Saturday, 31 May 2008

Benefits of a Diversified Portfolio in Retirement

Whew! I was pretty sure that holding a portfolio of uncorrelated assets would be just as worthwhile in retirement when withdrawals are being made as it is in the build-up phase before retirement but now I've found someone has crunched the numbers to demonstrate the fact. And the results are impressive.

Retirees are much more concerned to avoid downside risk, the risk of loss that cannot be recovered when poor returns occur, especially several years in a row of negative returns, such as happened in stock markets from 2001 to 2003. The opportunity to make up for losses by working harder or longer is not available to retirees. Capital preservation comes before everything. That fear is the reason many retirees stick to safe bonds, GICs, money-market funds. Unfortunately, such investments have low rates of return too.

In The Benefits of Low Correlation, Craig Isralesen shows that a balanced diversified portfolio is an attractive alternative. He calculates the results from the point of view of a US retiree withdrawing 5% a year (and adjusted upwards by 3% a year for inflation) from a hypothetical portfolio consisting of equal weights in seven different asset classes: large cap US equity, small cap US equity, non-US equity, intermediate term US bonds, cash (T-bills), REIT and commodities. He uses actual return data from 1970 to 2006. He works out the portfolio return and volatility but also shows - and this is the key part for a retiree - how much and how often the portfolio would go down, considering that the withdrawals were also taking place. What is particularly interesting and instructive (after all, he is a university prof) is that he starts with a portfolio of only two assets (the US equities) does all the calculations and then adds another one till the full seven are included. The progressive benefit of downside risk reduction, portfolio stability and return enhancement (or reduction, when a lower return asset like cash is added) comes out very clearly.

It is not the actual numbers he calculates that are important - a real portfolio would have transaction costs and tracking error and the future will not be exactly like the past. Plus a 4% withdrawal rate would reduce even further the risk of a reduction in the portfolio's value in any year, enhancing its sustainability. It is the effect and the magnitude of the effect of diversification through uncorrelated assets that is worth noting.

Here is part of Israelsen's conclusion:
"There are several quantifiable benefits of lowering the correlation of a retirement-withdrawal-mode portfolio's component assets. First, there is a dramatic reduction in the volatility of the portfolio's performance (i.e., lower standard deviation of return). Second, there is a significant reduction in the worst-case portfolio loss, or maximum drawdown. Third, the likelihood (or frequency) of loss is minimized. Fourth, performance does not suffer if sufficient diversification is achieved."

As a mini example of the benefits touted by this study, in my own portfolio, shown at the bottom of the blog, the huge rise in commodities and emerging markets has partially offset the fall in US and European equities, providing stability in the past year.

The lesson I draw is that a diversified portfolio is a viable alternative for a retiree, close to the safety of cash but with much higher returns. Happily, passive index mutual funds or ETFs provide a practical way of implementing such a portfolio. Finding new uncorrelated assets to put into the portfolio, such as inflation-indexed bonds (RRBs in Canada TIPS in the US), which Israelsen did not consider, will have similar benefits of further risk reduction or return enhancement, or both.

1 comment:

Four Pillars said...

Excellent post. I still need to do a bit more work on my diversification.


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