Monthly commentary

Readers who have known me for a long time will know that I am sceptical of using fully invested multi-asset funds or portfolios to provide risk mitigation in the event of an unexpected (or even planned) large withdrawal from the investor’s capital base. I prefer reserving cash and accepting the negligible or even zero return on that money and compensating with more aggressive investment of the money that is highly unlikly to be needed after allowing for all contingencies.

Like all investment strategies, my proposition needs checking from time to time and I have been doing that.

For purposes of testing the assumption, I used the Vanguard Lifestrategy funds to represent the invested portfolio. In the first situation, I have assumed all the actually invested capital was in the Lifestrategy 100% equity option, but only 80% was invested, leaving 20% in cash (Option 1). In the alternative option, all of the money is invested but in the Vanguard 80% Lifestrategy fund (Option 2).

For simplicity, the total capital available is taken to be 100,000 Pounds. So for option one 80,000 Pounds is in the Vanguard fund and for option two it is the full 100,000 Pounds.

Using these funds allows me to extract real world rates of long term investment returns after fees and to get a widely accepted measure of potential losses, the 3 year standard deviation.

I have assumed returns continue on average at the same rate as over the last 5 years and that a major market setback sees losses equal to 2 standard deviations.

Of course, this is not going to predict the future or any actual set of events, but I think it is a valid base for modelling some scenarios. All the scenarios below look at the situation 3 years down the line.

The data extracted from Morningstar gives 5 year annualised returns and 3 year standard deviation numbers (doubled) of 11%/9.3% and 29%/24% for the Lifestrategy 100% and 80% funds respectively.

Scenario 1 – Immediately after investing there is a correction

The capital remaining for Option 1 would be about GBP98000 but slightly more for Option 2 at about GBP99000

In this situation the higher returns on the 100% fund have not yet compensated for the sharper loss right at the start. After a couple more years of recovery, Option 1 would possibly be more profitable.

Scenario 2 – Immediately after investing there is a correction and the investor needs 20,000 Pounds urgently

The capital remaining for Option 1 would be about GBP78000 but rather less for Option 2 at about GBP73000

In this case, the option to take the cash reserved as a contingency and leave the equities fully invested to recover is very beneficial. Option 2 sees the capital base severely depleted by the market loss and the simulatneous withdrawal

Scenario 3 – The market sustains growth for 3 years, then there is a setback and the investor withdraws 20000 Pounds

The capital remaining for Option 1 would be similar to the first scenario at about GBP98000 and also for Option 2 at about GBP99000. This is not surprising given that the main elements of the arithmetic are the same, just the order of events is different.

Some observations

You may note that the returns from the 80% equity fund are more than 80% of the wholly equity fund, over the last 5 years. As cash has been assumed to have a zero yield in this case, that leaves Option 1 at a disdavantage from the start. The multi-asset fund has benefited from historic returns on its fixed income holding (the other 20%) while interest rates have been at record lows. That may not be the case in the near future – in fact I would think the fixed income holdings will be a drag on returns.

I accept of course that one would expect different outcomes with different cash proportions and amounts and timing of withdrawals but I see no point in running endless hypothestic scenarios. My objective was to see if there were any new reasons to stop holding cash to fund anticipated withdrawals and leave my invested portfolio with an aggressive market exposure. I have not discovered anything new.

In reality, I prefer the ‘three pots‘ strategy for people who, like me, need to take an income from their capital base but who know that you only make really good money by investing in global equities. The missing element in the simplified examples above is a portfolio allocation to low volatility assets that sit between deposit funds and the plain equity funds.

Mixing up the elements of the 3 ‘pots’ is a bit of an acquired skill! I do my best to pass it on to those who take my training sessions.