It has long been accepted that investments in the stock market provide the greatest long-term hedge against inflation. In other words, if you want to protect their purchasing power against the impact of inflation, the story goes, you must retain a considerable exposure to equities, even in retirement. In this article, I wish to refute this statement from several different perspectives.
Do stocks always go up? Obviously the answer to this is no, with several examples coming to mind. The average Canadian equity mutual fund returned an average -3.54% compounded over the past five years to May 31. The average US and European equity funds returned -4.81% and -9.18% respectively in the same period. And the average Japanese equity fund returned an average -11.22% annually.
As a matter of fact, stocks can have long periods of underperformance. Jim Otar, author of Unveiling the Retirement Myth, has done some excellent work in this area, looking at the probability of running out of money in retirement. One of Mr. Otar’s many conclusions is the fact that the odds of running out of money prematurely in retirement has much to do with the “cycle” environment in which you retire.
What does this mean? Well, history teaches us that the stock market and the economy ebbs and flows in 15- to 20-year cycles. The period from 1982 to 2000 represents one of the longest and strongest growth cycles in history. During this time, the S&P 500 grew by over 12% per year. Yet during the previous 14 years (1968 to 1982), the returns were negative. If you retired in 1982, the odds would have been very high that you’d pass away with more money than you retired with. However, if you had retired in 2000, the odds are high that you may run out of money prematurely. This tells us that we must invest in the context of the current market cycle and not rely on very long-term average returns for guidance.
Since the last great bull market peaked in September 2000, this would suggest that we are now in an extended sideways bear market cycle that could last another four or more years. The proof of this can be seen in the returns of equity funds for the past 10 years, as seen in the table below.
The risk of depleting capital
Many advisors focus on equities in your portfolio so as to offset the long-term risks of inflation. However, by focusing on the issue of inflation, you could be ignoring an even greater issue: year over year market volatility. You see, when you begin to draw an income from the portfolio, your greatest risk is the combination of both a negative rate of return and an income withdrawal.
For example, say you have $200,000 invested, and you wish to withdraw 4% of the value of the portfolio for income over five years. Let’s say that the rate of return is -2.0%, around the return of the average US equity mutual fund over the past 10 years. In this scenario, both your capital and your income would decline with each passing year. At the end of the fifth year, your capital value would be less than $150,000. Your capital has depleted by about 25% in just five years. And this doesn’t even take into account the impact of inflation, which would tell us that the actual purchasing power of that $150,000 is much less than it was when you started.
While this is a simple example of a straightline decline, the year-over-year calculations can be much worse, owing to the degree of volatility in equity portfolios. For example, the standard deviation of the average US equity mutual fund over the past 15 years was 16.02.
This means that with an average annual 15-year compound return of 0.33% for the average US equity mutual fund, 68% of the 15-year annual compound returns range between -15.7% and +16.4%, while 95% range between -31.7% and 32.4%.
Due to this very significant volatility, if your portfolio declined by, say, 13.5%, and you withdraw 4% of your portfolio, your $200,000 portfolio would be worth approximately $165,540 at the end of the year. Yet, to get back to $200,000, you now need to earn 26% so as to cover the current year’s income needs and recoup the lost capital. But to receive a 26% return, you are in the very upper range of the standard deviation. In other words, it would take only a very small probability event to recoup your losses.
With this in mind, what’s the greater risk: the loss of purchasing power due to inflation or the loss of purchasing power due to declining capital values? In my view, the greater risk is the loss from declining capital values. The probability of declining market values is heightened during this type of extended bear market cycle. Betting that the stock market will be higher one, two, or three years from now seems to be a very large speculative bet. Can you really be sure that stocks will be higher? What happens if they are not?
Again, in my view, the better approach would be to protect current capital values from declining and deal with the effects of inflation on your monthly budget rather than being forced to take both a cut in income (due to declining capital values) while also having to cut your monthly budget. With this thought in mind, some advisors suggest setting aside one to two years of income in a money market fund, thus allowing investments to grow over time and avoiding the chance of making withdrawals during a declining market. While in some instances this strategy can prove helpful, I believe the better approach is simply to have a more conservative portfolio that is fully invested at most times.
Next time: How to protect capital and purchasing power.
Doug Nelson, B.Comm., CFP, CLU, CIM, is a licensed financial planner and portfolio manager at Nelson Financial Consultants based in Winnipeg, Manitoba, and a regular contributor to the Fund Library. You can reach Doug at Nelson Financial Consultants, 102 – 147 Provencher Blvd., Winnipeg, MB, R2H 0G2. Phone: 204-956-0519; Fax: 204-942-6890; Email: firstname.lastname@example.org.
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