Retirement is one of the most important financial goals in our life. And yet, it is often unclear how our retirement plans are affected by investment decisions. In this post, we want to shed some light on the effect of volatility on retirement.
Market return vs. constant yield
To show the effects of volatility, we compare the market return, with a hypothetical investment vehicle. As a proxy for the market return we use the S&P 500 Total Return Index. Our hypothetical investment vehicle offers constant yield and zero volatility. We set the constant yield to match the market return over the observed period as closely as possible.
The chart shows, how an investment in the two assets would have developed in the 15 years between January 2004, and December 2018. We can see that both investments have the same average annual return, of 7.8%. Consequently, both investments lead to the same result, approximately tripling the initial capital. The path to this result is different though: The market has given us quite a bumpy ride, with many ups and downs. In contrast, our hypothetical investment’s return is smooth as glass.
Effect of volatility on accumulating wealth
Our next experiment is a little more complex. Every month, starting in January 2004, we invest some money into our two investment vehicles. We begin with $1,000 per month in January 2004, and increase the amount with the U.S. Consumer Price Index to adjust for inflation.
The longer we keep saving, the slower our accounts seem to grow. The reason is, that our monthly payments become a smaller and smaller fraction of the overall account value. And while the market’s volatility is still there, our monthly payments help to recover more quickly from drawdowns. After 15 years, we end with very similar total savings, even though the results are not identical. Volatility works to our advantage here, due to dollar cost averaging. Our investment in the market resulted in total savings of $435,000, while an investment in our constant yield instrument resulted in a total of $390,000.
Effect of volatility on retirement
In our third experiment, we simulate a retirement scenario. In January 2004, we retire with a total of $400,000. These savings are either invested in the market, or our constant yield instrument. Every month, we withdraw $2,500, again adjusted for inflation with the U.S. Consumer Price Index.
The chart shows how the differences between these two investments become dramatic. After 15 years of retirement, and with our savings invested in the market, our account shrunk to less than 30% of its original value. Had we invested our savings in an instrument with constant yield, our account would be at 65% of its starting value. That’s a huge difference, and this difference defines how long your savings will last.
What happened? As we can see from the chart, the speed at which our savings are depleted is generally accelerating, the longer we keep withdrawing funds. This is the opposite of what happened while we have been saving. When recession hit in 2008, we experienced a drawdown of more than 50%, while our monthly spending stayed about the same. Due that, we were withdrawing a much higher rate during that period. And because depletion is accelerating, we were unable to recover from this, not even during years of strong growth following 2009.
What if our constant yield had been much lower? The chart above shows that our investment in the market performed about the same an investment with a constant yield of 6.0%. In other words, volatility had the same effect as lowering our returns by 1.8% over the observed period. This implies that during retirement, a lower than expected return is much less of a concern than higher than anticipated volatility.
From the experiments above, we have seen the effect of volatility in real-life scenarios.
During wealth accumulation, volatility has some slight positive effects, due to dollar cost averaging. However, we should be careful in our attempts to use that to our advantage: What if we need to temporarily withdraw funds during a deep drawdown? What if we experience drawdowns as we approach retirement?
During wealth decumulation, volatility always has negative effects: Volatility speeds up the depletion of funds to a high degree, and we can typically not recover from that. We have seen that higher volatility has the same effect as significantly lower average returns.
With this in mind, it becomes clear why volatility is the most important aspect of any investment we hold during retirement. Instead of focusing on maximizing the average return, we should focus on low volatility and higher risk-adjusted returns instead.
We very much hope that this post provided some valuable insight into the tangible effects of volatility, especially during retirement. At Bertram Solutions, we pride ourselves in doing independent research, and this post is a good example of our approach to analyzing investments.