Calculating loss has two dimensions. The first is the duration of the loss, which we wrote about in my previous article. The second part is the dollar amount of the loss, which leads us to asset allocation.
Over the last century, markets have exhibited random or “normal” behavior (as it is known in Gaussian world) about 94% of the time. In the remaining 6% of cases, markets were in a fractal (abnormal, extreme, non-Gaussian) mode, with an equal split between up and down directions.
Classic strategies like asset allocation and diversification work great when markets are in random mode, but not so much in fractal mode. Then some clients will abandon their best-laid plans and withdraw from their investment. The key to success is sticking to plans even in fractal times, so that when normality returns, these strategies will once again work to the client’s advantage.
To analyze both random and fractal market behavior, we can look at the actual market history, which we call “recasting” (as opposed to “forecasting”). Aftercasting displays the performance of all historical asset values ​​of all portfolios on the same chart since 1900. It gives you a bird’s eye view of all the results for a given scenario.
It also provides success and failure statistics with historical accuracy because they take into account actual historical performance of equity, inflation and interest rates, as well as the actual historical sequence/correlation of these data sets.
The short-term impact of asset allocation
Let’s look at two hypothetical examples of accumulation.
Chase, 30, has a portfolio worth $100,000. He believes that stocks are a long-term investment. His portfolio contains 100% of stocks, half of which is in Canadian stocks (S&P/TSX) and half in American stocks (S&P 500). He plans to add $4,000 to his portfolio each year. He has never experienced an adverse market event and therefore his stated risk tolerance has never been tested.
Market history shows that, at worst, the value of Chase’s portfolio fell to $38,713 (in the starting year of 1929), as shown in Figure 1. This is after adding $16,000 to his portfolio ($4,000 per year for four years). and this represents 61% of the losses.
Figure 1: Accumulation Portfolio – Chase Summary (100% Stock)
Click here to enlarge the chart
The second hypothetical scenario involves Grace, who is also 30 years old. Like Chase, he has $100,000 in his wallet and plans to add $4,000 each year. Unlike Chase, he prefers a much more conservative asset mix of 40% equities and 60% fixed income, after his advisor conducts a rigorous risk tolerance assessment.
Figure 2 shows her aft view. At worst, her portfolio dropped to $84,159, a much smaller loss (16%) than Chase’s (61%).
Figure 2: Accumulation Portfolio – Grace Summary (40/60 Asset Mix)
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The main risk for an accumulation portfolio is the client’s willingness to continue investing in the event of unfavorable market events. Assuming other factors remain unchanged, Grace will be more likely to stick to the original plan than Chase.
The long-term impact of asset allocation
Let’s look at the impact of maintaining strength or “behavioral risk” over a 20-year period. For this purpose, we use historical median portfolio values ​​rather than worst case values.
After a year of painful losses, Chase is changing its asset mix to 40/60. Grace is also dissatisfied with her short-term profits, but tolerates volatility.
Both average portfolios are shown in Figure 3 after taking into account the initial loss.
Grace had staying power. It was able to accumulate more assets than Chase, which didn’t know its risk tolerance and had to cash out after the first year and reset its asset mix. This one mistake cost him a lot of money – approximately $104,000 after 20 years of compounding – not to mention a significant loss of accumulation time, totaling at least six years.
Figure 3: The value of knowing risk tolerance in accumulation portfolios
Click here to enlarge the chart
What if Chase hadn’t panicked and instead kept its original set of assets? His 100% stock portfolio would be worth about $260,000 at age 50, after accounting for the same initial loss, compared to about $236,000 after switching to a 40/60 mix, as shown in Figure 3.
We can now translate these findings into practical steps.
Know your risk tolerance: The most effective way for clients to increase their investing success is to understand the limits of their risk tolerance. If this is not completely clear, they should choose the side of lower risk.
Asset allocation at an early stage of accumulation: Clients may wish to maintain a conservative portfolio (40% home equity and 60% fixed income) until the annual dollar amount accumulates is less than 4% of the portfolio value. This could prevent customers from behaving like Chase and saving the day if volatility becomes too high.
Conservative portfolios also avoid the risk of clients feeling as if they are stoking losses after a downturn. This can happen during a multi-year bear market, when money flowing in merely offsets market losses – especially when the client knows the advisor is still collecting commissions.
Asset allocation at the stage of mature accumulation: When annual additions are less than 4% of the portfolio value – and if risk tolerance allows – the client can move to a 60/40 combination, which can provide sufficient growth at reasonable risk.
Asset allocation just before retirement: Ten years before retirement, clients may want to move their asset mix back to a 40/60 ratio. Why? As seen in the previous article, it can take 10 years to recover from a nasty black swan event. Reducing your risk between the ages of 60 and 65 can mitigate the damage.
Stability of retirement income: When a portfolio is switched from accumulation to decumulation, loss calculations are turned upside down. Even if withdrawals are completely sustainable (say, an initial withdrawal rate of 3%), after a seemingly small adjustment, clients may never again see the value of the portfolio’s assets before the loss.
Retirement income for essential expenses: If a client’s required withdrawal rate for basic expenses exceeds 3%, the client wants to consider a guaranteed income, such as an annuity or segregated funds with a guaranteed lifetime income. Why? Because a portfolio loss as small as 15% can significantly reduce income stability.
If the required distribution rate for essential expenses is less than 3%, the client may choose between investing in a traditional fund or a segregated fund, depending on estate planning considerations.
Retirement income from non-essential expenses where capital preservation is important: :
If portfolio withdrawals are intended solely for discretionary and non-essential expenses, but capital preservation is important, then segregated funds with a capital guarantee may be appropriate.
Stability of retirement income when income is used for non-essential expenses and capital protection is not important: If portfolio withdrawals are only for discretionary and non-essential expenses, and capital preservation is not that important, then a traditional investment portfolio may work well.
Please note that this analysis is based on the market history of the last century and assumes that the current borrowing frenzy could continue indefinitely. In the last century, fixed income was the “safer” side of the portfolio; this may turn to a more risky side in the future. We’ll see. In the meantime, enjoy this recovery.
MSc. Jim C. Otar is a retired certified financial planner and professional engineer; founded retirementoptimizer.com.
