Impact of volatility on retirement
This is part two.
In part one I shared the impact of inflation on retirement. Inflation is one of two risks that Roger C. Gibson explained in his book - "Asset Allocation" (Fifth Edition).
The second risk is portfolio volatility.
Let me illustrate with a fictive example. Let's say I have 400 🍏 to invest and there are two options, A or B.
In this example, the underlying investment in A’s returns swing from -13% to +25%. At the same period, B’s returns swing from -1% to +8%. And A has higher return than B after five years.
If I know for sure that I will not cash out the savings for five years, then A will give higher return.
But what if I do not know? What if there is a possibility that I may need to cash out earlier, due to an unplanned need?
In the above example, A and B take turns at being the better choice. If I need to cash out at the end of year 2 or year 4, B is better. At other times, A is better.
So it is not so straightforward.
Let me tweak the example. What if I keep the same annual returns but rearrange the sequence of the returns.
Let me show the scenario where the sequence starts with negative returns.
The ending balance at the end of year 5 is the same as in scenario 1. But in this case, if I cash out at the end of year 1 through year 4, B beats A. Only at the end of year 5, A beats B.
And now, let me show the scenario where the sequence starts with positive returns.
In this scenario, A beats B throughout the period.
We can never predict future performance. The above scenarios are just simulations to make a point. Portfolio volatility risk can have real implications on retirement.
Volatility tolerance is subjective. You and I tolerate volatility differently.
Take the scenario 3 above where positive returns were followed by successive negative returns. A's drop is more nerve wrecking than B's drop, although at the end of year 5 the balance is the same as in the scenarios 1 and 2. This kind of volatility is not for everyone.
The combination of my financial situation and my volatility tolerance is unique to me. And yours unique to you.
There is no magic formula that will uniformly apply to everyone. The plan needs to be custom fit for each individual's needs.
"Two investors can have completely different opinions about a specific stock or the market and both can be right (or both can be wrong). It all depends on the time horizon." (Ben Carlson)
And here is Gibson again.
"Time horizon is one of the most important dimensions of the investment management process. ...
For short investment time horizons, volatility is a bigger risk than inflation ... For long investment time horizons, inflation is the more significant danger ..."
There is pragmatic need to balance volatility risk and inflation risk, so I need to be clear about the investment time horizon. This determines how I need to approach volatility risk and inflation.
Interestingly, Gibson pointed out that "retirement horizon" should not be confused with "investment portfolio time horizon".
If the investment time horizon is longer, then this opens up more options to overcome the impact of inflation.
This does not mean that I can go risky all of a sudden. What I mean is that longer investment time horizon gives wider array of options to choose that fit my risk preference.
Have a great day.
(If you spot an error in the examples above, please email me. Thanks.)
Disclaimer: Anything I share is not intended as financial advice; I am merely sharing personal opinions and experiences. The information is of general nature and you should only use it as a place to start your own research and you certainly should do your own due diligence. You ought to seek professional financial advice before making any decisions.