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The Relationship Between Guaranteed Income and Safe Withdrawal Rates

Spending from your portfolio in retirement is always a balancing act between two competing goals:

  1. Minimize the likelihood of depleting your portfolio during your lifetime (i.e., don’t overspend), and
  2. Have as high a standard of living as possible (i.e., don’t underspend and end up with a giant pile of unspent money when you die).

In a recent paper David Blanchett of Morningstar looked at how that balancing act is affected by the portion of your spending that comes from guaranteed sources (e.g., Social Security, pension, lifetime annuities) as opposed to from a portfolio of stocks/bonds with unpredictable returns.

If your spending is primarily portfolio-funded (rather than coming from guaranteed sources), you cannot afford to take significant risk of depleting the portfolio. That is, Goal #1 (don’t overspend and deplete your portfolio) is so much more important than Goal #2 (don’t underspend) that you can’t really afford to think about Goal #2 very much. Conversely, if your overall spending is funded primarily by guaranteed sources, then Goal #1 becomes less important relative to Goal #2 and the “just right” rate of spending from your portfolio is going to be higher.

A lot higher, as it turns out. Here’s one of Blanchett’s findings:

“Results from this analysis suggest that optimal initial safe withdrawal rates varied significantly when guaranteed income was considered, from approximately 6 percent when 95 percent of wealth was in guaranteed income, versus approximately 2 percent when only 5 percent of wealth was in guaranteed income.”

In other words, holding all of the other variables constant, it’s reasonable for a person with a very high level of guaranteed income to spend from their portfolio at roughly three-times the rate of a person with a very low level of guaranteed income.

An important takeaway here is that if you are basing your own spending rate upon one or more specific pieces of “safe withdrawal rate” research, you should check that their assumptions are a good fit for your own personal circumstances. Does the research demand a higher (or lower) level of safety than you require given your own circumstances?

Another important point is that this factor (i.e., the percentage of your spending that comes from guaranteed income sources rather than from a stock/bond portfolio) is under your control to a significant extent. If you want to increase your level of safe income, you can delay Social Security and/or purchase a lifetime annuity with part of your portfolio. These are not things that everybody should do. But they do meaningfully increase the amount you can safely spend per year, because:

  1. The payout on the part of the portfolio that gets annuitized (or the part that gets spent down to delay Social Security) is higher than the safe withdrawal rate from a stock/bond portfolio, and
  2. As Blanchett discusses in the paper, your safe withdrawal rate from the rest of the portfolio can now be higher because it’s less problematic if the portfolio is ultimately depleted.

To be clear though, while this one factor does have a big impact, it’s not the only thing influencing the appropriate spending rate from a portfolio. The appropriate spending rate also varies significantly depending on:

  • The expected returns from stocks and bonds,
  • Your life expectancy (an 85-year-old can safely spend a higher percentage of their portfolio per year than a 65-year-old),
  • Your flexibility to adjust spending, and
  • The strength of your “bequest motive” (i.e., your desire to leave behind a lump-sum for your heirs).

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Investing Blog Roundup: The Future of Financial Advice

Over the last few decades, people have come to realize two things about mutual funds:

  1. Costs matter, and
  2. Most people don’t need anything fancy. (So paying a low cost for a cookie-cutter solution is usually just fine.)

This week John Rekenthaler of Morningstar predicts that, eventually, people will come to realize the same two things about financial advice.

Other Money-Related Articles

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“Total Market” Investing and Multi-Factor Models

A reader writes in, asking:

“I would like to ask you about factor investing. For background, I am a plain vanilla investor. I use the Vanguard Market-cap weighted Total World Stock fund. As simple as it gets!

However I have been reading literature about the case for factor investing. There seems to be a broad consensus that multi-factor models explain returns much better than the CAPM. [Mike’s note: the Capital Asset Pricing Model is an older model in finance that states that a portfolio’s expected return is a function of how sensitive the portfolio is to market risk. More recently, various multi-factor models have said that a portfolio’s expected return also depends on other things, such as how much of the portfolio is allocated to small-cap stocks (as opposed to large-cap stocks) or to value stocks (as opposed to growth stocks).]

I have heard many recommending tilting to small and value stocks.

Do I need to be concerned about my plain vanilla strategy? Am I potentially missing out on much superior returns over the long run?”

It’s true that there is, roughly, a consensus that multi-factor models explain returns better than CAPM. That isn’t an argument for or against a “total market” portfolio though.

To back up a step, a one-factor model such as CAPM tells us that stocks are riskier than bonds and should therefore usually have higher returns. But that’s not an argument for an all-stock portfolio (or any other particular stock/bond allocation). It all depends on your own personal balance of desire for return and willingness to take stock market risk.

Similarly, in multi-factor models, value stocks and small-cap stocks are generally considered to have higher risk and higher expected return than their counterparts. But that’s not an argument for any particular value/growth allocation or small/mid/large allocation. Again it all depends on your personal balance of desire for return and willingness to take risk.

In my experience, it’s usually the salespeople (e.g., certain advisors or purveyors of mutual funds) who argue that a given allocation is better, while the academics are much more neutral on the matter. For instance, Eugene Fama (one of the two people originally behind multi-factor research) was super clear in a video interview on Dimensional Fund Advisors’ website. The video disappeared when they restructured their site a few years back, but here’s the relevant quote:

Interviewer: Some people cite your research showing that value and small firms have higher average returns over time and they assume that you would recommend most investors have a big helping of small and value stocks in their portfolios. Is that a fair representation of your views?

Fama: Um, no. (Laughs) Basically this is a risk story the way we tell it, so there is no optimal portfolio. The way I like to talk about it when I give presentations for DFA or other people is, in every asset pricing model, the market portfolio is always an efficient portfolio. It’s always a relevant portfolio for an investor to hold. And investors can decide to tilt away from that based on their personal tastes.

But that’s what it amounts to. You can decide to tilt toward more value or smaller size based on your tastes for these dimensions of risk. But you needn’t do it. You could also decide to go the other way. You could look at the premiums and say, no, I think I like the growth stocks better. Then, as long as you get a diversified portfolio of them, I can’t argue with that either.

So there’s a whole multi-dimensional continuum here of efficient portfolios that anybody can decide to buy that I can’t quarrel with. And I have no recommendations about it because I think it’s totally a matter of taste. If you eat oranges and I eat apples I can’t really quarrel very much with that.

As far as still-available interviews with Eugene Fama, here are two:

In the first video, Fama talks about the origin of the 3-factor model. While he doesn’t explicitly get around to portfolio construction in this interview, he does state very clearly that his view is that the higher returns are the result of higher risk. (Around 5:26 is where the conversation leads to this point.)

The second video is longer and covers a lot of topics. The video’s publisher explicitly requests that it not be quoted, so I won’t quote it. Instead, I’ll just point out that around 28:45, Fama says things very similar to the interview that I quoted above. And at 35:28 he says something very clear about holding a market portfolio and whether he thinks it’s a good choice or not.

In my view, overweighting small-cap stocks or value stocks in your portfolio is a perfectly reasonable thing to do. But on occasion you’ll encounter people who indicate that doing so is the smart way to invest and only an uninformed investor would say otherwise. But that’s clearly not true.

Investing Blog Roundup: Another Challenge to DALBAR’s Math

Since 1994, research firm DALBAR has published an annual report that shows that mutual fund investors dramatically underperform their own mutual funds due to poor timing decisions (i.e., buying and selling at disadvantageous times), and their report is frequently cited within the investment industry. The underperformance that DALBAR reports, however, is quite a bit larger than the underperformance that Morningstar reports on the same topic.

Two months ago, Advisor Perspectives published an article from researcher Wade Pfau asserting that the difference is primarily due to DALBAR just doing the math incorrectly. DALBAR replied — disagreeing of course. But they they did not really provide any evidence or examples of how they do their math and why it would make sense to do it the way they do it.

This week, David Blanchett (head of retirement research for Morningstar) performed an independent calculation of investor performance to see whether his findings would mirror Morningstar’s official findings or DALBAR’s findings. The result is that we now have one more source indicating that DALBAR’s findings are way off the mark.

The takeaway: It looks like mutual fund investors aren’t nearly as dumb as some prominent sources would have you believe.

Other Investing Articles

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Using a Trailing Stop Loss to Reduce Risk

A reader writes in, asking:

“What are your thoughts on implementing a Stop Loss/Trailing Stop Loss for your positions? More specifically, does a trailing stop loss make sense given the added protection against downside risk? I thought it might be an interesting question given the current stock market valuation.”

How Does a Stop Loss Work?

For those who are unfamiliar, a stop loss order is an order that says, “if the price of this holding falls below $x, sell my shares.” A trailing stop loss is an order that says, “if the price of this holding falls by a certain dollar amount (or percentage) from its highest point since I placed this order, sell my shares.”

Example: Bob holds shares of an ETF that is currently worth $90, and he sets a trailing stop loss to sell if the price falls by 10%. That would currently mean that if the share price falls to $81, his shares will be sold. However, if the share price moves upward, the trigger price for his order will move upward as well. For example, if the share price climbs to $100, the new trigger price would be $90 (i.e., a 10% fall from the new high).

Does a Stop Loss Reduce Risk?

To answer the reader’s question, yes, a trailing stop loss is an effective way to provide some “added protection against downside risk.” It isn’t perfect protection, because the price at which the sell order is actually filled could ultimately be lower than the trigger price if the price is falling very quickly. Still, it does reduce risk relative to simply holding something without a stop order.

But, to state the obvious, the fact that something reduces risk doesn’t necessarily make it a good idea. Selling all of your existing holdings and moving everything into a short-term TIPS fund would also reduce risk, but it wouldn’t make sense for most people.

Is a Stop Loss a Good Idea?

Many people first learn about stop orders (trailing or otherwise) and think it’s a simple way to “miss” downward movement. For example: “I’ll set a trailing stop order to sell when the price falls by 10% and then I’ll buy again after it has fallen by 15%. That way I’ll get to miss out on part of the fall while still being able to experience the eventual rebound.”

The problem with this line of thinking is that it neglects to consider what happens if the stock falls 10%, but then rebounds before having fallen by 15%. In such a case, the person has sold their holding but does not buy back in at any point. At some point, they will have to decide whether they want to go ahead and buy back in anyway at a higher price than the price at which they sold.

Moving these two price points closer together (rather than 10% and 15%) does reduce the likelihood of such a scenario, but it also reduces the “payoff” when the strategy works out. That is, it reduces the amount of price decline that the investor gets to avoid.

In addition, on each roundtrip (i.e., selling the holding then eventually buying it again) there are transaction costs that must be overcome in order for the strategy to provide a net gain.

To state the issue another way: A stop loss order essentially says that you don’t want to sell at today’s price. But you would be willing to sell at a price lower than today’s price. For example, I don’t want to sell it today for $100, even though I could. But I would be willing to sell it in the future if the price falls to $90.

This is a line of thinking that does not, in itself, make sense. It only makes sense if you think that prices are predictable. That is, it only makes sense if you think that the lower price tomorrow means that it’s about to go down further rather than going back up. Unfortunately, short-term stock movements are not usually predictable. (This is why strategies that use price movements to predict future price movements are not generally successful.)

In summary, yes, trailing stop orders do reduce risk. But my personal view is that I don’t think most people should bother with them. Most people, if they desire to reduce the risk in their portfolio, are going to be better served by doing it in a simpler manner: by adjusting their asset allocation.

Investing Blog Roundup: What Length of Retirement Should You Plan For?

When developing a retirement plan, one of the most critical decisions is the time frame you will use for your planning. We have very good data about life expectancies, but unfortunately (for the sake of planning) what that data tells us is that there’s a high degree of uncertainty when it comes to how long one individual will live.

This week researcher Wade Pfau has a two-part series addressing the question of how to plan in the face of that uncertainty.

Other Money-Related Articles

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