Most Popular ArticlesJeremy Siegel v. Zvi Bodie
July 21, 2009
Let’s analyze one of those strategies—the QPP 50/50 portfolio—using the same techniques we used to examine Bodie’s and Siegel’s extremes:
Cumulative Returns of QPP 50/50 Portfolio vs. Bonds for 10 Years
The QPP 50/50 Portfolio is projected to match the returns on the aggregate bonds index at the 5th percentile after ten years (see above), and the median outcome provides a cumulative increase in portfolio value that is 63% higher than a portfolio that is 100% allocated to bonds.
While Quantext Portfolio Planner’s projections agree with Bodie that stocks do not become less risky with time horizon (as shown in the earlier charts), QPP still shows that a meaningful exposure to assets other than TIPS increases an investor’s ability to successfully fund his or her retirement. The QPP 50/50 Portfolio is projected to provide a 4% income (adjusted up by 3% per year) for a person retiring at age 65, with only a 10% chance of running out of money by age 98. The 100% TIPS portfolio is projected to have a 10% chance of being completely drawn down by age 84. These projections use data through May 2008.
When we run the simulation with data through May 2009 as a sanity check, we find that the QPP 50/50 Portfolio is still a better choice vs. a 100% TIPS portfolio, though the projected advantage has been considerably reduced because the of massive increase in correlations between asset classes in 2008-2009. Interestingly, the projected probability of a cumulative shortfall of the portfolio vs. TIPS has decreased (see chart below). The situation has improved as the correlation between this portfolio’s returns and TIPS has gone up.
Cumulative Returns of QPP 50/50 Portfolio vs. Bonds for 10 Years
All of these simulations highlight the tradeoff between market risk (the risks associated with market fluctuations) and longevity risk (the risk of outliving your money). In light of the market declines in 2008 and 2009, there will be many investors whose taste for market risk has declined to the point that they are willing to accept lower expected future income in return for taking on less market risk. This is a completely legitimate choice, but it is not universally preferable. Reducing longevity risk with a diversified portfolio of equities and bonds provides a higher probability of being able to meet future income needs. The optimal balance between these effects requires careful assessment of an individual’s specific situation and future needs.
The best solution, given all of the uncertainties, is for investors to build portfolios that provide the maximum sustainable income streams, but also to ensure that worst-case outcomes are tolerable. This notion is receiving more attention, but is still not widely understood. An important part of a balanced investment process is to be aware of all of the risks, and the potential for severe under-performance of equities over extended periods of time is a risk that often gets overlooked. A person near retirement who has little or no flexibility in when they retire and how much income they need in retirement must have less exposure to risky asset classes.
Geoff Considine is founder and president of Quantext, and the developer of the Quantext Portfolio Planner, a portfolio management tool. Extensive case studies, as well as access to a free extended trial, are available at http://www.quantext.com.
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