“I am a firm believer in the people. If given the truth, they can be depended upon to meet any national crisis. The great point is to bring them the real facts.”
-Abraham Lincoln
There are many ways to invest, which leads to many ways to do things sub-optimally. Unfortunately, the wide-ranging studies conducted on investor behavior and performance indicate that doing things incorrectly is the norm, not the exception. The good news is, the truth is out there, and if you are willing to grab it, it will lead you down the right path.
Let’s begin this quest for truth by examining investing during our retirement years, and let’s use an investor that is currently 61, Mickey, as our case study. Mickey is retiring at the end of 2016 and has amassed $3 million dollars. Starting in 2017, he will spend $120k a year until age 95, adjusted 3% per year for inflation. Mickey will have four different portfolios to choose from, and each one will be analyzed using Riskalyze, which is a tool that takes into account the expected return and standard deviation of the overall portfolio, then tests it for the future based on 1000 different trials. This sort of test allows us to see what range of outcomes we could expect to experience in the future. (These tools are very helpful, but they certainly aren’t perfect. However, they will allow us to use statistics to examine the portfolios, which will give us a solid basis for comparing them.)
Option 1- A “conservative risk” allocation. This is portfolio is made up of 20% stocks, and 80% bonds. After running the test, on a scale of 1-100, the portfolio is assigned a “low-risk” number of 35.
Mickey has just a 12% chance of still having money at age 95, with the first possible chance to run out of money in 2040, when Mickey is 85 years old. In order for this allocation to be feasible, Mickey would need at least $4,122,400 at the start of 2017. Given this result, the low-risk portfolio (mathematically speaking) will not be sufficient to provide for Mickey’s needs. (The Chart shows the average expected return, or mean, as the bold line. The shaded area around the bold line, is the range of possible outcomes, using the 1,000 different trials)
Option 2 – A “moderate risk” allocation. After seeing the results for option 1, Mickey decides to increase the risk by testing a portfolio that is made up of 60% stocks, and 40% bonds. (Many target date funds within 401ks will use an allocation similar to this.) After running the test, on a scale of 1-100, the portfolio is assigned a “moderate risk” number of 56.
Mickey has an 84% chance of still having money at age 95, with the first possible chance to run out of money in 2042, when Mickey is 87 years old. Mickey would need at least $3,542,300 at the start of 2017 to improve his results. This allocation is certainly much better than using a portfolio comprised of mostly bonds, but is it optimal?
Option 3- A “risky portfolio”. After seeing the much-improved results from option 2, Mickey decides to increase the risk even more by using a portfolio with 100% small cap stocks. After running the test, on a scale of 1-100, the portfolio is assigned a “high-risk” number of 90.
Mickey has an 89% chance of still having money at age 95, but the first possible chance to run out of money is in 2030 when Mickey is just 75 years old. Mickey would need at least $4,207,500 at the start of 2017 to improve his results. This allocation ups our percentage chance of success, but our worst case scenario is the worst yet.
Option 4- Lastly, Mickey decides to put Modern Portfolio Theory to the test, by building a portfolio that combines multiple asset classes with different correlations (Stocks, bonds, Natural Resources, Real Estate, Managed futures) and a fundamental valuation methodology. The portfolio is assigned a “moderate risk” score of 56, which is exactly the same as Option 2.
However, the results are quite different. Mickey has a 93% that he won’t outlive his money by age 95, with the first possible to chance to run out of money in 2047, when Mickey is 92. Mickey would need just $3,078,300 at the start of 2017 to maximize his results. It’s clear that this allocation has tested out as the best in all categories. It has less risk than the more “aggressive options”, yet it performs better. In fact, it performs better in all categories. (Best chance of success and of having money left over, least amount of starting funds required best worst case scenario, and best risk-reward characteristics.)
After running the tests, Mickey can now see that his investment strategy will make a significant impact on his retirement years. In order to simplify our comparison, we can put them in all in one table.
Option 1, which is the “low risk” option, is actually the worst option of the four and the most risky with regards to running out of money. (This is a perfect example of why risk shouldn’t be defined simply as “risk tolerance”, and it’s why it has been listed in quotes during this article.) Option 2, which represents many US Investors, will most likely get the job done, but it certainly isn’t the best strategy. Option 3, an all-stock portfolio, gives a high chance of still having money, but it has a really bad worst case scenario, a classic high-risk high reward situation. Option 4, using modern portfolio theory, allows Mickey to reduce his risk and increase his return, giving him the best results on all our testing points. Investors like Mickey, that are approaching retirement, regardless of their age, would be wise to use math, and not myth, in order to support their investment strategy. (Unless getting the optimal result is not important to them!)
*As always, all data is used for illustrative purposes. Actual investment results will vary.
