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Why Volatility Matters For Retirees

Volatility is one of the most underappreciated aspects of investing. Everyone likes to focus on rates of returns, but the volatility of a portfolio can be equally important. How much volatility should you expose yourself to? The answer lies primarily in your investment time horizon. In other words, how long will it be until you withdraw some or all of the money?

Let’s look at an example:

I was just working on a retirement income plan for a couple who recently retired. At Surevest, we use financial planning software to help analyze various scenarios. We entered this couple’s planned spending, guaranteed income sources (Social Security and pensions), investible assets, and age to which we want their money to last. We found that the portfolio we recommended had an 87% probability of supporting their planned lifestyle through the rest of their lives. The projected average annual returns for this portfolio were 6.7% with a standard deviation of 10.8%. Standard Deviation is a measure of volatility. You don’t need to understand the details of how it is measured, just that the lower the standard deviation, the better (more consistent returns).

The question is: Would a different portfolio give us a better chance of success?

Unfortunately, the reality of investing is that higher returns typically come with higher volatility. We looked at a portfolio that we expect to earn substantially more, 8.8% per year instead of 6.7%. You would think that the higher return would result in a higher probability of success. However, the more aggressive portfolio has an expected volatility of 18.3% and the probability of supporting this client’s lifestyle for the rest of their lives actually dropped from 87% to 76%. A range of projected returns, volatility, and probabilities of success follow in the table below. Naturally, this is for a specific couple based on their personal situation, but the concept is universal.

ReturnVolatility (Std deviation)Probability of Success

Notice that if you could get the same return every year (no volatility), your required returns would be much lower. Sadly, there are no investments with zero risk or volatility that are currently yielding 5.5% (at least that we know about).

PASS portfolio strategy partially insulates investors from Volatility

The investment committee at Surevest developed the PASS (Personalized Asset Segmentation Strategy) portfolio model to partially insulate our retiree clients from market volatility. This portfolio model is designed for retirees with portfolios over $1 million, who are taking systematic withdrawals. The PASS model segments portfolio holdings based on time horizon (i.e. how soon the money will be withdrawn from the account). Money that will be withdrawn within 4-5 years is held in investment grade or government bonds, not stocks. None of the money invested in stocks will be withdrawn for 4+ years. This time buffer gives the stock holdings time to recover in the event of a market downturn.

In normal years, the investor would spend one year of his/her “safe money” so we would rebalance the portfolio to replenish the safe money bucket.  However, if the stock market fell off a cliff, we would not need to rebalance (sell stocks) for up to 4+ years. In other words, each client’s portfolio is not automatically rebalanced to a static stock / bond allocation, instead there is a set of decision rules that rebalances the PASS portfolio based on each client’s financial plan and market conditions.  Research shows that this approach should significantly improve an investor’s probability of success, enable retirees to safely hold a greater portion of their portfolio in stocks, and result in a higher ending portfolio value.

Email me if you have questions.Disclosure: Returns are projected and do not represent any specific investment. Numbers are for discussion purposes only. Past performance is never a guarantee of future returns.