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S&P 500                +1.99%

10 Year US Treasury   -0.36%

Gold                    +0.84%

Volatility              -18.98%

Our Weekly Reading

Benchmarks and the Trouble with Indexing: The Final Chapter

Last week was our second installment of detailing the challenges with finding appropriate benchmarks for our retirement or goals-based investment portfolios.  We highlighted the issues of the Volatility Tax and demonstrated how it makes us more vulnerable to the sequence of investment returns, putting us more at the mercy of the beneficial timing.  At Calibrate Wealth we believe that long term investment success needs to be systematic, process-driven, and repeatable; an investment strategy which relies on forecast is doomed for failure.  Consequently, we believe that placing one’s financial plan and investment strategy at the mercy of timing is unacceptable. 

Unfortunately, this does not mean that we can predict, or guarantee returns (sorry, not only would government regulators come down upon us, but we also know that there is no predicting random events).  What we do suggest is selecting a strategy with a lower Volatility Tax.  Remember that Volatility Tax is the difference between the arithmetic returns and geometric returns, or more bluntly:  difference between the returns we actually receive and the returns the average annual return implied we would receive.  Prediction is impossible but choosing an investment strategy with lower variance of returns can make our investment plans for sustainable and reliable. 

It is important to remember, at all times, that we save for a purpose and that purpose or goal should serve as our benchmark.  If you are retired and your investment portfolio is helping provide income, then the percentage of your portfolio which you plan to withdraw could be a good starting place to benchmark returns.  The S&P 500, in contrast, has no idea what your needs are and therefore would be a fairly arbitrary benchmark.  It seems intuitive, but we all fall prey to the desire to mark our progress against something measurable.  If we choose measuring tools that are highly volatile by nature, even if just to observe them, we risk anchoring our retirement in too rough of seas. Fortunately, we believe that there is a way to achieve more dependable returns without having to sacrifice on the returns.

Winning by Paying Lower Taxes…Volatility Taxes

For those who’ve been clients ours you’ve heard us promote the benefits of utilizing a risk balanced approach to asset management.  By balancing your portfolio according to the volatility or risk inputs of each individual asset or market outcome, we have sought to design a portfolio that is less dependent upon stock market appreciation.  Removing dependence upon stock market direction, or economic climate, we seek to diminish the extent to which your financial plan is left to the benefit of “good timing.”  In addressing the concept of Volatility Tax, originally introduced to us through an article published by Mark Spitznagel, we have found another method of demonstrating the benefits of a risk balanced approach to investment management.

Sean Connery vs. Roger Moore:  A Look at Retirement Income Benchmarking

Last week we did a comparison study between George Clooney and Mark Wahlberg and showed how timing can alter investment returns.  Notably, we looked at the benefits enjoyed by Mr. Clooney, who enjoyed a slightly better investment environment than Mr. Wahlberg.  In that example, after 20 years of utilizing the identical savings strategies, George ended up with nearly 60% more money in his IRA than Mark.  This week I thought we would examine another scenario:  the income plans in retirement for Sean Connery and Roger Moore.  Let us assume that each James Bond decided to retire in January 1993.  Both Mr. Connery and Mr. Moore decided to adopt a more conservative investment approach in retirement, but each knew they would need support from their retirement portfolios to fund their extravagant lifestyles.  Constantly jetting off to tropical locations and 3-6 martinis per day has its consequences.  Sean chose to invest his money in a traditional 60/40 portfolio, putting 60% of his money in the S&P 500 and 40% in 10 Year US Treasury Bonds.  Roger, on the other hand, took a slightly different approach.  He knew stocks were more volatile than bonds (historically about 2 times more volatile) therefore, if he were to balance his portfolio risk, he would have to allocate about twice as much to bonds as to stocks.  When he put it all together he ended up with about 2/3 allocated to bonds and 1/3 allocated to stocks.  Knowing his penchant for high class living, Roger wanted also wanted the return potential that a portfolio like Sean’s offered, but didn’t want to take more risk than Sean.  Therefore, to get his portfolio to have the same amount of risk as Sean Connery’s, Roger Moore added 160% leverage to his portfolio. 

Each received a healthy pension for a lifetime in Her Majesty’s Service, so each decided to take a more conservative approach to income distribution.  They would each withdraw 5% of their prior year’s end of year portfolio balance for income in the coming year.  Eschewing a fixed dollar amount and allowing their income to fluctuate, neither would outlive their money, instead they would allow their income to fluctuate with their investment returns.  Each man started with $500k in savings and each continued with their original investment and income distribution approach for the entire 25 years, until Mr. Moore’s passing in 2017.  At the conclusion of the 25-year period, each enjoyed healthy returns, and each achieved a ending portfolio balance with more money than they stared.  Mr. Moore, however, was able to leave behind over $2.6 million to his heirs, while Mr. Connery currently has less than half as much, $1.2 million. 

But, since the money saved for retirement was meant for them to enjoy life in retirement, the greater interest was how much each income each was able to live on while alive.  During their 25-year retirement, Mr. Moore drew $1.7 million from his portfolio, while Mr. Connery only drew $1.06 million—or a difference in average annual income between the two of $70k vs $42.5k.  Perhaps more importantly, though, was the more consistency of income Mr. Moore received.  During the downturn between 2000-2003, Mr. Connery saw his income in retirement drop by 25% from $50k in 2000 to $38k in 2003.  It took him 14 years to get back to his income level in 2000.  Conversely, during the same period Mr. Moore saw his income rise from $58,237 in 2000 to $59,508 in 2003.  In 2008-09, as the market again sunk dramatically, Mr. Connery saw his income drop from $46,960 to $38,089.  During this period Mr. Moore’s income also fell, by a more tolerable amount—from $80,460 to $78,269.

This example should demonstrate that it is possible to simultaneously balance risk and achieve high, adequate returns.  We do not necessarily have to choose between increasing our allocation to riskier assets or receiving smaller returns.  Growth and the attainment of financial goals can be more reliably achieved through reducing the Volatility Tax and balancing risk.

Math and Tables for Those Who are Interested

*Leverage in this instance was 162% of the base level cash investible amount.  The amount of leverage applied was determined by comparing the risk of the two portfolios (60/40 vs 33/67) between 1945-1992. 

1993-2017:  Period Study of Volatility Tax Analysis

Comparison of Similarly Risked Portfolios:  S&P 500 vs. The Risk Balanced Risk S&P Risk Equivalent