In “Four steps to financial independence” I have demonstrated why investing is a crucial part of building wealth. However, investing involves risks that can jeopardize the return on investment and even the principal of the money invested. The higher the risk, the is higher is the expected return. Smart strategies can maximize the long-term growth of the investment portfolio but also reduce the volatility of the portfolio’s value.
Investment Portfolio Theory Explained
Portfolio theory claims that by investing in multiple assets, one can lower the risk because it is less likely that all investments lose their value at the same time. For example, if you invest in multiple bonds of different governments and corporations, then the catastrophic event of one borrower defaulting on the bond, will have only impact on a portion of your invested money. This will make your loss small as compared to you have invested all your savings in a single bond. On the other side, it is more likely that one of many borrowers will default on their bond. So a small loss will be more likely.
The second part of portfolio theory says that one can define classes of investments that do typically not lose value at the same time. For example, government bonds might fall in value, because stocks pay handsome dividends and so bonds seem to be less attractive. However, when dividend-paying companies start losing money, because of an economic downturn they lower dividends, and government bonds may rise in value again. So if you have both in your portfolio, they could balance each other out and the total value of your portfolio is less volatile.
Of course, the downside of this approach is to only participate with a part of your investments in the upside of the rising dividend payments. As well as only benefiting with a part of your investment from the appreciation of government bond values due to the economic crisis.
Does volatility matter in the long run?
I argue that in the long run, the volatility of my portfolio is less important than compounded return on investment. If I let my investment compound with a higher rate of return, then I can ignore the lows in between.
For example, an investment portfolio of $10,000 invested fully in the Vanguard S&P 500 index fund in Jan 1990 is worth $94,847 in Jan 2020. The same amount invested into a bond fund appreciated $11,891 over the same 30 year period.
However, the worst annual performance of the Vanguard bond fund was -2.26% (Feb 2019). The S&P 500 fund had plummeted at the same time by -37.02%.
This means if you looked every month back for the performance over the last 12 months, you could panic in Feb 2019 over a loss of almost 40%. However, if you closed your eyes for 30 years straight, you woke up to a total increase of 848% invested in the stock index, compared to a 19% increase for the bonds.
Standard Investment Portfolio Advice
The standard advice is to choose the maximum loss you are willing to take in your investment accounts and adjust your portfolio composition accordingly. This leads to portfolios, where you are investing X % into one class with a higher return and Y % in a class with a lower return and Z% into a class with an even lower return, choosing classes that historically have not correlated in their highs and lows in valuation.
A good example is the very popular Target-date funds that make it their business to shift the allocation of stocks vs bonds to lower volatility the closer the target date comes. Funds with a target date far away, let’s say 25 years away, are investing 80% in stocks with high returns but also high volatility and 20% into bonds, to smooth out some of the volatility. Once the target date is drawing near a glide path reduces the stock/bond ratio to maybe 20% / 80% or even 10% / 90%.
Smarter Investment Portfolio Allocations
I argue that a smarter, more personalized approach can achieve your goals better and/or faster. If you are investing for the long run, a higher return on investment beats lower ROI. If you look at investment classes, their long-term ROI is vastly different. So you benefit handsomely from choosing the higher-yielding asset class over the lower one because the ROI behaves like compounding interest.
Make sure that you look at compounding rates of return because those are stating that an investment with the returns re-invested has risen over the long run with this ROI.
The smart thing to do is to think about the time horizon you do not need that money you are investing. Let us say you are 30 and want to invest your excess savings to supplement your retirement income. You plan to retire at the social security age of 67. That means you don’t plan on touching this money for another 37 years. So you should not care what the numbers say on your brokerage statement for the next 27 years. You’d be best off to invest 100% of your money in (a portfolio of) the highest yielding asset class (stocks) for the next 27 years.
Adjust asset class by the time you do not need the money
As retirement age nears, you do plan to withdraw a certain amount every year. So you want to plan some years before starting retirement to put this money into less volatile or even stable investments.
Let’s assume you plan on using 4% / yr. of the value of your portfolio as your supplemental retirement income. As a smart reader, you might realize that even 10 years before retirement you’ll not plan on using all your investments on day one of your retirement.
To preserve the principle of this 4% you can move it to cash or a money market fund or government bonds that mature in 10 years. However, you keep 96% of your investment in the higher-yielding stock portfolio. One year later you put aside another 4% of your portfolio in cash or another bond that matures in 10 years. At the time of your retirement, you’ll still have a 60% of your assets invested in the stock market and a 40% in assets with little risk to the principle.
Is this too aggressive for a retirement investment portfolio?
Most money advisors would say this is an aggressive portfolio and it is. However, I find it overly cautious to be on the safe side with your investments, when your investment horizon is still decades.
Retirement lasts a long time
If you follow this plan of putting only a 10-year withdrawal horizon into cash-like investments, then you’ll continue selling the stock at a rate you want to withdraw money for your expenses and let 10x that amount in cash-like investments.
So you have a guarantee for the next 10 years to access the amount of money you planned for. This should be enough of a cushion to weather any storm in the stock market.
You will notice that the actual portfolio ratio will swing up from 60 / 40 % because over decades the stock part will still grow larger than the withdrawal rate that is fixed from the time of withdrawal starts. This way your portfolio does keep on producing high ROIs when you don’t know how long you’ll need your money.
This will allow you to do what is only prudent, to adjust your withdrawals for inflation. Otherwise, the purchasing power of your retirement income would decrease over time.
Safe withdrawal rate
When we know how to allocate our investments in the accumulation phase and the withdrawal phase of our personal finance life cycle, then the important question is what is the safe withdrawal rate, given the savings we were able to accumulate?
The answer depends on three parameters:
- How long you want to withdraw money?
- If you want to preserve the capital?
- What returns on investment you expect in the foreseeable future?
There is a widely used rule of thumb that 4% annually of the initial wealth will be safe to withdraw for 30 years. However, this is based on a simulation study that assumed that capital can be wiped out at the end of the period. So you need to be much more cautious if you plan on longer retirement than 30 years.