Investment Objectives & Advice

Portfolio Size >33x Annual Expenses; Should you retire?

Financial Independce, Retire Early [FIRE] has become the aim of each and every youngster for various reasons. Vicki Robin and Joe Dominguez published their book Your Money or Your Life in 1992, which popularized the idea of achieving financial independence rather than spending the best days and years of your life working in a 9-5 to make money. The most common reason why people aim for FIRE is the daily pressure on the job. The current stress due to COVID situation is definitely working as a fuel for FIRE seekers.

Last week, One of my friend lost his livelihood to the current crash in job market. He has been one of those diligent saver/ investor that at his age of 37, he is able to accumulate a corpus of 33x of his annual expenses without any large liabilities due in foreseeable future. This has drawn him to the thought about hangging up his boots and living life as he pleases on his portfolio income. He has seen many articles talking about retirement corpus to be 30x of the annual expenses and the 4% withdrawl rule to sustain in retirement on portfolio income.On the back of this conversation, I agreed to put together some numbers for him to make an informed decision.

“30 times the annual expenses with 4% withdrawl rate, One can sustain the retirement on portfolio income alone.”

I have earlier also written about the points of retirement planning including the steps to Calculate the required corpus, Adjust for Lifestyle inflation, Create a Core & Satellite Portfolio based on your risk appetite & risk capacity.

My friend was of the opinion that if he will take the withdrawl rate of 3% conservative to preached 4%, He can surely sustain his retirement. He was not aware of the other pointers around this thumb rule so he wanted to understand the same in details. The 3% withdrawl means that If we have a portfolio of 100, we will take out 3 for the expense and the reminaing money stays invested. For the exercise, we assumed the inflation to be 6% and return on investment as 7.2% (Equal to 40yr Govt of India bond). We calculated the balance at the end of each year as below and continued the same for next 60yrs. [Ignoring the liquidity requirement & Tax impact for now.]

YearPortfolioWithdrawl [For Expenses] @6% InflationReturns@7.2%Balance End of the year
1100.03.07.0 = 97*7.2%104.0
2104.03.18 = 3*(1+6%)7.3=
100.82 *7.2%

The orange/amber line in the chart represents the expenses, which continues to grow @6% inflation. At the end of 60th Year, It grew to almost 100 in itself due to exponential growth. The blue line represents the size of the portfolio, which continues to grow for next 30 years but the annual withdrawal amount grows higher than the return on portfolio and it start to deplete the portfolio. At the end of 42nd year, It depletes completely. This means you can survive for next 42years, at 3% withdrawal rate with portfolio size of 33x annual expenses. People retiring at the age of 60 +/- 2 can survive till the age of 100yrs but retiring early at the age of 37 can create a RISK OF LONGEVITY.

The next thing we analysed is the possibility of addition of investments with some risk but higher possible returns. The returns of such portfolio will be non-linear (varying from +ve to -ve), we can not simply use the mean return to draw a chart similar to above. Hence, I had set up a Monte Carlo Simulation to find out the impact of volatility. Over the 10,000 simulations I looked for success rate of >=95% such that Portfolio survives upto the 60yrs of age with 3% withdrawal growing at a 6% rate of inflation. This had helped us creating the minimum return required at a given risk/ volatility. [Chart Below]

Monte Carlo simulation can be done on excel itself for limited variablitiy, If interested to look at the file then drop an email to us and we will be happy to share the workings.

You can see as the risk/ volatility in portfolio increases, we need the higher returns to get 95% success to sustain 60yrs in retirement on portfolio income with 3% withdrawal. At 0% volatility, we need roughly 8.4% return in portfolio which is pretty difficult to get in the current scenario. At 5% volatility, we need returns just shy of the 10% and at the 20% volatility returns required is north of 15%. We need to make sure, the returns of the portfolio should be in the region higher than blue line for given risk of volatility.

Before you suggest that equity investing can give you the higher returns, let me quickly remind you that the annual mean return of equity index in India has been 11% over last decade+ with the volatility of annual returns of ~20%.

Using the concept of Asset allocation & Modern Portfolio Theory, we mixed the different asset classes using the Corr & Cov matrix along with their expected returns & volatility. We backtested the portfolio and it worked as desired, though as always future is unknnown. We reduced longevity risk of early retirement by inducing some volatility in the Portfolio. Though we come to conclusion that if he want to stay prudent, he should continue to look for the alternate employement and defer the complete dependency on Portfolio income by 3-5 years at the least. This would help him reduce the withdrawl value as well as number of years in retirement and create some buffer for unseen emergencies.

Let me leave you with these thoughts to ponder upon. Do you know the amount you need to be financially independent? Will it survive the required number of years? Have you backtested it? If not, then do it sooner than later and Keep Investing!!

Investment Objectives & Advice

Modern Portfolio Theory & It’s applications

With every increasing interaction with people, I come to realize that I have a “False Consensus Bias”. I have always assumed that what we learned in college/ school is something everyone knows and applies, It is not true!. A good majority of investors do not understand basic terms like volatility, difference between arithmetic/ geometric mean etc. Still, I am taking a plunge to start with one of the foundation concept in portfolio management “Modern Portfolio Theory” (There is nothing modern about it now, as this theory was first published in 1952.). It is relatively important to understand it’s basic premise and it’s applications can help you build a robust portfolio with little effort. Let’s start with few terms, which we need to understand before hand.

Risk/ Volatility (Variance/ Standard Deviation): Most of us might have heard that equity is a risky investment but only few of you can explain that “Equity is risky because of the wider range of returns possible and it is impossible to tell you the exact return for future.”  Among two investment options; The option with wider range of possible returns vs other, will be called riskier. So, Can you tell from the below chart of return distribution that between Large-cap and Mid-cap index, which is more risky & why? (Please answer in comment section.)

Large cap vs Mid cap

In statistical terms, it is measured using the variance or standard deviation of the returns. Higher the variance/ standard deviation, Riskier the investment.

Expected Returns (Mean/ Median): As Equity do not have a fixed return like our fixed deposits, we do get the range of returns as mentioned earlier and shown in above chart. Though, for our simple mind of common investor, we want to understand one return value as expected from the investment. This is roughly represented by geometric mean of the historical returns or median value. For our exercise, I have taken the geometric mean of the (rolling) returns for the period Mar 2007 – Sep 2019.

Avg Returns

Gold returns are of GOLD BEES ETF, N100 is Nifty 100 TRI, NM150 is Nifty Mid-cap 150 TRI and NS250 is Nifty Small cap 250 TRI

You will notice that the (geometric) mean returns of equity indexes N100, NM150 or NS250 increases when we look over a longer time horizon 3 yr or 5 yr at the same time, the volatility (StdDev) decrease. This is why we often suggest that equity is an investment class for longer time horizon. If you look at the return distribution graph for equities for longer horizons you will notice that it’s range of returns keeps on shrinking.

1 vs 3 yr return

Risk Averse Investor: In reality,  we all should be behaving like a risk averse investor. Risk averse investor means that an investor should not opt for risky investments unless he gets an additional returns. For example: if i suggest 8% returns in equity (which is volatile/ risky) vs 8% return on a fixed deposit in a credible bank. A risk averse investor should  always opt for fixed deposit. “This is why people have fed you with the notions that equity gives you a higher return over long period.” or “You can expect 12% or 15% or 20% returns on your equity investments etc.” Obviously the degree of being risk-averse will change from a person to person, hence one need to invest as per his risk appetite and risk capacity.

As per Modern Portfolio Theory (MPT), in simple terms, as an investor we should invest in an asset or portfolio which gives us the maximum expected return for a given level of risk (StdDev). In other terms, we should invest in a portfolio for a return which is least risky. for example: If i am looking at the 5yr rolling return Mean returns & risk. I will prefer to invest in Nifty Mid-cap 150 (NM150) vs Nifty Small cap 250 (NS250) because mid-caps have higher mean returns as well as lower standard deviations. Also, you can calculate the return per unit of risk to compare the portfolio and pick the portfolio with highest return per unit of risk. Among the 4 investments, if we calculate return per unit of risk using 5yr RR, Gold (8% / 8.7% =) 0.92 has the lower return per unit of risk vs Nifty 100 (11.5% / 4.5% =) 2.534 which is highest. This means that we should never pick gold among these 4 options and stick to Large caps to a large extent unless we want returns in excess of 11.5% in our portfolio (Based on the data).

Though MPT does not just stop here, but on the next level suggests that each investment option have a degree of Correlation. (Two investment options can have a similar return cycle, which means that both the assets/ investment option gives you positive return or negative returns, are having +ve correlation. They can have opposite cycle, which means that one of the assets/ investment option gives you negative return and the other have positive returns, and having -ve correlation.) Mixing these negatively correlated assets can reduce the volatility of the portfolio. Below table is the correlation metrics of these 4 investment options, This shows that gold has a negative correlation with all these equity indexes.

Coorelation Metrics

I am not going to get into the details of how to calculate the expected return and standard deviation of a portfolio with more than one investment option. Though it is much easier to perform those calculations in excel. Just to test the theory, I made a portfolio of 10% Gold and 90% Equity Nifty 100 TRI using 5yr RR. The expected return comes out to be 11.14% but the standard deviation reduces to 3.6%, which means our returns per unit of risk increases 3.06 vs 2.54 or Nifty 100 TRI alone. We can also find the maximum return per unit of risk in excel using Solver function. The max return/ risk turns out to be 3.9 while taking 29% Gold/ 71% N100, expected return 10.49% with standard deviation of 2.7% only. This at-least confirms one thing in theory that you should not ignore the role of gold in equity portfolio, if not more keep at least 5-10% in your portfolio. You can use the excel to identify the portfolio of your funds mix to get the best sharp ratio, just drop your email id and i will be happy to share the excel with pre-set formula to use. Some basic learning from this exercise:

  1. Equity investing should be for longer time horizons preferably >5yrs
  2. Large Caps (Nifty 100 TRI) has the best return per unit of risk, If you are happy with 10-12% returns then it is prudent to stay invested in Large Cap oriented funds only
  3. Small Caps have the poorest return per unit of risk, it is best to avoid them even for longer investment horizons. (You should read more at Should you buy Small Cap funds?)
  4. Definitely think of adding some gold to your portfolio 5-10% can do wonders in terms of not returns but reducing risk because of it’s negative correlation with equity. (You should also read Gold: To buy or Not to buy!)

This Dhanteras go ahead and buy some gold that glitters either it can be SGBs, Gold ETFs or Gold Funds, actual Gold coins in the decreasing priority. Happy Investing!!