How the pattern of your investment returns could quietly cost you a fortune
When it comes to understanding investment risk and return, most people get it wrong – and we can’t blame them as it can at times be very confusing.
We think this is because of a lack of transparency not only among certain asset classes but also in those factors that can influence a portfolio’s ultimate outcome. This is especially important for those in retirement drawing income from their investments as a misjudgement in risk can prove catastrophic when it comes to protecting and growing a family’s hard-earned wealth.
A great example that we’ve come across includes thinking that private equity and direct real estate investments aren’t as risky as investing in public markets. This quite often happens simply because these types of investments aren’t marked-to-market so the regular fluctuations in values are essentially hidden — until it’s too late when the accountants force a write-down or when you actually try to withdraw some of your principle.
For those drawing from a more traditional portfolio of stocks and bonds, there is another huge risk lurking within the dispersion of their portfolio’s returns. More specifically, it’s entirely possible to have two portfolios with the same annual rate of return but with a dramatic difference in terminal value simply due to the timing and pattern of realized yearly returns.
For example, the chart accompanying this column reflects two $2 million portfolios with the same 6.8 per cent annual compounded return (randomly generated) over the 20-year period. However, Portfolio 1 experiences more negative returns in the early years with positive returns being back-end weighted versus the opposite for Portfolio 2.
Both portfolios will have the same terminal value as long as there are no withdrawals from either portfolio. But it’s a much different story for someone who is trying to live off the money.
Let’s assume both of the aforementioned portfolios maintain their same annual compounded 6.8 per cent return, but each make an annual distribution beginning in Year 1 at $100,000 (5 per cent spend rate), growing 2.5 per cent per annum (for inflation) with total distributions amounting to $2,554,000 in each portfolio.
Notice that Portfolio 1 has a terminal value of only $712,000 at the end of Year 20 compared to Portfolio 2 that is substantially higher at $4.3 million. Therefore, two portfolios with the same annual compounded return will have drastically different outcomes to their estate simply because of the pattern of returns.
For those curious about whether this is affecting their own portfolio or not, look for a variance in time-weighted versus money-weighted returns being reported. Money-weighted includes the effects of external cash flows (deposits and withdrawals) and measures the actual dollar return generated at the end of the day.
Fortunately, there are some things an investor can do to minimize the risk of this happening to their portfolio.
First, returns need to be smoothed out by reducing portfolio volatility. This can be done through diversification that accounts for the spend rate from the portfolio and adjusting the equity and fixed-income weightings accordingly. We would also suggest some planning around balancing targeted terminal estate values against near-term lifestyle and spending needs — with either having to be ultimately being adjusted.
Unfortunately, in a low-rate environment some investors will try to avoid the reality of their situation and instead take on excessive risk, for example by buying illiquid private investments that promise what could be unsustainably high levels of income. Instead, we would look at adding in low-correlatation asset classes such as REITs which can be helpful in reducing overall portfolio volatility, enhancing income levels and returns while still offering liquidity.
Working on proper portfolio design and implementation is critical to ensuring that one’s goals will be met in the least risky way possible especially for those in retirement drawing off of their portfolios. The alternative is to think you’re doing OK, only to have the truth emerge when it’s too late.