Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

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Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by vineviz » Fri Mar 29, 2019 12:26 pm

Not enough investors, in my opinion, give enough considered thought to the diversification of their portfolios.

If they think about it at all they might consider their portfolio to be "diversified" if they own some bonds and some stocks. And within each of those asset classes some investors might think they are "diversified" if they own a fund that holds all or most of the total stock market at market cap weights. Some investors might think they are "diversified enough" if they just own stocks and bonds from the world's largest - for now - economy.

It will surprise few readers if I point out that each such group of investors is mistaken. I have an example I want to present, but first a little background on diversification.

==========

In finance, diversification has a particular meaning that is a little more nuanced than the "don't put all your eggs in one basket" maxim. When less-than-perfectly correlated assets are combined in a portfolio, the final portfolio has a lower volatility than the average asset in the portfolio.

By way of example, imagine two funds that each have volatility of 10% and are completely uncorrelated with each other. Even if both funds have the same individual risk (i.e. 10% volatility), a 50/50 portfolio of the two funds has lower risk (i.e. 7.1%). Diversification doesn't always lower the overall risk of the portfolio, because that's not the goal. The goal of diversification is to balance the risks within the portfolio.

Investors sometimes confuse diversification with a different concept known as "de-risking". The explicit goal of de-risking a portfolio is to lower its volatility. And just as diversification doesn't always de-risk a portfolio, de-risking doesn't always improve the diversification of portfolio. Back to mu earlier example: instead of combining the two hypothetical funds (each with 10% volatility) you could achieve the same level of portfolio volatility (7.1%) by constructing a portfolio by investing 71% in either fund and 29% in cash. This portfolio has the same level of volatility as the first portfolio but less diversificaiton.

==========

The Example

By many measures, one of the worst times in recent history to retire was November, 1965. This period is, more or less, the worst case for a retiree who wanted to withdraw a constant amount of real dollars from their portfolio over a 30 year retirement. It's basically the period that sets the maximum sustainable withdrawal rate.

A retiree who started November 1965 with $100,000 and withdrew $335/month (equal to a 4% SWR) ran out of money in November 1995. This assumes the retiree invested in 60% large cap U.S. stocks (basically S&P 500) and 40% intermediate US treasuries.

Image

Curious about how much difference it would make if this hypothetical retiree had made some effort to better diversify this portfolio (call it Portfolio 1), I constructed two additional portfolios.

Portfolio 2 replaces some of the large cap stock with small allocations to small cap value and global ex US stocks: 48% large cap, 6% SCV, 6% international. This portfolio is designed (with the benefit of hindsight) to have the same overall volatility (aka risk) as Portfolio 1: stdev = 9.91%.

Portfolio 3 increases the allocation to bonds in order to have the same overall returns as Portfolio 1 (9.94%). It is 30% large cap, 7.5% SCV, 7.5% international, and 55% bonds.

Image

Subjecting all three portfolios to the same withdrawals, the difference in sustainability is appreciable. All three portfolios suffered declines in inflation-adjusted principal value, but Portfolio 2 and Portfolio 3 were much less impaired than Portfolio 1.

Image

In fact, Portfolio 2 would have lasted nine more years (depletion in August, 2004) and Portfolio 3 would have lasted another six months yet (depletion in February 2005).

If the investor had started with a withdrawal of $315 instead of $333 (a SWR of 3.78%), both Portfolio 2 and Portfolio 3 would have lasted nearly fifty years (until October 2015) versus just 38 years for Portfolio 1 (depletion in November, 2003).

Remember that Portfolio 2 had the same risk level as Portfolio 1, and that Portfolio 3 had the same average return as Portfolio 1.

Because of their improved diversification, however, both Portfolio 2 and Portfolio 3 had greater money weighted rates of return and therefore superior longevity.

Also keep in mind that increasing the diversification didn't require HUGE shifts away from the original equity allocation of large cap US stocks. The S&P 500 equivalent was still 80% of stocks in Portfolio 2 and nearly 2/3 of stocks on Portfolio 3. In both cases neither small caps nor international stocks were more than 20% of the equity allocation.

My point, I think, is that even small improvements in diversification can improve your odds of meeting your investment goals in the face of adverse market conditions.

A diversified portfolio will always contain assets that are doing better than average and some that are doing worse than average. This is definitionally true.

I think one challenge investors face is that the nature of saving for retirement causes investors to develop a systematic under-appreciation of the value of diversification.

During accumulation, portfolio inflows absorb or offset a large portion of the sequence of returns risk. In the absence of sequence risk, diversification doesn't seem important: the savings rate matters most in early accumulation and the average expected return starts to matter more later on.

Investors spend decades learning that diversification doesn't pay, without realizing that the rules change considerably once they retire.

Many investors intuit that something is different even if they can't quite articulate it. This is one reason, I think, that people generally prefer defined benefit plans to defined contribution plans, and that so many people let themselves be hoodwinked into variable annuities.

It strikes many people as strange, even unnatural, that retirees likely need the diversification benefits assets like small cap stocks, international stocks, and long-term bonds MORE than someone in their twenties or thirties needs this things.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by galeno » Fri Mar 29, 2019 1:42 pm

A USA Boglehead can get a completely diversified stock and bond portfolio using two ETFs: 50% VT + 50% BNDW.
AA = 40/55/5. Expected CAGR = 3.8%. GSD (5y) = 6.2%. USD inflation (10 y) = 1.8%. AWR = 4.0%. TER = 0.4%. Port Yield = 2.82%. Term = 33 yr. FI Duration = 6.0 yr. Portfolio survival probability = 95%.

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by DonIce » Fri Mar 29, 2019 2:00 pm

vineviz wrote:
Fri Mar 29, 2019 12:26 pm
During accumulation, portfolio inflows absorb or offset a large portion of the sequence of returns risk. In the absence of sequence risk, diversification doesn't seem important: the savings rate matters most in early accumulation and the average expected return starts to matter more later on.
Thanks for the analysis. I'm sure many will find it helpful. However, I would argue that diversification is just as important during accumulation, if you consider the full world of investment strategies out there rather than just considering a rigid stock/bond allocation where the total equals 100%. For example, you can consider risk parity strategies, where multiple uncorrelated assets are held so that the standard deviation is reduced, and then you can apply leverage to the whole portfolio to target a specific volatility level, which can lead to higher returns than a less diversified portfolio that just tries for maximum returns with a high % equity allocation.

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by vineviz » Fri Mar 29, 2019 2:05 pm

galeno wrote:
Fri Mar 29, 2019 1:42 pm
A USA Boglehead can get a completely diversified stock and bond portfolio using two ETFs: 50% VT + 50% BNDW.
It's almost as if you didn't read anything I wrote.
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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by Random Walker » Fri Mar 29, 2019 2:24 pm

I strongly agree with Vineviz. Portfolio volatility and big drawdowns really hinder a portfolio. In retirement, with no new portfolio additions, the effects are much more obvious. Sequence of returns risk and lack of portfolio efficiency can hurt the likelihood of portfolio success. The expected return of a portfolio is the weighted average expected return of the portfolio components. The expected volatility of a portfolio is less than the weighted average of component volatilities because of correlations less than one. What a potential new addition adds to a portfolio depends on expected return, correlations, volatility, covariance with other portfolio components. Improved portfolio efficiency from diversification can be viewed as a move closer to the northwest corner of an efficient frontier plot or a distribution with same expected return but narrower SD. It is because of these issues that people discuss diversifying across geography, asset classes, factors, styles, alternatives.

Dave

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by vineviz » Fri Mar 29, 2019 2:24 pm

DonIce wrote:
Fri Mar 29, 2019 2:00 pm
vineviz wrote:
Fri Mar 29, 2019 12:26 pm
During accumulation, portfolio inflows absorb or offset a large portion of the sequence of returns risk. In the absence of sequence risk, diversification doesn't seem important: the savings rate matters most in early accumulation and the average expected return starts to matter more later on.
Thanks for the analysis. I'm sure many will find it helpful. However, I would argue that diversification is just as important during accumulation, if you consider the full world of investment strategies out there rather than just considering a rigid stock/bond allocation where the total equals 100%. For example, you can consider risk parity strategies, where multiple uncorrelated assets are held so that the standard deviation is reduced, and then you can apply leverage to the whole portfolio to target a specific volatility level, which can lead to higher returns than a less diversified portfolio that just tries for maximum returns with a high % equity allocation.
I agree that diversification is still useful in accumulation. It's a central piece of my portfolio construction process, and unshakeable so.

That said, do I think it's useful to acknowledge that it LESS important for accumulators.

Just by way of illustration, here are the same portfolios and the same time periods I used above but with the scenario inverted from decumulation to accumulation. The investors started with $1 and contributed $335/month adjusted for inflation.

Unlike the withdrawal situation above, in which the three portfolios had significantly different outcomes, the situation here is much less dramatic.

Image

Here, unfortunate sequence of returns for Portfolio 3 were a slight drag on performance relative to the other two portfolios.

For the retiree in my earlier example, though, I'd argue that the difference between having $0 left and $130,000 left isn't directly analogous to the accumulator in my second example where the difference is between $1.67 million and $1.55 million. Even though the difference is similar when measured in dollar amounts, a 95-year old retiree has many fewer options for dealing with it than a 65-year old retiree does.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by stan1 » Fri Mar 29, 2019 2:30 pm

How much of the described effect can be attributed to rebalancing? The Callan table is used as a graphic representation by slice and dicers to show opportunity and by total market advocates to show risk.

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by Tamarind » Fri Mar 29, 2019 2:44 pm

Similarly, how much of the benefit can be attributed to international diversification vs size diversification vs duration diversification?

I actually accept your premise outside the context of backtesting, but I'm curious if all 3 actually contributed to the diversification effect in this worst case scenario.

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by vineviz » Fri Mar 29, 2019 3:05 pm

stan1 wrote:
Fri Mar 29, 2019 2:30 pm
How much of the described effect can be attributed to rebalancing?
Very little.

Rebalancing frequency has a small effect on the longevity of Portfolio 1 but not in any significant or predictable way.(quarterly rebalancing gave you a few more months of survival than monthly rebalancing, annually was worse than semi-annually, and never rebalancing was worst of all).
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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by azanon » Fri Mar 29, 2019 3:15 pm

So much effort and time is put into avoiding the potential perils of using the 4% rule for retirement income (aka the "constant dollar" method), and often it is never realized that the greatest issue with that is actually the use of that withdrawal method itself. Said another way, trying to find the optimum portfolio for that retirement income method is the equivalent of trying to put lipstick on a pig.

"portfolio 1", but with constant percent or VPW, etc. would be vastly superior to any of the other portfolios with 4% rule.
Last edited by azanon on Fri Mar 29, 2019 3:17 pm, edited 1 time in total.

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by vineviz » Fri Mar 29, 2019 3:16 pm

Tamarind wrote:
Fri Mar 29, 2019 2:44 pm
Similarly, how much of the benefit can be attributed to international diversification vs size diversification vs duration diversification?
I used the same bond asset in all three portfolios, so duration wasn't really a variable in my examples.

Luckily for us, during this period the three equity assets had roughly similar returns: 10.1% for US large cap, 10.7% for US small cap value, and 12.8% for international. And by holding the return of Portfolio 3 equal to Portfolio 1, I think you can see that it is the diversification that helps and not getting lucky on a particular asset class.

Also, you would have received most of the benefit by adding either SCV or international. You didn't need both of them, though it helped.

I don't think you'd need to have a firm belief in any particular market risk model. Even if you didn't think that the small cap premium or large cap premium was real, the mere fact that small cap stocks are not perfectly correlated with large cap stocks is enough to justify adding them to a portfolio for diversification reasons.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by vineviz » Fri Mar 29, 2019 3:19 pm

azanon wrote:
Fri Mar 29, 2019 3:15 pm
So much effort and time is put into avoiding the potential perils of using the 4% rule for retirement income (aka the "constant dollar" method), and often it is never realized that the greatest issue with that is actually the use of that withdrawal method itself. Said another way, trying to find the optimum portfolio for that retirement income method is the equivalent of trying to put lipstick on a pig.
This ignores the point of my post, I'm afraid.

The use of the 4% withdrawal was merely an example used to illustrate a universal concept: the benefits of diversification are particularly critical to portfolios in withdrawal, whatever the method for calculating the amount of withdrawal.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by azanon » Fri Mar 29, 2019 3:26 pm

vineviz wrote:
Fri Mar 29, 2019 3:19 pm
azanon wrote:
Fri Mar 29, 2019 3:15 pm
So much effort and time is put into avoiding the potential perils of using the 4% rule for retirement income (aka the "constant dollar" method), and often it is never realized that the greatest issue with that is actually the use of that withdrawal method itself. Said another way, trying to find the optimum portfolio for that retirement income method is the equivalent of trying to put lipstick on a pig.
This ignores the point of my post, I'm afraid.

The use of the 4% withdrawal was merely an example used to illustrate a universal concept: the benefits of diversification are particularly critical to portfolios in withdrawal, whatever the method for calculating the amount of withdrawal.
Depends on POV (I'm afraid?). You have some potential solutions looking for a problem. I just pointed out why it's actually not a problem. Constant %, for example, never runs out of money.

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by Vulcan » Fri Mar 29, 2019 3:27 pm

vineviz wrote:
Fri Mar 29, 2019 12:26 pm
It strikes many people as strange, even unnatural, that retirees likely need the diversification benefits assets like small cap stocks, international stocks, and long-term bonds MORE than someone in their twenties or thirties needs this things.
So, buy Total World instead of S&P 500 and Total Bond instead of intermediate treasuries?

Well, duh!
If you torture the data long enough, it will confess to anything. ~Ronald Coase

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by vineviz » Fri Mar 29, 2019 3:32 pm

azanon wrote:
Fri Mar 29, 2019 3:26 pm
vineviz wrote:
Fri Mar 29, 2019 3:19 pm
azanon wrote:
Fri Mar 29, 2019 3:15 pm
So much effort and time is put into avoiding the potential perils of using the 4% rule for retirement income (aka the "constant dollar" method), and often it is never realized that the greatest issue with that is actually the use of that withdrawal method itself. Said another way, trying to find the optimum portfolio for that retirement income method is the equivalent of trying to put lipstick on a pig.
This ignores the point of my post, I'm afraid.

The use of the 4% withdrawal was merely an example used to illustrate a universal concept: the benefits of diversification are particularly critical to portfolios in withdrawal, whatever the method for calculating the amount of withdrawal.
Depends on POV (I'm afraid?). You have some potential solutions looking for a problem. I just pointed out why it's actually not a problem. Constant %, for example, never runs out of money.
Diversification is not a solution in search of a problem. The core concept of finance that benefits every investor. Plus, as I just said, a diversified portfolio will be superior to an on diversified portfolio regardless of your withdraw skiing. Using a constant with drawl percentage? Diversification allows you to with draw a bigger percentage.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by rkhusky » Fri Mar 29, 2019 3:33 pm

vineviz wrote:
Fri Mar 29, 2019 2:05 pm
galeno wrote:
Fri Mar 29, 2019 1:42 pm
A USA Boglehead can get a completely diversified stock and bond portfolio using two ETFs: 50% VT + 50% BNDW.
It's almost as if you didn't read anything I wrote.
Does appear to be more diversified than your 3 example portfolios. Should therefore have better longevity.

I think most of us agree that diversifying by adding new efficient investments to your portfolio should have benefits. I would be surprised if in the future that were not true. Thus, adding small caps and international stocks to a large US - only portfolio should be beneficial. Not guaranteed, but a high probability that it will be beneficial.

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by bryanm » Fri Mar 29, 2019 3:41 pm

vineviz wrote:
Fri Mar 29, 2019 3:32 pm
azanon wrote:
Fri Mar 29, 2019 3:26 pm
vineviz wrote:
Fri Mar 29, 2019 3:19 pm
azanon wrote:
Fri Mar 29, 2019 3:15 pm
So much effort and time is put into avoiding the potential perils of using the 4% rule for retirement income (aka the "constant dollar" method), and often it is never realized that the greatest issue with that is actually the use of that withdrawal method itself. Said another way, trying to find the optimum portfolio for that retirement income method is the equivalent of trying to put lipstick on a pig.
This ignores the point of my post, I'm afraid.

The use of the 4% withdrawal was merely an example used to illustrate a universal concept: the benefits of diversification are particularly critical to portfolios in withdrawal, whatever the method for calculating the amount of withdrawal.
Depends on POV (I'm afraid?). You have some potential solutions looking for a problem. I just pointed out why it's actually not a problem. Constant %, for example, never runs out of money.
Diversification is not a solution in search of a problem. The core concept of finance that benefits every investor. Plus, as I just said, a diversified portfolio will be superior to an on diversified portfolio regardless of your withdraw skiing. Using a constant with drawl percentage? Diversification allows you to with draw a bigger percentage.
Pssh. Now you're just trying to convince us that more money is better. ( :happy )

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by retiringwhen » Fri Mar 29, 2019 3:58 pm

vineviz wrote:
Fri Mar 29, 2019 12:26 pm
During accumulation, portfolio inflows absorb or offset a large portion of the sequence of returns risk. In the absence of sequence risk, diversification doesn't seem important: the savings rate matters most in early accumulation and the average expected return starts to matter more later on.
This is a very interesting observation and my own experience supports this well. Even though the 2000s decade was a lost decade in most ways for investors, I came through quite well because it also coincided with my best years of work income and therefore my most consistent and high regular contributions to retirement accounts. I bought a lot of low cost shares in both of the troughs in that decade simply by dollar cost averaging.... I was also at 85/15% stocks/bonds with 15% international in roughly a total market configuration with a slight value tilt. I was not actually well positioned to be invested in the winners of that decade (bond and international at least for the first half of the decade)

If I had been retired with that AA and taking out regular withdrawals, the decade would have had a very very different feel.

When I hit 50, the reality of de-risking became reality and I have moved in steps to a more conventional 60/40ish portfolio tracking towards retirement because I understand the diversification benefit.

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by LilyFleur » Fri Mar 29, 2019 4:04 pm

Thanks for your analysis. :happy

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by azanon » Fri Mar 29, 2019 4:07 pm

vineviz wrote:
Fri Mar 29, 2019 3:32 pm
azanon wrote:
Fri Mar 29, 2019 3:26 pm
vineviz wrote:
Fri Mar 29, 2019 3:19 pm
azanon wrote:
Fri Mar 29, 2019 3:15 pm
So much effort and time is put into avoiding the potential perils of using the 4% rule for retirement income (aka the "constant dollar" method), and often it is never realized that the greatest issue with that is actually the use of that withdrawal method itself. Said another way, trying to find the optimum portfolio for that retirement income method is the equivalent of trying to put lipstick on a pig.
This ignores the point of my post, I'm afraid.

The use of the 4% withdrawal was merely an example used to illustrate a universal concept: the benefits of diversification are particularly critical to portfolios in withdrawal, whatever the method for calculating the amount of withdrawal.
Depends on POV (I'm afraid?). You have some potential solutions looking for a problem. I just pointed out why it's actually not a problem. Constant %, for example, never runs out of money.
Diversification is not a solution in search of a problem. The core concept of finance that benefits every investor. Plus, as I just said, a diversified portfolio will be superior to an on diversified portfolio regardless of your withdraw skiing. Using a constant with drawl percentage? Diversification allows you to with draw a bigger percentage.
So what you ignored from my initial response, and thus failed to recognize the value in my post, is that you used an arguably reckless retirement withdrawal method to illustrate that more diversified portfolios would better adjust to the massive shortcomings of the withdrawal method being used. If a new user, not schooled in finance read your thread only, they might think they are going to be fine now if they use portfolio #2 or #3 with the 4% rule. So where we disagree, is that I'm concerned someone might have that mistaken impression, and presumably that does not concern you. I am assuming it doesn't concern you because you didn't mention anywhere that you're not actually recommending someone use the 4% rule for retirement income.

So, I don't know, maybe consider next time saying that's a good point, and that would also help even more than a more diversified portfolio, because it is by far the more important of the two adjustments starting from "portfolio 1 with 4% rule".

Oh, and don't get me wrong - I agree that diversification is important too for "retirement outcome". I'm currently using VG managed payout fund, which is actually more diversified than any of the portfolios you suggested.

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by vineviz » Fri Mar 29, 2019 4:30 pm

azanon wrote:
Fri Mar 29, 2019 4:07 pm
So where we disagree, is that I'm concerned someone might have that mistaken impression, and presumably that does not concern you.
If you want to discuss the pros and cons of choosing a withdrawal rate in retirement, I’m sure there are threads about that.

This thread is about diversification.

What about diversification do you object to?
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by rkhusky » Fri Mar 29, 2019 4:50 pm

vineviz wrote:
Fri Mar 29, 2019 12:26 pm
By way of example, imagine two funds that each have volatility of 10% and are completely uncorrelated with each other. Even if both funds have the same individual risk (i.e. 10% volatility), a 50/50 portfolio of the two funds has lower risk (i.e. 7.1%). Diversification doesn't always lower the overall risk of the portfolio, because that's not the goal. The goal of diversification is to balance the risks within the portfolio.
I've always had an issue with volatility being equated with risk. If one is using past performance anyways, it seems like a better and more functional measure for risk would be related to SWR. Standard deviation is obviously much easier to calculate and work with, but it's correlation with true risk is nebulous.

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by Tamarind » Fri Mar 29, 2019 4:54 pm

rkhusky wrote:
Fri Mar 29, 2019 3:33 pm
vineviz wrote:
Fri Mar 29, 2019 2:05 pm
galeno wrote:
Fri Mar 29, 2019 1:42 pm
A USA Boglehead can get a completely diversified stock and bond portfolio using two ETFs: 50% VT + 50% BNDW.
It's almost as if you didn't read anything I wrote.
Does appear to be more diversified than your 3 example portfolios. Should therefore have better longevity.

I think most of us agree that diversifying by adding new efficient investments to your portfolio should have benefits. I would be surprised if in the future that were not true. Thus, adding small caps and international stocks to a large US - only portfolio should be beneficial. Not guaranteed, but a high probability that it will be beneficial.
I concur. It appears Galeno actually took OP's post very much to heart by recommending a portfolio that includes small cap and international, albeit at market weight rather than underweight as in Portfolio 2.

But the point that diversification benefit (at least in this case) does not require that each class be held at or even near market weight is interesting.

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by vineviz » Fri Mar 29, 2019 5:28 pm

rkhusky wrote:
Fri Mar 29, 2019 4:50 pm
I've always had an issue with volatility being equated with risk. If one is using past performance anyways, it seems like a better and more functional measure for risk would be related to SWR. Standard deviation is obviously much easier to calculate and work with, but it's correlation with true risk is nebulous.
The I way have come to think about it is that variance (aka volatility) is not a complete measure of investment risk, but for most applications it is a pretty reasonable proxy.

There are some situations where variance is a direct risk (matching liabilities, for example), especially in that it transforms fairly directly into the dispersion of terminal values. If you are saving money for a $100,000 mortgage down payment in four years an asset with a mean return of 2% and a std dev of returns of 1% is almost certainly preferred by most people to an asset with a mean return of 2.2% and a std dev of returns of 10%. With the former you'd be virtually assured of not losing money in nominal terms, whereas the latter could literally mean you end up with half of what you started with.

That said, I do think we need to evolve our language around this. There is some literature suggesting that higher moments (like skew and kurtosis) are worth paying attention to and, in a world with Portfolio Visualizer and Excel, no more difficult to measure than mean and variance.

Other risks are context dependent, right? A 30 year zero coupon Treasury bond might present a ton of interest rate risk to an 80 year-old pensioner who needs to sell it next month to pay for groceries but none to a 35 year old investor who can hold it to maturity. That investor might face other risks (e.g. inflation risk) but not interest rate risk.

And so on.
Last edited by vineviz on Fri Mar 29, 2019 6:09 pm, edited 1 time in total.
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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by vineviz » Fri Mar 29, 2019 5:43 pm

Tamarind wrote:
Fri Mar 29, 2019 4:54 pm
I concur. It appears Galeno actually took OP's post very much to heart by recommending a portfolio that includes small cap and international, albeit at market weight rather than underweight as in Portfolio 2.
I was unduly curt. The error that prompted my reply was in referring to the 50/50 VT/BNDW as "completely diversified". The global market cap portfolio has many useful traits, but "complete diversification" isn't one of them.

Even just using those those assets (VT & BNDW), 50/50 is far from the most diversified combination. That'd be approximately 11% VT and 89% BNDW.
Tamarind wrote:
Fri Mar 29, 2019 4:54 pm
But the point that diversification benefit (at least in this case) does not require that each class be held at or even near market weight is interesting.

Thanks. You can take the reality to be even more broad: the market cap weighted portfolio is virtually never the most diversified portfolio. You can be entirely confident market cap weighted portfolio can always be more completely diversified.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by randomguy » Fri Mar 29, 2019 6:02 pm

azanon wrote:
Fri Mar 29, 2019 3:26 pm
vineviz wrote:
Fri Mar 29, 2019 3:19 pm
azanon wrote:
Fri Mar 29, 2019 3:15 pm
So much effort and time is put into avoiding the potential perils of using the 4% rule for retirement income (aka the "constant dollar" method), and often it is never realized that the greatest issue with that is actually the use of that withdrawal method itself. Said another way, trying to find the optimum portfolio for that retirement income method is the equivalent of trying to put lipstick on a pig.
This ignores the point of my post, I'm afraid.

The use of the 4% withdrawal was merely an example used to illustrate a universal concept: the benefits of diversification are particularly critical to portfolios in withdrawal, whatever the method for calculating the amount of withdrawal.
Depends on POV (I'm afraid?). You have some potential solutions looking for a problem. I just pointed out why it's actually not a problem. Constant %, for example, never runs out of money.
Sure but it does run out of income. If you don't care about how much money you can spend and when, any scheme works. Put constraints on needed income and when and constant % fails regularly.


The question with factor/international/gold/whatever investing is how often the diversification shows up when you want. In 1966 both international and SV helped a lot. In say 2000, SV helped but international was more neutral (helped up until 2008 but then has been a drag).

I am not sure how many people who didn't believe in diversification early in life will believe in it during retirement. It is easy to make up a bunch of charts. It is a lot harder for people to live with an underperforming sector for a decade.

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by rkhusky » Fri Mar 29, 2019 6:04 pm

vineviz wrote:
Fri Mar 29, 2019 5:28 pm
The way have come to think about it is that variance (aka volatility) is not a complete measure of investment risk, but for most applications it is a pretty reasonable proxy.
The problem that I have with standard deviation is that it doesn't account for the period of the fluctuations. An investment with 10% monthly fluctuations seems much less risky than an investment with 10% yearly fluctuations or 10% multi-year fluctuations.

It is also interesting that, in terms of past performance, a 100% stock portfolio had a higher SWR than did a 100% bond portfolio. So, were bonds really safer than stocks?

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by vineviz » Fri Mar 29, 2019 6:18 pm

rkhusky wrote:
Fri Mar 29, 2019 6:04 pm
vineviz wrote:
Fri Mar 29, 2019 5:28 pm
The way have come to think about it is that variance (aka volatility) is not a complete measure of investment risk, but for most applications it is a pretty reasonable proxy.
The problem that I have with standard deviation is that it doesn't account for the period of the fluctuations. An investment with 10% monthly fluctuations seems much less risky than an investment with 10% yearly fluctuations or 10% multi-year fluctuations.
This one is easy, since scaling variance over different time periods is simple to do.

If you want a fund that is unlikely to drop 10% in a year, it’s standard deviation tell you that.
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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by marcopolo » Fri Mar 29, 2019 6:25 pm

rkhusky wrote:
Fri Mar 29, 2019 6:04 pm
vineviz wrote:
Fri Mar 29, 2019 5:28 pm
The way have come to think about it is that variance (aka volatility) is not a complete measure of investment risk, but for most applications it is a pretty reasonable proxy.
The problem that I have with standard deviation is that it doesn't account for the period of the fluctuations. An investment with 10% monthly fluctuations seems much less risky than an investment with 10% yearly fluctuations or 10% multi-year fluctuations.

It is also interesting that, in terms of past performance, a 100% stock portfolio had a higher SWR than did a 100% bond portfolio. So, were bonds really safer than stocks?
The 100% stock portfolio had SWR because it had a higher expected value, which overcomes the higher variance over time. You can see this on long term growth trends chart that is often posted on this forum. The higher slope produces better long term outcomes, even though the variance (the squiggles around the ramp) is larger for equities, they are swamped by the slope over long periods of time.

So, how to measure risk depends on what you care about. Variance is a convenient measure, but without considering the expected value, and the time frame, may not tell the whole story.

But, I agree that you would rather have a multitude of asset classes with low correlations and similar expected value. That definitely improves performance.

The real challenge in my mind is identifying such asset classes ahead of time. Correlation change over time.
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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by DetroitRick » Fri Mar 29, 2019 6:32 pm

OP - just wanted to say thanks for the effort you took in putting this together. Very well done, and for me in retirement, a good and timely reminder on portfolio construction. What you laid out so well, is basically what I originally learned about portfolio construction, and what I've experienced first hand as an investor. Although - frankly - I didn't think of it in terms of increased importance in retirement. But yes, I do believe that makes extreme sense now that I think about it.

This stuff is easy to forget at certain times, because as we all know, diversification doesn't always work equally well all the time. I'm thinking how many investor comments I heard during that last recession about diversification being "worthless" as a risk management tool. But that has not been my experience and is not supported by the data either (or my own long-term returns, thankfully). Still, over time and as part of a thorough plan of portfolio construction, it's the best game in town. And so I've always placed a lot of value on it.

Thanks! Stellar post.

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by galeno » Fri Mar 29, 2019 6:34 pm

You and I have a different idea of diversification. Here's mine:

5 individual stocks reduces your non-systemic risk by 50%. 12 individual stocks reduces it by 70%. 30 individual stocks reduces it by 80%. 50 individual stocks will reduces it by 85%.

After 50 individual stocks you are fully diversified (85%) and adding more stocks does nothing as far as non-systemic diversification. You CANNOT diversify away systemic risk.

I have a cool image that shows this asymptotic graph but I can't post it here.
vineviz wrote:
Fri Mar 29, 2019 2:05 pm
galeno wrote:
Fri Mar 29, 2019 1:42 pm
A USA Boglehead can get a completely diversified stock and bond portfolio using two ETFs: 50% VT + 50% BNDW.
It's almost as if you didn't read anything I wrote.
AA = 40/55/5. Expected CAGR = 3.8%. GSD (5y) = 6.2%. USD inflation (10 y) = 1.8%. AWR = 4.0%. TER = 0.4%. Port Yield = 2.82%. Term = 33 yr. FI Duration = 6.0 yr. Portfolio survival probability = 95%.

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by galeno » Fri Mar 29, 2019 6:40 pm

BTW. The above definition of diversification is an academic definition from my advanced investing class which I took as an advanced elective finance class back in the 1990s when I got my MBA from "the Harvard" of Central America: INCAE.

It hasn't changed AFAIK.

It would nice if I could get the pic on one of these posts.
AA = 40/55/5. Expected CAGR = 3.8%. GSD (5y) = 6.2%. USD inflation (10 y) = 1.8%. AWR = 4.0%. TER = 0.4%. Port Yield = 2.82%. Term = 33 yr. FI Duration = 6.0 yr. Portfolio survival probability = 95%.

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by marcopolo » Fri Mar 29, 2019 6:47 pm

galeno wrote:
Fri Mar 29, 2019 6:40 pm
BTW. The above definition of diversification is an academic definition from my advanced investing class which I took as an advanced elective finance class back in the 1990s when I got my MBA from "the Harvard" of Central America: INCAE.

It hasn't changed AFAIK.

It would nice if I could get the pic on one of these posts.
You can upload the image to tinypic.com and generate a URL link that can be posted here.
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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by packer16 » Fri Mar 29, 2019 7:08 pm

I agree with you on diversification but I am skeptical of factor diversification benefits because they are so time dependent & explanations so behavioral dependent. Clearly stock, bonds, international assets & other assets like re-insurance & specialty credit provide diversification benefits as their underlying return drivers are different. But factors are empirically derived relationships with no clear tie to economic drivers beyond speculation after the relationship is shown. Also those relying on irrationality for these factors may be observing one effect at the micro level (in behavior) that may not manifest itself in prices or only be manifest at times of distress.

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by pokebowl » Fri Mar 29, 2019 7:09 pm

marcopolo wrote:
Fri Mar 29, 2019 6:47 pm

It would nice if I could get the pic on one of these posts.
Would be interested in seeing it, is the issue just with finding an image host to upload or is it restricted use?
Nullius in verba.

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by galeno » Fri Mar 29, 2019 7:37 pm

Here's the diversification graph.

Image
AA = 40/55/5. Expected CAGR = 3.8%. GSD (5y) = 6.2%. USD inflation (10 y) = 1.8%. AWR = 4.0%. TER = 0.4%. Port Yield = 2.82%. Term = 33 yr. FI Duration = 6.0 yr. Portfolio survival probability = 95%.

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by vineviz » Fri Mar 29, 2019 8:11 pm

galeno wrote:
Fri Mar 29, 2019 6:34 pm
After 50 individual stocks you are fully diversified (85%) and adding more stocks does nothing as far as non-systemic diversification. You CANNOT diversify away systemic risk.
I will grant you that many old investment texts might have presented the topic in this way.

It's not correct, though, because it focuses on one characteristic (the number of stocks) that is irrelevant to the concept of diversification and ignores the three that are relevant: correlation, variance, and weights.
galeno wrote:
Fri Mar 29, 2019 6:34 pm
You CANNOT diversify away systemic risk.
This part is true: it must be since it's a tautology. What the older explanations ignored is that fact that company-specific risk isn't the only form of non-systematic risk.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by vineviz » Fri Mar 29, 2019 8:15 pm

packer16 wrote:
Fri Mar 29, 2019 7:08 pm
I agree with you on diversification but I am skeptical of factor diversification benefits because they are so time dependent & explanations so behavioral dependent. Clearly stock, bonds, international assets & other assets like re-insurance & specialty credit provide diversification benefits as their underlying return drivers are different. But factors are empirically derived relationships with no clear tie to economic drivers beyond speculation after the relationship is shown. Also those relying on irrationality for these factors may be observing one effect at the micro level (in behavior) that may not manifest itself in prices or only be manifest at times of distress.
Nothing I presented depends on factors. Expert consensus is clear that risk factors actually DO explain many of the benefits of diversification, but the benefits accrue regardless of whether this explanations are correct or not.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by rkhusky » Sat Mar 30, 2019 7:37 am

vineviz wrote:
Fri Mar 29, 2019 6:18 pm
rkhusky wrote:
Fri Mar 29, 2019 6:04 pm
vineviz wrote:
Fri Mar 29, 2019 5:28 pm
The way have come to think about it is that variance (aka volatility) is not a complete measure of investment risk, but for most applications it is a pretty reasonable proxy.
The problem that I have with standard deviation is that it doesn't account for the period of the fluctuations. An investment with 10% monthly fluctuations seems much less risky than an investment with 10% yearly fluctuations or 10% multi-year fluctuations.
This one is easy, since scaling variance over different time periods is simple to do.

If you want a fund that is unlikely to drop 10% in a year, it’s standard deviation tell you that.
STD ( SIN (2*pi*t/1 yr) ) = STD (SIN (2*pi*t/1 month) )

However, perhaps the Fourier transform of stock market returns would show that all fluctuation frequencies (1/period) are equally likely, and therefore, there are no funds that exhibit a higher rate of change than another. Or no one can predict what the period of the next fluctuation will be. On the other hand, bonds seem to be fluctuating with a multi-year-long period.

Another way of phrasing the questions is: what is the probability that after the next stock market drop of X%, will it take the market Y months to recover to the value just before the drop? The answer to that question is how I view risk.

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by vineviz » Sat Mar 30, 2019 8:53 am

rkhusky wrote:
Sat Mar 30, 2019 7:37 am
Another way of phrasing the questions is: what is the probability that after the next stock market drop of X%, will it take the market Y months to recover to the value just before the drop? The answer to that question is how I view risk.
I if I understand you, the question can be phrased more succinctly I think: what is the probability that the stock market will gain Z% in Y months where Z = 1+(X/(1-X)).

If you know the mean and variance of the asset you can answer this question easily and can do it regardless of whether Y is measured in days, weeks, months, or years.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by CyclingDuo » Sat Mar 30, 2019 9:35 am

vineviz wrote:
Fri Mar 29, 2019 12:26 pm
Not enough investors, in my opinion, give enough considered thought to the diversification of their portfolios.

If they think about it at all they might consider their portfolio to be "diversified" if they own some bonds and some stocks. And within each of those asset classes some investors might think they are "diversified" if they own a fund that holds all or most of the total stock market at market cap weights. Some investors might think they are "diversified enough" if they just own stocks and bonds from the world's largest - for now - economy.

It will surprise few readers if I point out that each such group of investors is mistaken. I have an example I want to present, but first a little background on diversification.

==========

In finance, diversification has a particular meaning that is a little more nuanced than the "don't put all your eggs in one basket" maxim. When less-than-perfectly correlated assets are combined in a portfolio, the final portfolio has a lower volatility than the average asset in the portfolio.

By way of example, imagine two funds that each have volatility of 10% and are completely uncorrelated with each other. Even if both funds have the same individual risk (i.e. 10% volatility), a 50/50 portfolio of the two funds has lower risk (i.e. 7.1%). Diversification doesn't always lower the overall risk of the portfolio, because that's not the goal. The goal of diversification is to balance the risks within the portfolio.

Investors sometimes confuse diversification with a different concept known as "de-risking". The explicit goal of de-risking a portfolio is to lower its volatility. And just as diversification doesn't always de-risk a portfolio, de-risking doesn't always improve the diversification of portfolio. Back to mu earlier example: instead of combining the two hypothetical funds (each with 10% volatility) you could achieve the same level of portfolio volatility (7.1%) by constructing a portfolio by investing 71% in either fund and 29% in cash. This portfolio has the same level of volatility as the first portfolio but less diversificaiton.

==========

The Example

By many measures, one of the worst times in recent history to retire was November, 1965. This period is, more or less, the worst case for a retiree who wanted to withdraw a constant amount of real dollars from their portfolio over a 30 year retirement. It's basically the period that sets the maximum sustainable withdrawal rate.

A retiree who started November 1965 with $100,000 and withdrew $335/month (equal to a 4% SWR) ran out of money in November 1995. This assumes the retiree invested in 60% large cap U.S. stocks (basically S&P 500) and 40% intermediate US treasuries.

Image

Curious about how much difference it would make if this hypothetical retiree had made some effort to better diversify this portfolio (call it Portfolio 1), I constructed two additional portfolios.

Portfolio 2 replaces some of the large cap stock with small allocations to small cap value and global ex US stocks: 48% large cap, 6% SCV, 6% international. This portfolio is designed (with the benefit of hindsight) to have the same overall volatility (aka risk) as Portfolio 1: stdev = 9.91%.

Portfolio 3 increases the allocation to bonds in order to have the same overall returns as Portfolio 1 (9.94%). It is 30% large cap, 7.5% SCV, 7.5% international, and 55% bonds.

Image

Subjecting all three portfolios to the same withdrawals, the difference in sustainability is appreciable. All three portfolios suffered declines in inflation-adjusted principal value, but Portfolio 2 and Portfolio 3 were much less impaired than Portfolio 1.

Image

In fact, Portfolio 2 would have lasted nine more years (depletion in August, 2004) and Portfolio 3 would have lasted another six months yet (depletion in February 2005).

If the investor had started with a withdrawal of $315 instead of $333 (a SWR of 3.78%), both Portfolio 2 and Portfolio 3 would have lasted nearly fifty years (until October 2015) versus just 38 years for Portfolio 1 (depletion in November, 2003).

Remember that Portfolio 2 had the same risk level as Portfolio 1, and that Portfolio 3 had the same average return as Portfolio 1.

Because of their improved diversification, however, both Portfolio 2 and Portfolio 3 had greater money weighted rates of return and therefore superior longevity.

Also keep in mind that increasing the diversification didn't require HUGE shifts away from the original equity allocation of large cap US stocks. The S&P 500 equivalent was still 80% of stocks in Portfolio 2 and nearly 2/3 of stocks on Portfolio 3. In both cases neither small caps nor international stocks were more than 20% of the equity allocation.

My point, I think, is that even small improvements in diversification can improve your odds of meeting your investment goals in the face of adverse market conditions.

A diversified portfolio will always contain assets that are doing better than average and some that are doing worse than average. This is definitionally true.

I think one challenge investors face is that the nature of saving for retirement causes investors to develop a systematic under-appreciation of the value of diversification.

During accumulation, portfolio inflows absorb or offset a large portion of the sequence of returns risk. In the absence of sequence risk, diversification doesn't seem important: the savings rate matters most in early accumulation and the average expected return starts to matter more later on.

Investors spend decades learning that diversification doesn't pay, without realizing that the rules change considerably once they retire.

Many investors intuit that something is different even if they can't quite articulate it. This is one reason, I think, that people generally prefer defined benefit plans to defined contribution plans, and that so many people let themselves be hoodwinked into variable annuities.

It strikes many people as strange, even unnatural, that retirees likely need the diversification benefits assets like small cap stocks, international stocks, and long-term bonds MORE than someone in their twenties or thirties needs this things.
Good post!!!

We are big believers in diversity that goes beyond the risk portfolio when it comes to income streams. Diversity of income streams during the accumulation years, as well as diversity of income streams during the decumulation years.

Retirees in 1965 also had diversity of income streams via the typical pension, SS, and portfolio. In addition, only a small percentage of the population born around 1900 made it much beyond the 30 years from 65-95 to take them past age 95 from that demographic group, with the highest percentage being female.

That time frame is pretty much where my grandparents fit (retired in the mid-1960's). I wasn't consciously aware of it at the time, but now in retrospect totally understand the diversity of income my maternal grandparents (to illustrate one set of grandparents) used. Pension from the railroad. Small pension from the municipality after serving for years. Social Security. Risk Portfolio (US bonds and dividend stocks). Orchards (apples, peaches, cherries). Always raised about 30 head of cattle. Farm land that they rented out in retirement. Stabled a few horses for monthly fees. Free range chickens (for eggs and fryers) and a turkey or two. Huge garden and they canned all of their produce to eat throughout the year. Grandpa did everyone's taxes in the small town for a fee (or barter) in retirement up until the year he died. So they had diversity of income streams that were non correlated. Obviously, all of the grandkids spent various parts of our summers on the "farm" doing chores and getting an inside look at how they functioned - even though we were not aware of the why of their diverse financial income streams. We all learned a lot about peaches, apples, cherries, canning, cattle, horses, chickens, eggs, killing snakes, shoveling manure, bailing hay, making cherry/apple/peach/blackberry cobbler and pies, etc... .

That set of grandparents died at 89 and 92 and did not outlive their money or diversity of income streams. Other sets of grandparents all had unique diversity of income streams as well.

Simply posting to add that diversity of investments in the stock/bond portfolio is not where the discussion about non correlation should end. Diversity of income during pre-retirement as well as post-retirement, diversity of income streams, and thinking about preparing for a 30+ year period that improves retirement outcomes could certainly include a broader look than just the risk portfolio. :beer
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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by Tyler9000 » Sat Mar 30, 2019 10:44 am

We need a standing ovation emoji. Fantastic post, vineviz. :beer
vineviz wrote:
Fri Mar 29, 2019 12:26 pm
It strikes many people as strange, even unnatural, that retirees likely need the diversification benefits assets like small cap stocks, international stocks, and long-term bonds MORE than someone in their twenties or thirties needs this things.
Personally, I'd argue that most people could use more diversification in their portfolios regardless of age, although for different reasons (your math on the raw numbers is spot-on). Younger accumulators likely don't have the experience or sense of investing history to understand the true downside risk of their asset allocation choices, and popular high-equity portfolios run a good chance of eventually spooking them to sell at the exact wrong time. And for retirees the reason is a lot more practical, as volatility is even more measurably damaging to your compound returns once you start also accounting for regular withdrawals. So IMO the connecting factor for both is the desirability of consistent investing options that grow and protect your money in both good times and bad. Such portfolios do exist, but to your point they require more forms of diversification than many people are accustomed to.

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by packer16 » Sat Mar 30, 2019 10:56 am

vineviz wrote:
Fri Mar 29, 2019 8:15 pm
packer16 wrote:
Fri Mar 29, 2019 7:08 pm
I agree with you on diversification but I am skeptical of factor diversification benefits because they are so time dependent & explanations so behavioral dependent. Clearly stock, bonds, international assets & other assets like re-insurance & specialty credit provide diversification benefits as their underlying return drivers are different. But factors are empirically derived relationships with no clear tie to economic drivers beyond speculation after the relationship is shown. Also those relying on irrationality for these factors may be observing one effect at the micro level (in behavior) that may not manifest itself in prices or only be manifest at times of distress.
Nothing I presented depends on factors. Expert consensus is clear that risk factors actually DO explain many of the benefits of diversification, but the benefits accrue regardless of whether this explanations are correct or not.
Not directly but the SCV benefit is dependent upon the historical premium being there and as divergent from US stock returns as it has been in the past. In terms of explanation, factors have explained past returns but they may or may not explain future returns. IMO the danger of factors is depending upon their past behavioral characteristics continuing going forward which IMO is a speculation & the reason why some many historically good looking diversification moves do not work out going forward.

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by vineviz » Sat Mar 30, 2019 11:09 am

packer16 wrote:
Sat Mar 30, 2019 10:56 am
Not directly but the SCV benefit is dependent upon the historical premium being there and as divergent from US stock returns as it has been in the past.
Not here, it's not. As I said in my original post:
Portfolio 3 had the same average return as Portfolio 1.
If an asset you add to get better diversification happens to turn out to have higher return than the portfolio you started with, that's definitely a bonus.

But it's not necessary: combining two assets with the same return can improve outcomes so long as their correlation is anything less than 1.0.

You can even add an asset with LOWER returns to a portfolio in decumulation and end up with MORE money, either in terminal value or amount of income.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by Tyler9000 » Sat Mar 30, 2019 11:10 am

Tamarind wrote:
Fri Mar 29, 2019 2:44 pm
Similarly, how much of the benefit can be attributed to international diversification vs size diversification vs duration diversification?
The key insight of guys like Ray Dalio and Harry Browne that has influenced me most is the concept of economic diversification. The idea is to choose different assets that respond strongly to core economic conditions like prosperity, recession, inflation, and deflation. Economic conditions may be impossible to predict and time for trading purposes, but the response of the asset when that condition manifests is often well-known and allows you to build an asset allocation prepared to work in any situation. In my experience, the portfolios that do this well tend to have superior retirement performance thanks to their overall consistent growth.

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by packer16 » Sat Mar 30, 2019 11:49 am

vineviz wrote:
Sat Mar 30, 2019 11:09 am
packer16 wrote:
Sat Mar 30, 2019 10:56 am
Not directly but the SCV benefit is dependent upon the historical premium being there and as divergent from US stock returns as it has been in the past.
Not here, it's not. As I said in my original post:
Portfolio 3 had the same average return as Portfolio 1.
If an asset you add to get better diversification happens to turn out to have higher return than the portfolio you started with, that's definitely a bonus.

But it's not necessary: combining two assets with the same return can improve outcomes so long as their correlation is anything less than 1.0.

You can even add an asset with LOWER returns to a portfolio in decumulation and end up with MORE money, either in terminal value or amount of income.
The issue IMO of the replace stocks with more bonds/SCV is the result is very time dependent & dependent upon the increased expected returns for SCV vs. stocks showing up. I had thread that was following Larry S.'s suggestion of this after he appeared in the NYT:viewtopic.php?t=169397. The results were not encouraging and I have been following this up and LP is still not above the standard portfolio. Here are the results from 2012 (the year after Larry was published in NYT) to 2018: 60/40 (S&P 500/Vanguard Bond) 8.5% return, 7.5,% std dev,; 50/50 (LP - 50 SCV/50 Bonds) 7.0% return, 8.4% std dev; 40/60 (LP) 6.0% return; 6.9% std dev. So clearly if someone was implementing & expecting SCV premium to show up, he was disappointed. IMO, for withdraws you have some additional timing risk here & diversifying into SCV does not help. IMO if you do this switch it incurs timing risk associated when/if the SCV risk premium will show up.

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vineviz
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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by vineviz » Sat Mar 30, 2019 12:10 pm

packer16 wrote:
Sat Mar 30, 2019 11:49 am
The issue IMO of the replace stocks with more bonds/SCV is the result is very time dependent & dependent upon the increased expected returns for SCV vs. stocks showing up.
This isn't a thing you get to have opinions about: what you say is just wrong. It is theoretically wrong, empirically wrong, and mathematically wrong.

I'm pretty sure I just explained why.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

rkhusky
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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by rkhusky » Sat Mar 30, 2019 1:39 pm

vineviz wrote:
Sat Mar 30, 2019 8:53 am
rkhusky wrote:
Sat Mar 30, 2019 7:37 am
Another way of phrasing the questions is: what is the probability that after the next stock market drop of X%, will it take the market Y months to recover to the value just before the drop? The answer to that question is how I view risk.
I if I understand you, the question can be phrased more succinctly I think: what is the probability that the stock market will gain Z% in Y months where Z = 1+(X/(1-X)).

If you know the mean and variance of the asset you can answer this question easily and can do it regardless of whether Y is measured in days, weeks, months, or years.
STD ( SIN (2*pi*t/1 yr) ) = STD (SIN (2*pi*t/1 month) ) = 1/sqrt(2)
MEAN ( SIN (2*pi*t/1 yr) ) = MEAN (SIN (2*pi*t/1 month) ) = 0

You cannot differentiate these two cases of fluctuations with a period of 1 month versus a period of 1 year with the standard deviation and the mean.

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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by vineviz » Sat Mar 30, 2019 2:30 pm

rkhusky wrote:
Sat Mar 30, 2019 1:39 pm
You cannot differentiate these two cases of fluctuations with a period of 1 month versus a period of 1 year with the standard deviation and the mean.
I'm not sure I understand your question, then.

Annualized standard deviation is just monthly standard deviation times the square root of 12.

Annualized mean return is just (1 + monthly return) ^ 12.

If you know the monthly mean and variance, you know the annual mean and variance: they are literally just mathematical transformations of each other.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

TxInjun
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Re: Diversification Can Improve Retirement Outcomes (SWR) [Very Long Post]

Post by TxInjun » Sat Mar 30, 2019 3:12 pm

Hello vineviz,

Excellent analysis, thanks. I'd like to play around, I can clearly see you did this analysis on PortfolioVisualizer :-) but am unable to see where you are able to push the start window to 1965. Can you please let me know how you constructed this analysis on PV?

Thanks and cheers

TxIn

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