maintain the value of their portfolios.
As investors we can choose what rewards (gains) to seek. Any approach to rewards, though, comes with risk.
Retirees in particular should be concerned with risk. Being forced to spend down a weakened portfolio has bad effects on your future spending ability.
Even index investors are not immune from this. The S&P 500 notoriously has flat decades in between its great decades. Retiring at the start of a flat decade can really spoil your plans. It is not unlikely that we are there now.
But my focus today is not on those returns, except as context. You set expectations for gain by your portfolio strategy and on top of that your tactics may perhaps increase those gains. Examples follow.
The main focus of this article, though, will be on the impact of losses. They deserve more attention than they usually get.
Strategy, Structure, and Returns
Index investors are seeking the long-term, 8% real returns domestic stocks have produced over the last century. One downside there is that these averages reflect both great decades and decades that are flat or worse, as just mentioned.
Blue-chip value investors seek to invest in quality stocks that have dropped in price 30% to 50%, usually during bear markets. Between price appreciation and dividends, this approach can produce a CAGR near 15% over time.
Such an investor today might be holding Boston Properties ( BXP ) and Alexandria Real Estate ( ARE ), for example.
This is pretty much where I fit today, with some wrinkles. The downside structurally is that returns may end up being smaller for various reasons.
Deep-value investors look for stocks with more upside and are willing to go to firms with lower credit quality or other risks. This approach can target CAGRs near 20%.
Such an investor today might be holding SL Green ( SLG ) and NewLake Capital Partners (NLCP).
The downside here is that some of these investments will fail and produce large losses of principal. Success lies in having enough more winners than losers over time.
Growth investors seek to own rapidly growing firms. Here again some will fail but big winners can easily overcome all losses. A lot of people with a lot of Apple ( AAPL ) today got there in this way.
Speculators seek very high upside and will suffer total losses more often.
Finally, High-Yield Investors place their funds in high-yield vehicles. These nearly always involve leverage (either directly or indirectly) and financial engineering or other serious risks.
Times have been good for such investments, but color me skeptical on level of risk. I may have more to say on this topic another time.
My own view is that only the first two categories are sensible places for a retiree to be with any funds that may need to provide dividends or be spent. The other categories can suffer from pretty severe sequence of returns risks or other risks and in my view are only suitable for “excess funds”.
I expect that most investors are not purely in any one of these categories and neither am I. But many investors will be mainly in one category.
The Terror of Tactics
Choice of strategy places a frame around your possible outcomes. But it is the tactics involved in specific investment choices where investors really lose money.
If you are prone to panic selling, then you should not be reading investing articles or investing in stocks at all. Look at simple annuities with no ongoing commissions.
But even investors not prone to panic selling can make bad choices. I cringe every time I see an investor in a chat room considering whether to sell a position just because it is down.
A momentum investor may do that, to cut his losses. But save perhaps for a few outliers with special skills, investors do not win trying to psych out the market. A value investor should never sell something just because it is down.
Still, though, investments do implode. Investment theses do break.
This may not seem like a big deal. Taking a substantial principal loss on 1 investment in 25 once every year or two (a strategic loss) may not seem like much at the time, but we will see the effect.
Similarly, taking annual losses that average a percentage or two of the total portfolio seems pretty small. But the losses add up.
We will quantify the effects of these losses for retirees below. They are not negligible.
A Simple Model
To capture the main features here we can use a simple model of one decade. We could pursue this topic with a much more complicated statistical model, which is what I started to do. Alas, this would be much more fun for me than for you, so not today.
The model parameters are CAGR of the portfolio, rate of episodic (strategic) annual losses , initial rate of withdrawal, inflation rate increasing the withdrawn amount, and steady rate of minor (tactical) losses.
The approach here is that the investor chooses target returns by their strategic choices. But some of the investments fall far short of those targets.
One could do the model in terms of an achieved return. But that is not how we think about it as investors, or at least not how I think about it.
We have targeted returns and some of them don’t work out. The model implements this approach.
The CAGR will be produced by the investor’s strategy, as described above. Of course the gains will not be steady in practice, but here we will treat them that way.
The episodic annual losses will tend to come in clusters during the bad periods that happen about once a decade. Here, to be conservative, we will assign them all at the start of the decade, based on a compounding of the yearly failure rate.
That gives us this relation between how much we discount the initial investment and the annual rate of failures:
One gets a 25% impact for a 3% failure rate. This would be 1 failure every 16 months in a 25-position portfolio. In real time it would not seem like a lot.
Outcomes Without Withdrawals
To get used to the format that will present the results, we look first at gains for the unreal case of no inflation and no withdrawals. We show the net gain over the 10 years by colors and contours.
The investment CAGR is on the abscissa (as it will always be). The failure rate per year is on the ordinate for now.
You see that a strategy that would produce a CAGR of 20% with no failures gets you a 6x multiple over a decade. But that drops to 5x for a failure rate of only 2%.
Also, there will be inflation and it will reduce real returns. Inflation may well be episodic but here we will treat is as steady and having a 4% rate. This to my mind is on the high side of likely long term but perhaps not for the next decade or two. Looking at real portfolio value for 4% inflation and no withdrawals, here is what we have.
Now that 6x multiple for no failures at a CAGR of 20% becomes 4x. And if getting that 20% costs you a 4% annual failure rate, then the outcome drops below 3x.
Now 3x is decent and why the high-risk, high-reward approach can work well for pre-retirees with long timescales. Even the 2x one might get at a CAGR of 15% and a 3% annual failure rate is not bad. For comparison, the index investor with an 8% return amidst 4% inflation only sees the real value of their portfolio increase by 1.5x in ten years.
Outcomes With Withdrawals
The retirees of interest need to withdraw from their portfolios at some rate to support spending. Winning that game is seeing the real value of the portfolio increase in spite of the withdrawals.
To model this, we take the initial withdrawal rate to be some fraction of the initial portfolio value. We then boost the amount withdrawn with inflation each year.
Now we do plots for selected annual failure rates, starting with 4% per year.
The initial withdrawal rate is now on the ordinate. The colors and contours show the real value of the portfolio after ten years, relative to its starting value. The heavy dashed line shows where there is no net change in real portfolio value.
Here we can see one of the outcomes that matter. If your withdrawal rate is a relatively conservative 4%, you still need more than a 13% CAGR from your investments to overcome a 4% failure rate.
My Rates for Withdrawal and Failure
I got full control of my retirement savings and started investing nearly full time at the beginning of 2020. Absent some part-time work, my need to support spending would have been a 9% initial withdrawal rate.
My failure rate in 2019 and 2020 was near a total of 11%. On the one hand, had that pace continued, my portfolio would have been likely to lose real value by 2030. On the other hand, were I to avoid further failures through 2029, the effective annual rate, from the first plot above, would be about 1% per year.
The portfolio was still on track to last 20 years or so, which is my minimum need. But it was not winning the game or adding to funds for a legacy.
Those failures were in mall common or preferred stock positions I would not invest in today, and also in the maritime shipping sector, which I concluded was a bad fit for me. My view is that they were learning experiences not to be repeated.
Then in the heady days of 2021, I followed a friend who had had a hot hand into two investments, without my own due diligence. That was really dumb; you should be shaking your head. Anyway, in combination that was only a 2% hit but they are two of my three biggest percentage losers.
Since then my focus has increasingly turned toward lowering risk. My goal now and going forward is to have a failure rate near 1% per year.
This is about the same as the default rate of a BB+ bond. It would imply 2 to 3 failures per decade for nominal position sizes of 4%. Seeking to achieve this leaves me out of some opportunistic possibilities, such as SL Green ( SLG ).
Having this failure rate, with no other losses, would produce this outcome:
Achieving this would represent quite good success. Meeting my earlier goal of a 9% initial withdrawal rate might be achievable without loss of real value.
On top of that, success with investing since early 2020, among other things discussed below, has pushed down that 9% to about 6.5%. Supporting that with no loss of real portfolio value would require a CAGR below 13%.
But the full story is not quite that good for me. Over the past two years I have averaged 1.4% per year of tactical losses.
These were from broken theses. But one of them broke as a result of the adjustments when my portfolio goals evolved.
Right now it feels as though there will be no more changes. But will those feelings prove out?
History says probably not. But it is also clear that I should keep a focus on such losses and limit them.
So here is the result for 1% per year total strategic loss of principal on average combined with 1.4% per year of tactical losses. You can see here that this reduces the gains relative to the previous case that had no tactical losses.
The plot implies that to support my 6.5% initial withdrawal rate without loss of principal, my investments that do not take losses must deliver a CAGR of 14%. Considering my strategy, this is in the ballpark of plausible.
Pushing Down the Initial Rate
Evidently, your portfolio will do better if you can push down the initial withdrawal rate, reduce your losses, or increase you returns (without adding losses).
My initial rate has gone down nearly 30% since 2020, as was mentioned above. Three things made that happen.
For one, 2021 was a great year for me, with a 50% gain. That was a consequence of effective investing during the pandemic.
The second contributor was deciding to start Social Security early. I did this as soon as I realized that all the standard calculations do not discount the cash flows.
The third contributor was bringing in other income via part-time work. As a result, my start date for substantial withdrawals has kept receding.
This is the usual story you find in many articles on retirement. Delaying the time when full withdrawals start has a remarkable impact.
At the moment, I’ve done well across this bear market. My portfolio recently set new all-time highs until early August, and remains above its pre-2023 high.
What’s more, I see a lot of the positions I hold as undervalued. If that proves out, my initial withdrawal rate will drop further over the next year or two.
Questions for You
The question for you and your portfolio is whether your risks are aligned with your circumstances and goals.
The higher your need to tap your portfolio, the lower the losses you can afford. Your strategy needs to be consistent from this perspective. If you need a 14% CAGR and are invested in index funds, you will fall far short in about half of likely decades.
Equally important, your tactics need to limit trading losses. This includes those associated with changes in plan.
My suggestion for everyone is to do a year-end review of your investment. For me that usually goes in an article.
But what really matters is to spend some time analyzing the failures and losses one had. Ask whether they are strategic or tactical.
Ask whether they reflect patterns of behavior on your part that should be changed. Ask whether you really have the temperament for this investing game, with its guaranteed volatility and disappointments.
Seek to up your game every year.
For further details see:
Risk And Reward For Retirees