How Dedicated Portfolios Reduce Behavioral RiskAdvisor Perspectives
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The recent market volatility has caused stress, fear and even panic. But that emotional toil can be alleviated by constructing what we call “dedicated portfolios,” rather than blindly following the precepts of modern portfolio theory.
Most exposed are retirees who need to take withdrawals from their portfolio. They are subject to sequence risk, because taking withdrawals from their portfolio when markets are down is a worst-case scenario of reverse dollar-cost averaging. They also face the behavioral risks of abandoning all or part of their investment strategy because they can’t stomach the volatility. Of course, selling out and going to cash locks in the sequence risk unnecessarily at the worst time.
The market turmoil caused by the COVID-19 pandemic resulted in a massive stock market decline. But something that caught investors off guard was the bond market dislocation that led to more than an 8% drop in the Barclays Aggregate Bond index from March 2 to March 18. Historically (back to 1927), about 20% of the time when the U.S. stock market went down, so did bond prices (intermediate-government bonds -8%, long-term governments -24%, corporates -20%, munis -36%)
A total-return/systematic-withdrawal approach to generating retirement income failed under those circumstances, putting financial plans in jeopardy. Obviously, stock market declines put a lot of pressure on the portfolio. But a total-return approach to fixed income, using bond funds, makes the situation worse if NAV declines coincide with the need to take withdrawals for spending needs by selling.
How should retirees construct portfolios to be resilient through stock and bond market volatility, especially when their portfolios are the source of cash flows needed to cover living expenses? The portfolio needs to provide protection against sequence risk on both the stock side of the portfolio (the growth portfolio), and on the fixed income side (the income portfolio), as well as a foundation to help investors weather the storm and stick to their investment plan.
Dedicated portfolio theory (DPT), a branch of the institutional discipline of liability-driven investing (LDI), suggests that investors should segregate their assets into functional groups dedicated to the purpose to which they are best suited. Money needed for spending in a year or less is dedicated to cash in the investor’s checking account. Money needed for spending needs over the next several years (to between 5-15 years) is dedicated to a portfolio of individual bonds held to maturity in the income portfolio, where maturities and coupon payments match spending needs in terms of time and quantity. The balance of the portfolio is dedicated to long-term growth in stocks in the growth portfolio.
This means cash flows for spending needs are immunized from the market declines because the fixed income holdings are not subject to sequence risk. They mature as scheduled. The sequence risk for stocks is greatly reduced because they will not need to be sold for many years – up to 15 years in the most conservative case, far longer than the longest bear markets have ever been. Coupons and maturing individual bonds in the income portfolio provide a thick buffer of protected cash flows, giving stocks time to recover. On average, since 1925, when U.S. large-cap stocks have declined by more than 10%, it has taken 3.1 years to recover from previous peaks, with the longest taking 15 years (1929-1944).
Read the full article here by Stephen J. Huxley, Brent Burns and Jeremy Fletcher, Advisor Perspectives