Maximum Drawdown and a few other questions

7upfree1973

Hello,
I am new to the forum (which is excellent btw) but think I have a reasonable understanding of equity investment and portfolio management more generally. I have been investing since my early twenties and have never been tempted to sell in a crash. However, as you get older, you have more to protect, hence my queries below.


Drawdown
I wonder if the collective wisdom of the forum has a view on the following strategy to deal with an unpleasant drawdown situation arising at the cusp of retirement (figures are illustrative and are expressed in present day value).
If we assume that I need, for example, £9k of income per anum at age 67 and that I have decided this will be taken at the rate of 3% per anum from a fund built up over the next 25 years or so. On the face of it, I will need a fund of £300k to fund my lifestyle. As at today’s date, I can invest in either equities (5.8%) or bonds (2.4%) to build up a fund of this size. Clearly I will need less if equities perform as expected (hoped!). However, that will not protect me if I suffer a drawdown of c. 50% the day before I retire.
To protect myself, I decide to invest 66% more (the broad increase in funding required to achieve my £300k fund). Ordinarily I would need to invest £750 at 2.4% and £450 at 5.8%. However, I invest £750 in equities. If I hit my 5.8% my fund is worth just under £500k. A 50% drawdown leaves me at £250k with an income of 7500 @ 3%. As I understand it, if I am all in bonds for 25 years (2.4%) my risk of a max drawdown is 12.4%. leaving me with £262k and a level of income at or around the same level as the 5.8% return on equities.


As far as I can tell, there is only one instance in the USA since 1926 over a single 25 year period where equities returned less than 5.8% net. Anecdotally, this would appear to be replicated in the UK. However, keeping in mind the spectre of Japan, I am internationally well diversified and am really betting that world stock markets keep rising. The risk of suffering a maximum drawdown is also low but it seems that it may occur 3-4 times every 100 years or so.



Is my strategy for over-investing a good plan for dealing with maximum drawdown in retirement? It seems to me that if you have twice as much as you might need, the odds are that you will enjoy a higher return come what may yet still be protected if the worst should happen.


Bonds
That leads me to my next question. I know that timing the market is a mistake when investing. However, if I am a Japanese investor in 1989 and can see that the PE of the Nikkei is over 80, would I really keep investing? My guess is not. At the extremes, all rules fall by the way side in my experience. That being so, can anyone see any value in the bond market at the moment? Could anyone really commit say 40% of their portfolio to this asset class given the price\yield environment? Despite what I say above, I would quite happily go 60/40 equities/bonds for all of the reasons that have been said elsewhere over many years. If not bonds, what other asset classes for a stable return? I have looked at global property reits but don’t fancy 40% of my money in that asset class (particularly where my house is paid for meaning that I am already overly exposed to the class). Maybe the answer is simply cash at the best rate that can be obtained (maybe not as much as 40%, though).

Star Managers
I completely accept the wisdom of index investing and that is where most of my funds sit. However, I am left with 25% of my equities with managers that have performed very well and have outperformed the index net of fees during my ownership. Most of this is because they happen to be in sectors that have performed well. The question is this: would you sell now or wait until they start to underperform?


Thanks in anticipation.

dunstonh

As far as I can tell, there is only one instance in the USA since 1926 over a single 25 year period where equities returned less than 5.8% net.

In the 20th century, the US was an emerging market. It is no longer an emerging market.

Is my strategy for over-investing a good plan for dealing with maximum drawdown in retirement?

Yes. Anything you put aside is always going to be helpful later.

That being so, can anyone see any value in the bond market at the moment?

The use of bonds is often there to allow other parts of the portfolio to be more adventurous. They counterbalance the risk and volatility and that helps with re-balancing. When bonds fall, a crash is more in the 5%-10% range. When equities crash, its more like 20-40%.

I have looked at global property reits but don’t fancy 40% of my money in that asset class (particularly where my house is paid for meaning that I am already overly exposed to the class).

Your main residence is what you live in. It is not an investment (for you anyway). REITs are very different and commercial property funds even more so.

I completely accept the wisdom of index investing and that is where most of my funds sit. However, I am left with 25% of my equities with managers that have performed very well and have outperformed the index net of fees during my ownership. Most of this is because they happen to be in sectors that have performed well. The question is this: would you sell now or wait until they start to underperform?

Why sell? Does the investment strategy of those funds suit your objectives?
A portfolio with mix of index tracker and managed is quite normal. Being totally biased to one of the other means you compromise.

7upfree1973

Thanks for the response.

I don't disagree that the house is not an investment as such. However, it is far larger than we will ever need when we retire and to some extent equity will be released when we inevitably downsize and sell. I appreciate that a REIT is quite different and more diversified than ownership of a single property could ever hope to provide. I see the equity in the house as an asset. For example, if we had decided to retain the cash and not purchase the house it would be in equities at this point in time. On the other hand we would have had a large mortgage. I think lots of people fail to look at debt when establishing their net worth.

In relation to the bond market, my concern is that while they act as a break, many people are relaxed about the performance of a 60/40 portfolio because of the returns that the 40% bond component has offered over the last 40 years. In the preceding 40 years, bond returns were far lower. I think if people thought the return component would be lower in the future their attitude to the portfolio would be different. Also, long term bonds are going to take a pounding when (if!) interest rates rise. I think the max drawdown rate would be a lot higher than the 25% figure that is quoted (I read somewhere that a 1% increase in rates would drop long term bonds by 10%).

Agree re the star managers. I will run them until they stop performing, I think (or my profile changes).

Thanks again.

kidmugsy

dunstonh wrote: »

Your main residence is what you live in. It is not an investment (for you anyway).

It is often what will pay the "care" bills. That makes it an investment.