The wealth effect is an economic concept that describes how people’s spending behavior changes when their perceived wealth changes, even if their actual income hasn’t changed.
When people feel richer, they tend to spend more.
When people feel poorer, they tend to spend less.
I used to struggle to understand why housing is such an important component to US consumer spending but if the respected investors tell me there is a wealth effect in housing, then maybe let me accept that.
More and more Americans own stocks and the fall in equity valuations may have start to worry Americans enough to refrain from spending.
3Fourteen Research shows this chart that shows that the recent market drawdown has caused a drawdown in household equity that is equivalent to 23% of US GDP. This ranks as the fourth worst since 1950.
Jenny Van Leeuwen Harrington, Chief Executive Officer of Gilman Hill Asset Management mention in a recent episode of the Compound and Friends show that one of her clients retire this year with a pretty decent portfolio. The client is freaking out when she saw her portfolio down more than 10% and won’t dare to travel and buy stuff.
I learn that listening to someone telling you that you have money to spend, that your portfolio can handle this kind of capital volatility is very different from your very own perception of how your portfolio behaves.
An adviser at Providend shared with me how a couple that came in as clients nodded and show that they understand what the adviser is sharing during sessions about how we look at investing, and what we understand about market turbulence. We go through how the actual investing experience can be like, why we build the portfolio, the income strategy in certain ways specifically to address some of these potential concerns.
In the end, the pair of clients kept bugging, was shock that their portfolios can have poor performance periods, especially early in their time investing with us, and we could not jog their memory well to when we explain these concepts to them.
We always have a perception, an inference or a “hope” that some stuff are too complicated and when the time comes the plan will be okay.
This kind of market, when major equity indexes are down 18% in a very short span of time, is when you would revisit whether your plan is okay if you decide to retire may be at the start of this year.
Sometimes, I felt that some readers will feel that it is draggy for me to write so much content about topics like what are sustainable income strategies, the safe withdrawal framework, various aspect & application of these framework.
I like to consider the breadth of what are the likely outcome, and how well the sustainable income strategy that we considered will handle these breadth of outcomes, before we go through the outcome themselves.
If you haven’t, what you will be thinking about are EXACTLY the things I been trying to explore.
I read this very good financial advisory post from Alina Fisch, who serves women at Contessa Capital Advisers LLC about how we can plan in a forward-looking world that looks rather dystopian.
She shared this short white paper that is put out by AllianceBernstein specifically for retirees that are or have been thinking about retiring that needs income.
Its called Anti-Depression Advice for Retirees:
- Is cash the safest strategy for troubled times?
- How does this economic crisis differ from the Great Depression?
- What opportunities might exist despite the downturn?
Whoa… this sounds bad and it feels like it was written for you if you are retiring today.
Except that it isn’t.
It is written for those during the 2008 Great Financial Crisis.
The Great Financial Crisis was… so bleak at a certain point that we do not know if there will be a financial markets still. And I guess there are enough people that consider the best form of action is to have a portfolio fully in cash when they retire.
You won’t understand how bad it was until you fully experienced it.
This paper is basically to show the people back then that retiring in a cash portfolio is a poor strategy.
I find myself telling a few people in Providend this year: Risk during your income-spending phase is different from accumulation. It is no longer measured by your risk capacity (which is based on a risk profiling questionnaire), and your time horizon (how long of a run way you have before the point you need the money for your financial target).
Risk in income-spending phase is define as whether you will run-out of money, and not have a certain pre-agreed stream of income for the period that you need. It is no longer just about whether you can take volatility but whether you will run out of money.
If this is the way we define it, then we will realize all the risk profiling for investors is meant more for accumulators and does not work so well for income-spenders.
Anyway, I thought if someone does the research, and the illustration looked great, I should share it.
But first I want to share a little about what I understood of what AllianceBernstein did.
The Income Experience AllianceBernstein Simulated
They want to find out by using historical data to model the experiences of people who retired in every period starting from 1926 and answer 2 key questions:
- Would people retiring in previous periods have run out of money?
- Which asset allocation would have been the best strategy to fund retirement?
With the data from 1926 till the time of the paper (I suspect 2009), they are able to imagine if we split Kyith into 53 Kyith and send these 53 Kyith down each 30-year periods between 1926 to 2009.
They want to compare two asset allocations:
- 100% cash strategy
- 60% stocks 40% bonds
Each Kyith will take out 5% per year and see if it last 30 years. Now I have to admit, based on what I read, I think is more like Kyith will spend an equivalent of $50,000 on the first year from a $1 million portfolio, and continue to spend a flat $50,000 a year after that for the rest of 30 years.
This is because I cannot imagine how spending 5% of the prevailing portfolio value will make either portfolio run out because it is just mathematically not possible. E.g. if my portfolio is left with only $20,000 and 5% is just $1000 yearly. Very little income but my portfolio is not zero technically.
There are NO inflation adjustments.
Later on, instead of a flat 5% of the initial year, they decide to see how the allocation will fare if we adjust for inflation.
Now let’s see the illustrations.
No Contest – A 60/40 Portfolio Historically Has Been the Best Approach
Love the matrix but I think I need to explain. The matrix split the performance of the cash strategy and the 60/40 based on whether
- They last the entire 30-years.
- Ran out of money at some point.
All the 53 Kyith who are on the 60/40 strategy have that flat $50k yearly income for the 30-years. This means that whatever the shit that happen from 1926 to 2009 (high inflation, going off the Gold standard, Great Depression, oil shock, war and conflict), all the Kyith retirement survives.
In contrast, 51% of the Kyiths on 100% cash has an income that last 30 years.
This illustrations show which Kyith’s income stream survive and which one doesn’t. The year shows the starting year that a specific Kyith start spending from and attempt to spend for 30-years.
You will realize that in the last 27 periods, both strategies last for 30 years and it was the first 26 periods where the cash strategy ran out of money.
This is bloody interesting when presented this way because you would have thought a 100% cash strategy instead of one with equities would work better in those challenging 1930s periods.
After looking at so much safe withdrawal rates, I may know why. If your income stream is adjusted to inflation, and during those period there is very high deflation, your inflation-adjusted income went down but not in the case if you just spend a flat $50,000 yearly. But this does not explain everything.
The main reason is the returns of a 60/40 ends up higher despite the challenging conditions.
If We Consider Inflation Adjustment in Our Income Simulation
If we consider adjusting the income by inflation, then we will start seeing some of the 60/40 strategy to run out of money prematurely. 64% of those 26% that ran out of money lasted longer than a 100% cash strategy.
The 100% cash strategy ran out of money in 100% of the simulation.
You can see which are the challenging years where both strategies ran out of money pre-maturely.
I would always tell people if you want to only test the challenging periods, test if your strategy survives the 30-year period starting in 1937, 1966 and 1968. If they survive these three periods… your strategy is pretty robust.
The strategies that is most challenging are those periods starting in 1961 to 1973.
Why?
Persistently high inflation.
You will notice the retiree retiring at the height of the Great Depression did okay in a 60/40 portfolio spending 5%.
What made the Safe Withdrawal Rate closer to 3-4% isn’t a recession or market drawdown but persistent high inflation that you need to adjust your spending upwards.
Now if you understand this, you will know a few things:
- If you want to take risk by not factoring in a drawdown like a Great Depression 15-year bear, then you can start with a higher income.
- If you are okay to lose purchasing power during high inflation period and cap your income, you can start with a higher income.
How About Against 100% Fixed Income?
A fixed income strategy has higher returns than cash:
The 100% bond strategy improves the outcome for some of the periods where you spend an inflation adjusted income but not by a lot.
It is also interesting that in those periods that Kyith ran out of money, sometimes the bond strategy last the longest, sometimes its the 60/40.
It goes to show that when view over a spectrum of many different market periods, some strategies might not do as well.
Ending Words
I have a few ways to describe the safe withdrawal rate framework when it comes to income planning and this is one that I seldom brings out but I might as well did:
We are essentially trying to plan not based on the average outcome, before we start, and get a shock 1/4, halfway or 3/4 into it but to consider that we can be both very lucky and unlucky. If we have a good idea how unlucky we can be, then we can decide if we want to start our planning being very conservative or we want to live with the risk.
Most in this world would plan with average outcomes and in their minds, the unlucky situation happens “only to the most unlucky people”. Or they can be flexible with their spending if need to.
i can live with it if you wish to be flexible but again what is hard to get is the perception about how much you need to adjust or the nature of your income stream.
I can explain till the cow comes home but if you don’t actively listen, have a different perception in your mind, then you will still be shock or fearful when things that I have said could potentially happen before actually happen.
But I like the Alliance Bernstein paper. The illustration is nice.
Just don’t think a 100% cash strategy would always work well even if you want a flat income for 30-years.
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Kyith is the Owner and Sole Writer behind Investment Moats. Readers tune in to Investment Moats to learn and build stronger, firmer wealth foundations, how to have a Passive investment strategy, know more about investing in REITs and the nuts and bolts of Active Investing.
Readers also follow Kyith to learn how to plan well for Financial Security and Financial Independence.
Kyith worked as an IT operations engineer from 2004 to 2019. Currently, he works as a Senior Solutions Specialist in Insurance Start-up Havend. All opinions on Investment Moats are his own and does not represent the views of Providend.
You can view Kyith’s current portfolio here, which uses his Free Google Stock Portfolio Tracker.
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