Searching for the Perfect Portfolio – Part 2

search2In the previous post we checked the performance of 3 types of portfolios and found big differences between them. Now let’s see how timing affects these portfolios. Why is it important? Because we can’t really influence it. Market crashes can happen at any time. It may be tomorrow, but stock prices can also continue growing for many years in a row. I want to find the perfect allocation that makes my portfolio as bullet proof as possible, without sacrificing too much potential returns. Furthermore what I would definitely like to avoid, is to jeopardize the sufficient income during the years of early retirement.

You remember Steve, Mike and Bob from the previous post. It turns out that they have also convinces their sisters, Stacey, Molly and Babette (yes, the parents all loved alliteration) to regularly save and invest. The three girls have also managed to collect USD 600,000 before 5 years of their planned early retirement date. The only difference is that they are exactly one year behind the guys. Their story starts in 2004.

All the ladies have continued their family traditions about investment principles. Stacey had a 100% stock portfolio (in the form of Vanguard Total Stock Market ETF), Babette has invested in the iShares iBoxx Investment Grade Corporate Bond ETF, Molly had a 60-40 allocation between these two. All of them have invested an extra 2k per month. Let’s see how their portfolio has performed until their last day at work.

2009

Not good. Remember how Steve got retired with a 1.3 million portfolio in the beginning of 2008? That time Stacey also had nearly 1 million, but within a year it melted down to almost 600k. The performance of the last 5 years has been vanished… Similar bad news for Molly, ending up 2nd with 678k. Babette has performed the best (remember how far behind Bob was among the guys?); her portfolio worth 751k.

Choosing early retirement in a situation when you’re so far behind of your initial plan of portfolio value is extremely risky. Nevertheless let’s assume that all 3 ladies have went on this route. This is what has happened (assuming a 3% withdrawal per year, plus using the dividends to cover expenses).

20162

Within 3 months from retirement Stacey’s portfolio has bottomed at 479k. Losing over 100k in your very first period without a salary is definitely not something you want to see. Nevertheless since then she is doing really good. Since 2013 she is the best performer of the 3 of them. If you carefully look at the chart, you would see that this ride is a wild one. It happened 4 times when her portfolio has shrank with more than 100k within a short period. Some people might be able to handle it easier; I personally would have some sleepless nights during such periods…

As expected, Molly had a very similar, but smoother ride, while Babette has been moving within a 100k-150k range.

The value of a portfolio is important (especially considering that part of the money they use is coming from the yearly 3% withdrawal), but we shouldn’t forget about the dividends. These two are equally important part of the income that could be used during the early retirement years. Let’s see how their monthly income looks like based on the above rule. By now we can kind of expect that we will see similar patterns as in the previous post. So instead of comparing the 3 ladies, let’s compare each of them to their brothers in order to see what a difference a year makes.

100% Stock Portfolio

100stock

As you can see the pattern is the same, but there is a big difference between the monthly income of Steve and Stacey. In 2009 it was USD 600, and the gap is getting bigger and bigger. In 2015 Steve could spend 1.1k more on a monthly basis. They both have their investments in the same ETF, both have the same withdrawal rules, this difference is solely caused by one important factor: timing.

100% Bond Portfolio

100bond

I had to recheck my calculation a few times as it seems so unbelievable. It is partially caused by a coincidence, but the difference is indeed only 1-2 dollars per month. Usually 1 year timing difference shouldn’t cause a big change anyway, but getting this close is very odd. The important facts are on the chart: high, but continuously declining monthly income.

60-40 Portfolio

60-40

A 60-40 portfolio does not only provides relatively stable income over the years, but also the gap caused by the 1 year timing difference keeps being around 550-600 if you compare how Mike and Molly are doing. Considering the fact that Molly has retired with 678k after her portfolio was seriously hit by the financial crisis, the fact that her monthly income  (bear in mind that we are always talking about before tax) has never fallen below USD 4,000 is pretty impressive.

Conclusions So Far

This was only the second part of the series about searching for the perfect portfolio, but we might already make some conclusions:

  • A portfolio that only (or at least very heavily) consists stocks will most likely provide the best long term returns. Nevertheless it will be a really bumpy ride and it is definitely not for everyone (especially not for people with a family history of stroke and cardiovascular diseases).
  • A 100% bond portfolio is too conservative. It is not suitable for wealth building. You can still make (or even lose) money with bonds (to see how, you might want to read this basic introduction about bond investing), nevertheless the way I see its role in a long term investment plan is more like a part of the portfolio that smooths the effect of stock market extremes (in either way).
  • A mixed portfolio of both stocks and bonds could be the ideal combination for an early retirement plan. But is the 60-40 rule the best? How about different ratios? How about different stages of the investment cycle? I’m trying to find the answer for these in the next parts of this series.

You can find the other parts of the Searching for the Perfect Portfolio series under the below links:

 

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2 Comments

  1. Daniel September 28, 2016
    • Roadrunner September 28, 2016

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