Tuesday, July 30, 2013

The Power of Diversification and Safe Withdrawal Rates

In the new issue of Advisor Perspectives, Geoff Considine has written an article called, "The Power of Diversification and Safe Withdrawal Rates." It is a response to, "Asset Valuations and Safe Portfolio Withdrawal Rates," written by David Blanchett, Michael Finke, and myself.

Fortunately, he first confirms the general findings from our article for the two asset classes we chose, U.S. large-cap stocks and U.S. government bonds.

But that is just a starting point. The purpose of his article is to show how the 4% rule is still viable in today's market environment by using broader portfolio diversification. Certainly, a limitation which much of the existing research on safe withdrawal rates experiences is that it only uses two simple asset classes. This is an extension of the idea that a lot of the early research was conducted using historical rolling period analysis, and there simply are not that many asset classes for which we have a sufficiently long dataset of historical returns.

In the article, Geoff Considine describes his own model for incorporating broader diversification into the mix to show the viability of the 4% rule.

Last year, I also presented a simpler version that was meant to help break readers free from whatever assumptions are made by the researchers writing any particular article on safe withdrawal rates. My approach is still not super easy, as you must at least know how to make a modern portfolio theory style efficient frontier based on a selection of asset class returns, volatilities, and cross correlations. But, at least if you can do that, you can come up with your own estimates for safe withdrawal rates by plotting the portfolio returns and volatilities on diagrams I made showing sustainable withdrawal rates for different time horizons and probabilities of failure.

The original research article about this was, "Capital Market Expectations, Asset Allocation, and Safe Withdrawal Rates," and further figures showing how this all comes into play for different retirement scenarios are provided at this blog entry.

Thank you to Geoff for emphasizing the important point that portfolio diversification matters, and with better diversification even in the current market environment, it may still be possible to put together a portfolio that will more confidently sustain the 4% withdrawal rate.

Caption: The figure below comes from a past blog entry which shows how users can customize their own portfolios, plot the arithmetic real return and volatility of their portfolio on the diagram, and see a visual representation of the sustainable withdrawal rate for a given failure rate and time horizon.