Sequence of Return Risk

Discussion in 'Share Investing Strategies, Theories & Education' started by dunno, 2nd Sep, 2017.

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  1. Nodrog

    Nodrog Well-Known Member

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  2. Redwing

    Redwing Well-Known Member

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    Having a look at My Story on that Link

    At age 20, I moved from Istanbul to Toronto to pursue higher education. I finished the faculty of engineering at the University of Toronto in 1975 (mechanical) and started working as a systems engineer designing refineries and petrochemical plants with M. W. Kellogg (now KBR). During that time, I also completed Master of Engineering at the same university.

    Engineer... :D

    He did mention William Bernstein’s

    The Retirement Calculator from Hell

    This goes from Part 1 to Part 5 though, so get a coffee, put your comfy slippers on and pull up a chair
     
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  3. Nodrog

    Nodrog Well-Known Member

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    This is where I first learned about Otar then read a number of Otar's articles on his website and elsewhere:

    Bogleheads.org - Search (Otar)

    I've also read widely on other Authors in the field including Bernstein in particular, Bengen, Swedroe, Kitces and Pfau ... . Trouble is most of the research is US based. Although Pfau was a co-author with Jeremy Cooper (Challenger) in writing the following Australian report (annuities anyone:rolleyes:):

    eDocument Viewer (Yin and Yang of Retirement Income Philosophies)

    But what I like about this thread created by @dunno is that the focus is on Safe Withdrawal Rate and Retirement income etc research relevant to the Australian environment with it's unique characteristics. So the more Aussie research and data we can source as a group the better:). A very important topic I believe.
     
  4. dunno

    dunno Well-Known Member

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    The Otar site looks very good. What he calls aftercasting is exactly how I'm modelling my scenario's. If he has Australian data I suspect the software would probably be worthwhile exploring for somebody that doesn't have the data and excel knowledge. Although I find doing the calcs in the spreadsheet really helps me to comprehend the magnitude of the results.

    I absoulutly love his article on Monte Carlo simulation, He is spot on. You would not believe how many futile discsuuions I have had with traders that 'know it all' yet are oblivious to the zero serial correlation assumption that underpins the suitability of Monte Carlo simulations.
     
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  5. dunno

    dunno Well-Known Member

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    There has been some very good links posted - thanks everybody.

    But Austing 100 pages before breakfast!! Is that home brew making you get up too many times in the night?

    Who would have thunk it, Im on a property chat site and the knowledge, thinking and linking to relevant references is better than any investmen/share chat I've come across.

    Things you find hidden in the most unlikely of spots hey.
     
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  6. Nodrog

    Nodrog Well-Known Member

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    He he. I rarely wake up very early but for some strange reason I did this morning. Probably having nightmares about SWR:eek:. I hadn't read all of these in detail when I posted the links but enough to think them worthy of posting. Besides the beauty of being retired, have been since 41 (now 57). I've just woken up from a deep after lunch nap to recover from the stress of it all:D.

    I was a fanatical trader many years ago albeit TA oriented rather than fundamentally driven. I invest for the long term nowadays and let others do the work for me. I do however still enjoy reading about more general investing material such as this.

    I no longer own investment property but the reason why I hang out here is that the Investing / Share sites are dominated by traders who drive me insane if trying to have a discussion about more generalised investing, tax, SMSFs, structures and LICs etc. So I hide out here to avoid all that other madness. More time spent reading about these topics is likely to be much more rewarding to most rather than analysing what stock to buy.

    It's a shame @Il Falco is too busy to post at this time as he would be able to make an excellent contribution to the discussion as he always does. Very well read and an excellent deep thinker.
     
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  7. dunno

    dunno Well-Known Member

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    Somewhere I came across, but can’t remember the reference, the idea of a maximum of 4% of current balance or 95% of last year’s withdrawal. The 95% of last year is there to counter the volatility in income that a straight % of current balance creates.

    4% and 95% resulted in too many failures.

    upload_2017-9-5_14-31-58.png

    3% and 95% had 100% survivability for historical sequences.

    upload_2017-9-5_14-33-52.png

    But I don't like the distribution of income.

    upload_2017-9-5_14-36-30.png

    The Y scale is multiples - lets say of 80K. therefore the range of income is between 48K and 1.2M and some of the biggest income years coming late in retirement. Also I don't see a lot of sense in smoothing out the reduction in windfall income of 1M plus at the expense of low potential minimum outcomes. If your blowing a million, its on luxuries you don't need, so what if you have to pull back from that quickly if the market tanks. I'd rather higher minimums than smoothing volatility at the top of the income range - Next.
     
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  8. dunno

    dunno Well-Known Member

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    Ok. Dead simple (now were talking my language) straight % of current balance.

    Capital can’t run out under this method but income can get pretty small fairly quickly if you push the withdrawal % too high.

    Here’s the income distribution for 10% withdrawal starting with a lump sum multiple of 40, with 13 years of prior accumulation. The top of the income distribution range is about 22x and its early in retirement which is good, but by about 20 years a lot of the paths are down to about 0.5x and for the lump sum I’m looking at allocating that means about a 40K income.

    upload_2017-9-5_15-20-3.png

    The sequences for capital balances has got brewers droop. The lowest mutiple if my wife makes a 100 would be about 2.2x. 10% seems to be asking a bit much.

    upload_2017-9-5_15-24-59.png
     
  9. dunno

    dunno Well-Known Member

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    6% looks a good balance.

    lowest income multiple 0.5x and enough capital to still recover from the bad sequence causing that income level. Top of the income range 14x.

    upload_2017-9-5_15-31-11.png

    Capital range stays pretty well above 10x up too about 250x If you're lucky - Are you feelin lucky!!!!

    upload_2017-9-5_15-33-48.png

    Getting somewhere Now.

    Just got to play with the spreadsheet and see if I can put a minimum income in there without blowing the capital up. I ideally don't want the minimum income to be below 1x
     
  10. Lacrim

    Lacrim Well-Known Member

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    So what does all this mean - whats the key message??:confused:
     
  11. dunno

    dunno Well-Known Member

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    Trying to find a rate that can be spent from a capital sum that is very unlikely to see you run out of money.

    The Key message is the huge range in historical/potential outcomes driven by nothing more than the luck of when you were born dictating the time that you will go through different stages of saving/living of your financial capital.
     
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  12. dunno

    dunno Well-Known Member

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    O.K I think I’m done – could read, analyse and caress the numbers for ever but ultimately the future is unknowable so best get on with it.

    I have chosen the value of my multiple to be Average weekly ordinary times earnings (AWOTE) which currently stands at $1543.80 a week $80,500 p.a.

    AWOTE is consistently calculated and widely communicated so I think it serves as a good measure of changes in purchasing power that I want to match.

    I am going to allocate a multiple of 40 or 3.2M to funding retirement and that is what is embedded in the model.

    My Asset allocation is 100% equity.

    My draw down rule will be the greater of 1.25x AWOTE or 5% of current balance.


    Here’s the historical sequences for income.
    upload_2017-9-5_16-53-21.png
    And for Capital.
    upload_2017-9-5_16-54-33.png


    5% and 1.25x minimum won’t give high probability of avoiding finacial ruin in everybody's situation – If you don’t have exactly the same starting multiple and the same 13 years of accumulation remaining before attempting to live on the capital you will have an entirely different capital and income distribution. The key takeaway is not the numbers that work for my situation but that its enlightening to run the numbers for your own situation and be aware of the huge range of the distribution so that you can be prepared mathematically and mentally for at least the historical precedents.

    I’ve always understood the theory of sequence risk, but didn’t fully comprehend the incredible magnitude of the ranges until I did this exercise.

    Must remember to not beat myself up if luck goes against me – must also remember to try and not be to big an egotistical rich prick if luck goes with me.
     
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  13. Nodrog

    Nodrog Well-Known Member

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    At the start of this exercise in the current low interest rate environment I suggested a very conservative 3% SWR. Realistically around 3.5% would give the average investor a fairly high probability of not outliving their investments. Of course wealthy investors who invest sensibly have little to worry about unless a catastrophic event occurs. I assume in difficult times the average investor would adjust spending accordingly. The age old rule of Spend less than you earn!

    I also agree with Bernstein that given an unknown future and the amount of variables involved that trying to predict anything beyond an 80% chance probability of success is wishful thinking.

    Then again I'm just a rank amateur who really knows very little. Hence why I err on the side of being more conservative to provide a greater margin of safety.
     
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  14. dunno

    dunno Well-Known Member

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    After this process, I don’t like the traditional definition of SWR as in setting a fixed withdrawal amount based on initial capital and then adjusting for inflation, at least not if you have a significant allocation to equity. Trying to force a fixed income from a volatile asset is totally inefficient.

    Even imposing a minimum income which in my case equates to a SWR in the traditional sense of less than 1.5% looks to have one of the historical pathways closing in on an irrecoverable dive within our potential lifespan. I don’t see a traditionally defined SWR of 3 -3.5% as conservative – More a reasonable stab using a very inefficient tool- should give your 80% probability, so better than no heuristic rule at all.

    I think continually framing withdrawal capacity on current financial capital values is much more robust and efficient. You just have to be able to live with the volatility that holding volatile assets creates. If you can’t then you need to hold less volatile assets.

    “The age old rule of spend less than you earn” I agree with this principal but for financial capital, “earn” is ‘rubbery - what is earnings? Statutory profit? Discretionary free cash flow? Dividends? Is mark to market price fluctuations a part of your personal earnings?

    One thing we know for sure is the more capital we have the more we can spend. So maximising financial capital earnings is imperative. But as mentioned above defining earnings is rubbery and measuring on return outcomes is hijacked by the luck of the return sequence. So we can’t measure by outcome – We have to measure by process – Its only the process we can control.

    If the process is passive investing: all you control is your diversification choice, your expenses and your turn-over. If you want to maximise the process you need to go broad with low turnover and low costs.

    An active process is an entirely different beast – but you must be better than average – because average for all active is mathematically destined to be worse than passive.

    Totally agree with the unknown future – nothing is learnt here about the future, we are just learning some things from the past which we hope will hold us in good stead for the future – nothing is guaranteed. No amount of sophistication is going to allay the fact that all our knowledge is about the past but all our decisions are about the future.

    For me this exercise has been about seeing the historical sequence volatility for market returns (passive by default) I want to invest the funds I have allocated to retirement passively as I don’t like my chances of achieving above average when I’m old and senile or just don’t give a crap about investing anymore. Never focused on passive before – so I’ve got some learning to do, I'm off to check out some of the other threads.
     
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  15. willair

    willair Well-Known Member Premium Member

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    Maybe something to plan for very carefully , when as you say your old and senile and don't give a crap about investing..
    But I know one item when I go off in a few months to the companies AGM'S around Australia that I have been investing for over 25 years..You get there early and watch who comes out of the lifts most not all are above 60-age range maybe the others are at work or don't care... Some of those people are in their late 70's and ones that I talk too every year all have a different idea on insuring against what happened to them over the past 30 years and have experienced a very differential wealth from the rest of the people working 9-5 AND 5-9..

    You can learn a massive amount from people like that ,one Man that I talk too each year told me 20 years ago,, when I was lucky enough to sit down next to him told the only way to look at everything is in a quote by a US baseball coach ..Yogi Berra..
    quote..
    "It tough to make predictions --especially about the future."

    https://www.commsec.com.au/content/...c_Reporting_Season_Infographic_August2017.pdf
     
    Last edited: 6th Sep, 2017
  16. dunno

    dunno Well-Known Member

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    oops maybe I’ve created a wrong impression.

    I’m not dishing the possibility of older people being good active investors or being enthusiastic about investing or extremely experienced and knowlegable..

    I’m just preparing my plan for funds allocated to retirement on the basis that I might want to do something other than spend time on investing latter on or that I might lose my mental capacity to actively invest or that I might die a long time before my wife who has an equal interest in the capital but no enthusiasm for investing.

    I am in most ways a passionate active investor and I certainly respect experience – didn’t mean to create an impression that either active or older people were inferior. Just putting my reasons for wanting to invest the retirement allocation passively.
     
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  17. dunno

    dunno Well-Known Member

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    Actually, don’t think I truthfully addressed the real reason for wanting to go a passive investment approach to the retirement allocation.


    The biggest reason is that it’s a hedge against my otherwise active approach. I’ve had a good run so far but much like sequence risk – is that a result of luck or skill? I’ll never have enough evidence to know if I’m above average. If I’m average or below then I’m in for a bad trot to bring my results back to average. Carving out enough capital at this point to fund an adequate retirement based upon a passive approach and the worst historical sequences is insurance against myself. With that insurance in place I can continue to peruse my passion of active investing with PAF allocated funds and I can be motivated by achieving a good outcome because the cause is worthwhile instead of becoming disinterested because of the declining utility of personal money.


    Sorry probably getting off topic – but wrote it to clarify my own thinking, mods can remove it if its too out of line with sequence risk – my (probably weird) way of thinking sees it all related because market volatility is less than potential volatility from active and volatility more than average return drives sequence risk.

    Enough dribble - I had better go and do something productive.
     
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  18. Nodrog

    Nodrog Well-Known Member

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    In our circumstances the first priory is minimising the risk of us outliving our investments. Whatever's left over will be split between family and charities.

    I still agree with and feel most psychologicallly comfortable with the views of the likes of Bogle, Bernstein and numerous other wise and knowlegible older heads who suggest that the safest path is to be able to live off the natural yield of the portfolio. Of course behavioural factors come into this also. For those wanting to focus on mostly / all equities that natural yield is of course dividends. Then allow for the worst case historical impact on dividends being the Great Depression where dividends were cut for a period by 50%.

    Having enough of a cash cushion to top up dividends is important to us as retirees. It minimises the risk of ruin during that first decade in retirement and should another Great Depression scenario occur during our retirement. Of course some will complain about cash being a drag on portfolio returns but it's safety first in our case. And really the cash allocation required to top up dividends for even a long period is relatively small compared to the overall portfolio. Why? Because the unfortunate fact is that to live comfortably purely off dividend income will require a sizable equity portfolio.

    Let's also we realistic. If dividends are cut noticeably worse than during the Great Depression I think our investments will be the last thing on our mind. The Government will likely default on its debt so bonds will be worthless and Banks will potentially fail. It would not be pretty at all.

    And living off dividends doesn't mean one can't still drawdown capital at some stage preferably after the first decade or so of retirement when sequencing risk is less dangerous.

    Critically one needs to live within one's means. If dividends are cut substantially we'll adjust our lifestyle accordingly then use the cash cushion to top up any shortfall still remaining.

    Other risks we take into account include "home country" risk. And hence why we hold an allocation of "unhedged" International equities through ETF / LICs. If Australia goes to sh*t our dollar will likely do same hence the reason for "unhedged" equities. It's for insurance more so than returns.

    Of course I'm just a simple person, no expert on these matters and no doubt our approach is far from perfect. Based on history, barring a catastrophic event eg world wide nuclear war, the odds of us outliving our wealth is certainly low. More importantly it lets us sleep well at night. And after all that's all that matters. Otherwise the plan will fall to pieces at the worst possible time if it doesn't fit ones risk and psychological makeup.
     
    Last edited: 6th Sep, 2017
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  19. Nodrog

    Nodrog Well-Known Member

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    Interests and hobbies evolve over time especially in retirement. Priorities change. One also needs to consider his / her partner and interest in investing in regard to complexity. My wife doesn't share my interest in investing so I keep the portfolio's simple and requiring bugger all maintenance. The Beauty of dividend investing, nothing to do but watch the cash hit the bank account. No selling and rebalancing decisions required.

    For example this is now a part of our interests in retirement:

    The Vege Garden Thread
     
  20. Zenith Chaos

    Zenith Chaos Well-Known Member

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    A fixed value is too simplistic approach and used because most people can understand the concept and how it applies to them - ie I will get about $X0000 a year. A fixed rate is better, as it takes the current situation into consideration. I think all factors should be considered when determining how much to withdraw each year. One other thing people fail to consider, as you get older you spend less money. That could be included in the modelling.

    The investment side of decision making should only be about risk reward. "How do I maximise total return while minimising risk". Risks can be that someone knows sweet FA about investing or just doesn't want to risk wasting time on it and wants to go for a simple approach. Everyone has a risk appetite, which can be variable -"I'm about to retire, I have no more job income, I want to take on less risk".

    Put it all together and you have a risk managed model for how to invest and how to withdraw. You could keep it simple - keep cash allocation as age / 100 % and withdraw amounts in proportion to past year performance. I need to think a bit more about the model.