Returns and Sequence of Returns

I recently watched a video made by an Italian content creator on Safe Withdrawal Rates and Sequence of Return Risk (even if I do not think he formally mentioned the two definitions ever). The video is done well and, as a bonus, the author shares his Python code so that anyone can play with Monte Carlo simulations and stock indexes, withdrawal amounts and even a cash buffer.

For his simulation he uses a portfolio that is 100% invested in the S&P500, mainly because historical Total Return data are easy to get. During the video (or maybe in the comments, I do not remember) someone asked him if he could try with different portfolios and his reply, data availability aside, was that anything different from 100% (US) stocks will only lead to worse results.

Is it?

I remember I read on Kitces.com that even with a simple mix of just stocks and bonds, the optimal mix wasn’t 100% stocks. Unfortunately, I couldn’t find that piece in the time slot I allocated (15 seconds) but I found the following table from EarlyRetirementNow, an equally valid source:

As you can see, the classic 4% WR has a higher success rate for the 75/25 portfolio, if we consider the other classic, the 30-year retirement period. 80/20 or 60/40 were working even better, but I would not trust my memory these days. Admittedly, this looks like cherry-picking: for longer periods, and the video looks up to a 50-year horizon, the 100% stocks portfolio indeed beats any combination with bonds (unless you want 100% certainty, in that case the 75/25 is still better).

But as an avid reader of PortfolioCharts, I know there are better and more resilient portfolio alternatives. During the video, the author highlights the specific path to ruin: a big and prolonged drawdown at the beginning of “retirement”. It is a bit surprising that, armed with this knowledge, he did not concede that a portfolio with shallower and shorter drawdowns, even with lower average returns, could perform better.

I contacted my YouTube-partner-in-crime Giovanni and proposed to him to do…not a reaction (jeez I hate that term, I am a booooooooomer) but a construction, a video that builds on top of another video (for sure, other creators already came up with a better definition for this type of content but I bet you are not here for marketing insights).

So I created a very quick deck with images stolen from PortfolioChats. Then I realised that maybe, you too might be interested in this topic (I also have 0 material for the blog this week…). If you do, please go on PortfolioCharts and donate some $$$ to that magical guy; his website is even translated into Italian, so you do not even have to bother to ask Google as you do for my blog (I see you ;)).

A few, last considerations about the video:

• I understand why he added the option of using Italian inflation: that’s his audience. But the dynamics in Italy before the introduction of the EUR were very different compared to today. Also, as you saw last year, stock market returns and inflation are correlated; picking random and disjointed figures for the two I do not think is correct. This is relevant because we are looking at the worst scenarios to establish the Safe Withdrawal Rate, not the average.
• Taxation in Italy is bonkers. I never thought about the effect of capital gain taxes on SWRs because in the UK I had the ISA and in Switzerland there is no capital gain tax (in both places, private pension schemes are taxed as income and in both places income tax is lower than CG tax in Italy, if we are not considering a very fat FIRE). The video’s very depressing conclusion, a 2.15% SWR, is a consequence of the tax penalty. Neither I nor the video’s author are here to give tax advice but there are ways to limit the damage, like tax loss harvesting…or, going to live 183 days a year in a place where the tax man is less greedy.

Average Returns

PortfolioCharts provides useful and visually appealing metrics for the best and most famous portfolios. Here are the inflation-adjusted average returns:

The all-stocks portfolio is the undisputed number one. But what is the average annual return? It is simply the arithmetic mean of all yearly returns in the analysed period. Did any investor actually experience that return? Not really…

Average returns are widely used because they are really easy to calculate. But investment returns, in real life, are affected by compounding. We want compounding! Money earning “an average rate of return of 10%” might actually grow only by 7% per year. Or, to spin it in a more positive way, if you earn 7% per year, every year for ten years, you are going to double your capital; you do not need a 10%/year return (100% divided by 10) because of…compounding!

CAGR, or the compounded annual growth rate, is a better way to measure returns and its formula is:

1. Your Compound Annual Growth Rate won’t match your average annual rate of return. (The exception is when your investment earns the exact same interest rate each year, then the CAGR will be the same as the average annual return.)
2. Your CAGR reflects your actual rate of return, which is typically less than your average rate of return, regardless of whether your account starts out with a winning or a losing year.
3. The more volatile the market or the investment, the greater the difference between your Compound Annual Growth Rate and the average rate of return.

This is the formula that links CAGR (=Geometric Mean) and Average Return (=Arithmetic Mean):

The two factors that contribute to volatility, and therefore to the difference between CAGR and Average Return, are negative returns and the distribution of the returns. It’s math 101: whenever you lose money, it takes a greater return to just break even. If you lose 20%, you must earn 25% to get back to where you began. The more you lose, the worse the situation gets. Lose 50% and you must double your money (grow by 100%) to get back to even. If you lose 50% and earn back 100%, your average is 25% but the CARG is 0. As the distribution of returns widens, the compounded returns shrink.

PortfolioCharts has another nice graph to show the effect of volatility on the difference between Average Return (AVG in real terms) and CAGR. Here are the historical data for portfolios that can invest in stocks and bonds (from 100% bonds to 100% stocks):

Baseline Return

To take into consideration the impact of volatility on the returns effectively experienced by investors, PortfolioChats introduces the concept of Baseline Return.

The technical definition of the baseline return is that it’s the 15th percentile inflation-adjusted compound annual growth rate (CAGR) for a given investing duration looking at every start date we have access to.  Practically speaking, the baseline return is just a reasonably conservative real-world annual return that accounts for inflation, uncertainty, and compound returns while excluding the worst outliers. 

Using the baseline return will set you up for far more realistic investing expectations and allow you to build a reliable savings plan to meet your important financial goals no matter what the future holds.

This is important because the stocks’ average return you read everywhere is calculated over a very long period and returns tend (past performance is not bla bla bla) to consistently converge to the mean only after a holding period equal to 30 years. Can you sit tight while underperforming your expectations for that long?

So how much of a difference does it make to use the baseline return over the average return when selecting a portfolio?  You might normally expect high average returns to correlate to high baseline returns, but not all portfolios are created equal and variations in the underlying uncertainty of each asset allocation can really affect the numbers.

Here is the ranking:

Whoopsie Daisy.

Look, I am not denying the fact that investing in stocks is the best way to grow your wealth. It is still very very very true. But that’s the accumulation phase. Here we are focusing on the decumulation phase, using a financial portfolio to fund your expenses and die with, at least, a little bit more than zero.

The average scenario for a retiree holding the Total Stock Portfolio is to stop working being worth a million and die with three or four. Yes, including the inflation-adjusted 4% yearly outflow. If you live the average path, your kids and grandkids will build you a statue (ok, probably they will still be pissed at you because you were a cheap bastard before departing but they will be mad while partying hard). Go check it, I am not trying to sell you a course at the end of this post.

But if you are reading this post instead of engaging in something funnier means you are an unlucky mf like yours truly. We have to plan for the worst because our fan is broken given the amount of shit that already went through it.

Sequence of Returns

The best way to ruin your retirement is to stop working just before a nasty, long bear market. The best way to increase your chances to incinerate your savings is to go all-in on something that did this in the past:

Now compare that with PortfolioCharts favourite portfolio, the Golden Burrefly:

Which portfolio do you think has the best survival chances, and therefore offers you the highest Safe Withdrawal Rate?

A necessary disclaimer about the Golden Butterfly. Given that it suffered its worst drawdown yesterday and it was double the previous drawdown, it might well be that it was just a nice backtest:

This fact does not invalidate the overall thesis. Here you can see that every portfolio did better than the Total Stocks in terms of Safe Withdrawal Rates:

“Hey TheItalianLeatherSofa, this ranking is based on a 30-year timeframe!“

Good spot, Champ. Here is the ranking based on the Perpetual Withdrawal Rate, the rate at which money can be withdrawn without ever depleting the inflation-adjusted principal balance of the portfolio:

Source: ValueStockGeek

Yes, this means that if you retire with X, you will leave those ungrateful heirs X adjusted for inflation [Disclaimer: also the “My Portfolio” in the above picture, which is the Weird Portfolio on PC, suffered its worst drawdown yesterday]. The Total Stock portfolio still sucks, you can safely spend more with basically any other portfolio configuration.

The Good News

If you retire and the market does not drop the next day (= years), you can profit “glidepathing” your portfolio into more stocks. Meaning you can start selling assets other than stocks and either spend more, either plan to leave even more to your kids. This works better for traditional retirement, if you are FIREing you can invest the excess in an annuity (for example). Or send me a thank you card.

The guy behind PortfolioCharts is of the idea of investing in the Golden Butterfly (or your portfolio of choice) even before retiring. Behaviourally it would be easier to stick to the same strategy throughout the investor’s life instead of switching from the all-stock portfolio (or any high-return generating strategy) to the Golden Butterfly.

If you are not new to this blog, you already know how to compensate for the lack of returns of the Golden Butterfly&friends: leverage. Which means use leverage JUST in the accumulation phase and UP TO a risk level your are comfortable with. There is no point of dealing with a less volatile strategy if you then make it more volatile than stocks.

If you are not new to this blog, you already know the biggest portfolio ingredient PortfolioCharts is missing: Trend Following (and/or CTA and/or Managed Futures). There is a valid reason why it is not there: the strategy has no beta. It is hard to model without referencing to a particular manager or group of managers.

If you look at research, and find a suitable way to implement the strategy, TF should further de-risk a stock-bond ensemble without penalising too much prospected returns. Things can go wrong in many ways and I cannot assure I would be able to maintain a portfolio with a TF sleeve that is underperforming for a decade while depending on that portfolio to provide for my family. I am putting my money where my mouth is but to be clear, I am not 100% in it (as I do not think anyone is): I have a rental apartment that is cashflow positive and my private pension savings cannot invest in TF strategies. I have “an hedge on my hedge” 😉

Bonus Point

In simplified terms, when Swiss taxpayers retire, they can decide to receive the amount saved in their employer pension fund as a lump sum or as an annuity. The annuity amount is calculated as the Total Saved Amount * conversion rate. This conversion rate varies from provider to provider but is generally around 5% and is stated in each monthly report, it is very transparent.

In a world where many experts declared the Safe Withdrawal Rate dead, you would expect people in Switzerland to be very happy about their circumstances: 5% guaranteed, no longevity risk and no portfolio design shenanigans? Sign me in!

The conversations I have with colleagues and friends, who bless them do not even know the existence of the acronym SWR, are mucho different. The fact that the conversion rate was above 7% in the 90s and is steadily declining does not frame the conversation in a positive way. To the “untrained eye”, 5% is nothing to rejoice about, especially for workers that do not have a saving pot in the millions. Funny enough, many told me that they would for sure take the lump sum option because “what can I do with just that 5%“, basically implying they would be able to generate a higher withdrawal rate (or plan to die sooner?!?) on their own.

To the “trained eye”, the Swiss system ain’t perfect either because private pension funds, on the hook for that conversion rate, tend to manage their portfolio quite conservatively. Meaning that in the accumulation phase, workers generate sub-par returns compared to the option of having a 100% stock portfolio. What is the optimal choice? Push hard on the employer plan to save taxes today and exploit the annuity option or minimise contributions, pay more taxes today but generate higher returns and have a portfolio that should generate a 0% income tax in the future (remember, no capital gain tax)? What about the wealth tax impact? What about the fact that each worker has to contribute to their employer fund, so there are idiosyncratic elements that make the search for a universal optimal solution futile?

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