The Arithmetic of Prudence, Part 3

Part 2 of this series dealt with the asymmetry of marginal utility and that prudence often requires maximizing the probability of reaching a minimum objective rather than maximizing the expected portfolio value. This is especially true when one or more of the following applies:

  • The time horizon is short, e.g. < 10 years.
  • The investor is a prodigious saver; i.e., less reliant on returns to reach goals.
  • The portfolio is in distribution.

The table below summarizes my portfolio recommendation depending on the life stage of the investor.

The demarcation between early and late accumulation, early and late distribution are 10 years to and from the retirement date, respectively. Other authors have referred to the decade before and after retirement as the retirement red zone. Michael Kites recommends a “bond tent” from 10 years before to 15 years after retirement. It has a more elongated taper but based on the same principles.

The recommendation is for principles only. There isn’t specific allocation recommendation due to the enormous variation in individual risk tolerances. 70% stocks/30% bonds may be ultra conservative to one and a roller-coaster ride to another. However, the relative measures of risk ought to hold for the same investor at different stages of his investing life. I also believe in the soundness of some popular advices: greater allocation to equities during early accumulation and the use of annuities (SPIAs) for baseline income during late distribution.

As laid out in Part 2 of this series I advocate sacrificing some growth for reduced volatility in late accumulation and early distribution. The need to do so is recognized by mainstream writers but I find their typical advice of increasing the fixed income allocation too simplistic. I have written about the alternative asset classes in Beyond 60/40. In my own portfolio I continue to explore cost-effective ways to incorporate these assets consistent with modern portfolio construction methods such as risk parity, minimum correlation and maximum diversification but tailored to an individual investor with a desire to reduce trading frequency.

We live in an age where competition in the financial services industry has given the individual investor access to an unprecedented array of products at reasonable costs. Of course, not all of them make sense and the onus is upon us to separate the wheat from the chaff. But quite often I see in the PF blogosphere and forums an avoidance on principle. In some there is a suspicion to all things from the financial services industry, a suspicion no doubt born out of experience with its dodgy business practices. In others, it feels like a fundamentalist fervor against anything not a 3-fund portfolio. Whatever the reason, the majority of the DIYers continue clinging to 60-year old portfolio construction methods. I have never tried to convert anybody but have always read forum (e.g. Bogleheads) exchanges about alternative assets (typically gold) and portfolio construction (slice-and-dice, factors) with interest — when emotions are high and arguments are well-thought it makes a great spectator sport!

In the table I had the same recommendation for both late accumulation and early distribution. For obvious reasons my mental efforts have been directed to late accumulation. After the retirement threshold I can see greater emphasis on income generation: increasing allocation to CEFs, higher yielding stocks, more aggressive option writing, and less emphasis on speculative assets. The asset categories will remain the same but the percentage will differ. I expect tax considerations to play a larger role than return-volatility trade-offs.

Speaking of the distribution phase, two recent opus (both are deserving of this word) contributed significantly to our understanding: a series by EarlyRetirementNow and the work by none other than the great Bill Sharpe. Bill Sharpe also called decumulation “the nastiest, hardest problem in Finance”. It is indeed difficult, if not insoluble, if the requirements are:

  • The only allowed assets are equities and bonds.
  • The allocation is static or follow a simple age-dependent formula.
  • The withdrawal rate is anywhere close to 4%.

As they say, 2 out of 3 ain’t bad. Variable withdrawal strategies can help, but critics will say they’re market-timing in disguise: in effect, if not on purpose. PortfolioCharts has repeatedly shown the benefits of gold in increasing the safe and perpetual withdrawal rates, but gold haters will continue to hate. I suppose that leaves getting more money/requiring less as the fool-proof way of ensuring success. But try to tell that to a 23-yr old ER-aspirant!

So far as my own plan is concerned, none of the three bullets apply. But since I’m far from the Epicurean ideal, I’ll be working for another 10-12 years yet!