Because you wouldn’t want to sell tissue
This is a follow-up article from the previous article I wrote on "Retirees, here is an example of converting capital gains to an income stream".
Professional financial planners have been debating ways to improve the success rate of the retirement portfolio. ‘Success’ is defined as the retiree not outliving his or her resources.
The success rate of the retirement portfolio depends very much on the following factors:
- Expected returns of the retirement portfolio;
- Expected withdrawal rate;
- Volatility of the retirement portfolio;
- Expected Inflation;
- Expected expenditure and where the retirement portfolio is required to fund ‘long-tail’ expenses such as medical and disabilities; and
- Risk tolerance of the retiree.
Among all the factors above, I have found that most retirees find it hard to understand the impact of volatility. Without understanding the impact of volatility, the success rate of the retirement portfolio is in jeopardy.
Most of my clients say that volatility is not important as long as the expected return is good. This misconception arises due to the common notion that it does not matter how you travel as long as you reach your destination. Unfortunately, volatility (how you travel) is as important as the expected returns (the destination). The jargon that is often used by professional investment advisers is ‘path dependent’.
Consider two investments. One is a risk-free with returns of 4.5%pa over a 14 years period. Another is a more volatile investment also with 4.5%pa returns over a 14 years period. I used MSCI AC Asia ex Japan as a proxy for this volatile investment. Below is a chart to illustrate that over 14 years, both gives the same returns from end of April 2000 to end of April 2014:
Let’s say you invested $1,000,000 of your money into a retirement portfolio and you withdraw $7500 every month for 14 years. How would each of these two investments perform? The chart below shows that the risk free investment would still have some money left (to be precise it is $113,242) at the end of 14 years. However, the volatile investment runs out of money at the end of 12 years. To the retiree, he could end up outliving his resources due to volatility. Imagine at such an old age, you have to go back to selling tissues because you run out of money before you are called to paradise. By the way, you need to pay an annual licensing fee to sell tissues. If you do not wish to sell tissue and pay a licensing fee to do so, make sure you improve the success rate of the retirement portfolio by watching the volatility.
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