The importance of low volatility can be demonstrated by looking at recent performance in the stock market.
In 2008, the S&P 500 lost over 37% of its value1. Many investors who were allocated primarily to equities lost similar amounts or more. If a client portfolio declines 40%, the return necessary to recoup the loss is 66.7%. As the losses increase, the amount of return needed to recover increases exponentially.
If a portfolio begins at $1 and loses 50¢, the amount needed to recover to $1 is 50¢ or a 100% return. Adding onto the exponential loss dilemma is the psychological impact of an extreme loss in a portfolio. If we look back at the end of 2008 and the beginning of 2009 when the markets were extremely volatile and investors were panicking, there were countless articles published in newspapers about people abandoning their 401(k)s and moving all assets into stable value funds and extremely low-risk investments such as CDs and savings accounts. Equity mutual fund redemptions were at an all-time high2. An investment loss of 20%, although uncomfortable, seems much more palatable than a loss of 40% and therefore much less prone to lead an investor to make a rash decision. Studies have repeatedly shown that the best way to profit consistently from the stock market is to remain invested for long periods of time rather than trying to time the market as it rises and falls3.
Consistent cash flow in the form of dividends from stocks and interest payments from fixed income is vital to a retirement distribution portfolio. Each year, a retiree's portfolio may be paying out as much as 4% or more to cover living expenses. If a substantial percentage of the monthly payout to the retiree can be made from dividends and interest, then the amount of principal value that must be withdrawn decreases. If a hypothetical portfolio yields 3% in dividends and interest, and the withdrawal rate is 4% per year, 75% of the payouts needed in the first year will come just from dividends and interest. Even after ten years of average inflation and zero portfolio growth, 50% of the retiree's payout is coming directly from the dividends and interest.
In rapidly fluctuating markets as well as in flat markets, by keeping more of the principal invested, the investor will reduce the need to sell investments at a loss and therefore recover faster when the markets improve. Keeping more principal invested also has an effect of investor psychology. If a large amount of a payout needs to come from principal during a down market, the idea of "locking in losses" may appear in investors' minds. Investors may therefore be more apt to make radical changes to investment philosophy and that would adversely affect their probability of success.
The final factor of capital appreciation affects probability of success due to the purchasing power erosion caused by long-term inflation. Assuming an average 3% inflation4, the cost of goods and services doubles once roughly every 25 years. If an individual retires at age 60, the cost of living will double by the time he or she reaches 85; therefore, the payouts will need to increase proportionally.
If a retiree tries to rely on a portfolio of just fixed income and cash, the likelihood of running out of money is significantly greater than if he or she has a diversified mix of stocks, bonds and alternatives to allow for some growth as well as income5. It is crucial to find the balance between low volatility, consistent cash flow and capital appreciation to maximize the probability of success in retirement.
1. Source: Standard and Poors
2. Source: Morningstar
3. Source: Blackrock
4. Source: US Bureau of Labor Statistics. Inflation varies regularly. Many sectors of the economy inflate at different rates. 3% is the generally accepted overall inflation rate.
5. Source: Financeware