October 16, 2023
Article
What's your protection if inflation is stickier or growth is weaker than anyone expected?
If you’ve spoken to an investor who retired immediately after the Global Financial Crisis of 2008, the first thing they might tell you is that the retirement lifestyle they had banked on through decades of saving and investing disappeared almost overnight. Portfolio losses hurt when you are contributing funds in the accumulation phase, but they are downright deadly when you’re in the withdrawal phase.
Sequence of Return Risk
If you started with a $100,000 portfolio and made no new contributions or withdrawals, the sequence of returns of that portfolio are irrelevant to your ending value. For example, let’s say you experience five consecutive years of +10% annual returns followed by five consecutive years of -10% returns. You would end up with $95,099 (Figure 1).
Figure 1: Investment1
If the order of those returns were exactly reversed, with five consecutive years of -10% returns followed by five consecutive years of positive 10% returns, you would have the exact same $95,099 outcome (figure 2).
Figure 2: Investment2
But if you add cash flows, either through contributions into the portfolio or withdrawals out of the portfolio, the sequence of returns can have a big impact on the ability of your portfolio to fund your goals.
Using the same two return scenarios, let’s now withdraw $10,000 annually at the end of each year. In the scenario where the strong returns occur first, we end up with $18,098 after 10 years, even after taking out $10,000 every year (figure 3).
Figure 3: Investment 1 with Withdrawals
But in the second scenario where the returns were initially weak, we would run out of money just after the end of year seven (see figure 4).
Figure 4: Investment 2 with Withdrawals
Extrapolate this example out for a retirement scenario and the sequence of returns could make for the difference between a comfortable retirement with a residual legacy, versus running out of money. The different timing of drawdowns and subsequent compounding accounts for the different outcomes of the two paths. The timing of drawdowns matter, and they matter a lot.
How Often Do Drawdowns Occur?
During the 78-year period starting from December 1945, the S&P500 experienced 82 pullbacks (defined as a decline between -5% and -9.9%), 29 corrections (-10% to -19.9%), and 13 bear markets (more than a 20% decline). During this timeframe, the single biggest decline for this index was a 57% drop in 2008. That’s an average of 1.6 drawdowns per year over the 78-year period (see Table 1).
Why The Old Playbook May Not Work
John Wilson, Co-CEO, Managing Partner, and Senior Portfolio Manager at Ninepoint Partners, is quick to point out that investors today are facing a paradigm shift that hasn't likely been priced into the market yet.
Asset values over the last 40 years have benefited from price stability generated by globalisation, demographics, technology, and policy discipline. That period is over.
Today, geo-political tensions (onshoring, sanctions, tariffs, disruptions), energy transition (investing in/complying with a net-zero future), and demographic headwinds (pension funding, labour shortages, union growth) all suggest a lengthy period of persistently higher costs and, as a result, higher levels of inflation than we've been accustomed to.
Beyond inflation, the above scenarios could further promote market uncertainty and unwanted drawdowns. "The question investors have to ask," Wilson commented, "is what's my protection if inflation is stickier or growth is weaker than anyone expected? Has the playbook changed?"
Table 1 - Declines in the S&P500 from Dec 1945 - Aug 2023
Diversification in a New Economic Order
It continues to be true that one of the best ways an investor can chart a smoother journey for their portfolios is to ensure that their portfolio is well-diversified – spreading investments across a range of uncorrelated asset classes to reduce overall portfolio risk.
Investors have long accepted the idea that uncorrelated asset classes were good for portfolios – that’s always been the logic behind the traditional 60% stock/40% bond portfolio. Of course, the efficacy of a 60/40 portfolio can become strained in an inflationary period, with correlations between stocks and bonds typically becoming more undesirably positive (Figure 5). What's more, if interest rates do tick higher, the safe-haven status of longer-dated bonds can be compromised.
Figure 5 – Correlation Between Stocks and Bonds at Different Inflation Rates (% of time positively correlated)
In today’s economic environment, the question becomes what combination of investments will produce that smoother investor journey, helping to buffer a portfolio from damaging drawdowns? Enter the world of alternative investments.
“There’s a wide range of assets and strategies that fit into the ‘alternative’ asset class, because really, alternative just means something other than owning stocks and bonds,” says Wilson.
“Many people are already heavily invested in alternative asset classes because they own their own house. Real estate has attractive long-term rates of return and, importantly, the way real estate goes up and down is not heavily correlated with what happens in stocks and bonds.”
Other alternative assets that become interesting in today’s environment include those that diversify bond exposure: actively-managed, alternative fixed income funds are worth considering because they have a broader range of strategies to draw from to manage interest rate risk. Investments that are tied to inflation rates become a consideration: infrastructure and real estate often meet that criteria and generally exhibit low correlation to equities. Investments that offer alternative sources of tax-efficient portfolio income – for instance, investments that make use of options – can also add value should interest rates move down.
Of course, there are many considerations when exploring investing in alternatives. Like a house, an alternative investment may not have the same level of liquidity as publicly traded securities. But homeowners generally understand the role that real estate plays in meeting their long-term financial objectives and, like a house, investors would generally expect a return premium for those less-liquid investments. The first step, in all cases, is to engage a financial advisor to determine the suitability of alternative investments to meeting the investor’s financial goals.
Reducing The Risk of Running Out of Money
The idea of adding alternative investments as an asset class to complement the more traditional asset classes is a time-tested one. In the world of large pension plans and sovereign wealth funds, alternative asset classes have been used for decades to produce income, return, and improved portfolio diversification. Today, as retail investors gain more access to professionally managed alternative investments and strategies, they stand to benefit from more effective portfolio diversification. In doing so, they can also better manage their risk of running out of money.