Best Portfolio to Achieve 8% Annualized Return with Low Volatility

[Bailing-Bob]

It is generally accepted that 4% is a SWR
Plan for an average annual inflation rate of 3%

Based on the above all we really need is a portfolio that achieves an annualized return of 7%. Lets add a point and make it 8% to give us a bit more margin.

So rather then increasing risk (volatility) to achieve the maximum gain, we should be shooting for an 8% return with the lowest volatility possible.

Opinions respectfully solicited on recommended portfolio/asset allocations with the lowest possible volatility that will still have a reasonable chance of achieving an 8% annualized return.

Thanks

[wabmester]

Real estate. Inflation protected. Higher yield than bonds. Lower volaility than stocks.

But I would wait until the correction is over.

[ScaredtoQuit]

It's amazing how like-minded we are on this board. I have mulled that same concept over in my head many times also. However, I always come to the same conclusion... as soon as you go after a return more than about 6%, you are subjecting your money to the same types of risk as when you are going after 10%. You can moderate your volatility by increasing the percentage of your portfolio devoted to bonds, however in order to get that extra oomph, you've got to include equities and as soon as you do that you've got volatility. An interesting observation on your allocation... The lower the percentage of equities in your portfolio, the better they have to perform in order to pull up the substandard return of your bonds. The higher the return expected on your equities, the higher the volatility.

Some would say that all you have to do is wait until long term rates hit 8 to 9% and then lock in a portfolio of all bonds. That might work over an extended period of time if you make sure none of them are callable. But if long term rates are up that high, it's a good chance we are already in an extended period of very high inflation which would probably mean that 8 or 9% isn't cutting it anyway.

Interesting question and a reasonable goal. My view is that there is no free lunch. Anyone else care to give us the benefit of your experience?

[Spanky]

Quote:

Originally Posted by wab Real estate. Inflation protected. Higher yield than bonds. Lower volaility than stocks. But I would wait until the correction is over.

REIT funds are still going up while TIPS funds are stagnant.

[Hamlet]

I don't think that there is a way to do this with asset allocation, but I think there are portfolios of individual equities that could perform with less volatility than the market as a whole.

If I was building a portfolio to get an 8% return with lower volatility than the indexes, I would try something like:

USB
O
PFE
GAS
KO

Basically, find stable, slow-growth businesses with fairly decent dividends (shoot for about 4% average). You want as many different industries as possible.

I don't have anything to back this up, but I would guess the 5 stocks above would have less volatility together than the market as a whole, although I would also expect them to return a little less than the market as a whole.

Quote:

Originally Posted by ScaredtoQuit It's amazing how like-minded we are on this board. I have mulled that same concept over in my head many times also. However, I always come to the same conclusion... as soon as you go after a return more than about 6%, you are subjecting your money to the same types of risk as when you are going after 10%. You can moderate your volatility by increasing the percentage of your portfolio devoted to bonds, however in order to get that extra oomph, you've got to include equities and as soon as you do that you've got volatility. An interesting observation on your allocation... The lower the percentage of equities in your portfolio, the better they have to perform in order to pull up the substandard return of your bonds. The higher the return expected on your equities, the higher the volatility.

[Lsbcal]

I'd like 8% too with low (no?) volatility but that is a fantasy. TIPS right this moment will give you a real 2.38% for 30 years. If 8% equates to 5% real then the market cannot accomodate us with very low risk. So some equities will have to be thrown into the mix.

To get a picture of the volatility one can run FireCalc (advanced version) and look at the spreadsheet results for various periods. It is helpful to construct a histogram of past yearly returns to get a volatility picture and put your current returns into perspective. For instance, with a 55/45 portfolio where the equities are a total market fund and bonds are 5 year treasuries and one is withdrawing about 4.2% to live on I find that about 29% of the time the portfolio return for the year will be below a -2.5% return. Also about 9% of the returns will be below -12.5%. This was for the period 1925 to 2004. On a happier note 53% of the time the return was greater the +2.5%.

FireCalc does not have all the combinations of investment classes I'm currently in like TIPS and international funds but it's a good tool to get an idea of past downside volatility.

Les

[cute fuzzy bunny]

Pssst....Wellesley!

[Nords]

Quote:

Originally Posted by ScaredtoQuit Interesting question and a reasonable goal. My view is that there is no free lunch. Anyone else care to give us the benefit of your experience?

Go for higher returns with a high-equity portfolio, and deal with the volatility by keeping 2-5 years' expenses in cash. Consume the cash during years that the portfolio returns less than 7% and replenish it in up years.

Right now the yield curve is pretty flat, but bulding the cash stash from a ladder of small long-term higher-yielding CDs would minimize portfolio drag. The only downside of breaking into a CD in a down year would be forfeiting some interest.

Then there's always Bob Clyatt's approach of part-time work when necessary or for extras.

This portfolio gave great long-term returns during the accumulation years, including the 1987 & 2000-2002 air-pocket roller coasters. It's also worked well during our 2002-present ER years, but we'll have to get back to you on the long-term results in a couple decades.

Quote:

Originally Posted by El Guapo Pssst....Wellesley!

Or, uhm, yeah-- what he said.

[cute fuzzy bunny]

Or what I used to do...half wellesley and half wellington. Nice 50/50 split stock/bond. Right about a 4% dividend payout, much of it qualified dividends. Roughly a 9-10% total annual historic return. Low volatility.

[Bailing-Bob]

Thanks for the feedback.

For those who thought I was looking for a no risk ride, my original post did not say that. I know I need to assume some volatility to achieve any return north of what I can get from a CD. I am just looking for the lowest volatility portfolio that has a reasonable chance of getting an 8% return. No pension or employer funded medical to fall back on here.

I have considered a 50/50 portfolio of Wellesley and STAR (Star gives some exposure to international). Long term returns have been in the 8-10% range with SD in the 6-8 range. Only a couple down years with a 50/50 allocation to those funds. Might be the best combo, but I thought it was a good idea to field the forum for ideas.

Nords: Your approach assumes there will not be an extended period of returns south of 7%. You say your portfolio has worked but you did not say what your portfolio is, but since you are senior member of this forum I am sure you have posted in the past. Are you saying don't touch the equities and use all cash to fund expenses when return is less then 7% and tap the equities to cover all expenses when return is greater then 7%....or is there some proration calc you are using to determine how much expense gets funded by cash and how much from equities?

I know the holy grail does not exist but I think in ER we should not be shooting for the fences, when we just need a good series of singles to get us through retirement (but 3 strikes and were out of the game).

Thanks Again.

[JohnEyles]

Quote:

Originally Posted by Bailing-Bob It is generally accepted that 4% is a SWR Plan for an average annual inflation rate of 3% ... all we really need is a portfolio that achieves an annualized return of 7%.

Only if you need for it to last forever. A simple spreadsheet shows that a ROR
of 6% (i.e. a real return of 3% above your assumed 3% inflation) will support a
4% WR for 40+ years (assuming 3% inflation). This holds true over a wide range
of inflation rates. Even a real return as low as 2.375% (typical TIPS coupons)
supports 4% WR for 36-37 years.

The problem of course is that inflation and ROR don't tend to be consistent from
year to year. However, even if inflation varies wildly, if real return remains
constant (in other words, ROR tracks inflation), portfolio survival is similar.
The problem is when the two are out of sync, as so often happens, and high
inflation occurs during the same years as low ROR; you'll need high real returns
during some years to compensate for these evil years of low real returns. (It
may be instructive to build your own spreadsheet and play with this yourself).

What would be very helpful would be an investment where ROR *IS* locked to
inflation and thus real return is constant from year to year. There is one - it's called
TIPS ! If coupons were a wee bit higher, your best bet might be an all-TIPS portfolio.
You'd need a "ladder" scheme, where one TIPS matures each year, so that you can
pull out a little principal (when you roll the maturing TIPS to a new one) to
supplement the coupon interest and reach your 4% WR.

[cute fuzzy bunny]

Then you just have to hope you're dead 40 years from now...

Wellesley and Star work also, although the expenses on star are a little higher as there arent any admiral shares.

Wellington has about 10% foreign holdings, wellesley about 1%. So you're not completely domestic.

Then you can have the well fleshed out arguments about whether holding large US based multinational conglomerates like GE and XOM constitutes 'close enough' for some additional foreign exposure.

Or you could slap a little 'total international' tail on the donkey to round it up, which is what I ended up doing. Sort of felt like I was playing with the 'last 2%' but it made me feel like I was doing something and didnt cost much.

[REWahoo]

I'm doing another version of what El Guapo mentioned. In addition to a couple of years expenses in cash, I'm in Wellesley, Dodge & Cox Balanced, with a dash of Dodge & Cox International.

Don't know if it is the perfect solution, but if I'm not dead 40 years from now, look me up and I'll let you know how it worked out.

[cute fuzzy bunny]

Dodge and cox balanced is another very good fund for this, although the ER is a little more than I like to pay.

Oakmarks balanced is another decent on, although again, a bit expensive.

Although I havent done the numbers in a couple of years, wellesley was tough to beat on the loss side of things. Very few losing years and the losses were small. Might be a different story now. As of 2002-2003ish, they never had two down years in a row, never had a double digit down year, and the year following their individual single digit losses usually made up for it and then some.

More upside in the dodbx, but a higher stock component.

Wellesley also benefited greatly from the bull market in bonds in the 90's and early 2000's. Which might not repeat.

Several smooth rides available.

[Lsbcal]

I own Dodge & Cox Stock, Income, and International funds among others and agree that having a good dose of conservative funds could help in the future. Some have pointed to previous smooth rides with funds like Wellesley or Wellington that have a long and illustrious history.

Would just like to point out that you need to correct for inflation/deflation when checking the long term records. This is particularly important in an era of economic crisis like the early 1930's and 1970's. That's why I put down some of the FireCalc data in my previous post. Basically we all need to be prepared for some back to back years of economic crisis and then hope that it doesn't happen!

Les

[cute fuzzy bunny]

Good little chart
http://inflationdata.com/inflation/i...flation_SM.gif

I guess the simple perspective is 4% draw, 3% inflation, 1% to taxes and miscellaneous vs 10.74% for wellesley since 1970.

Lot of stuff happened in the last 37 years. Certainly nothing like the depression or the 65-75 mudhole, but I cant see what the forward looking investor would have bought that would have done well, or even any better, in those periods.

[brewer12345]

Quote:

Originally Posted by El Guapo Lot of stuff happened in the last 37 years. Certainly nothing like the depression or the 65-75 mudhole, but I cant see what the forward looking investor would have bought that would have done well, or even any better, in those periods.

A modest allocation to commodities would have gone a long way to better performance in the inflationary times. 30 year fixed treasuries would have been a great help in the depression. I intend to have both when I check out.

[Nords]

Quote:

Originally Posted by Bailing-Bob For those who thought I was looking for a no risk ride, my original post did not say that. I know I need to assume some volatility to achieve any return north of what I can get from a CD. I am just looking for the lowest volatility portfolio that has a reasonable chance of getting an 8% return. No pension or employer funded medical to fall back on here. I have considered a 50/50 portfolio of Wellesley and STAR (Star gives some exposure to international). Long term returns have been in the 8-10% range with SD in the 6-8 range. Only a couple down years with a 50/50 allocation to those funds. Might be the best combo, but I thought it was a good idea to field the forum for ideas.

You also might want to dig into Bernstein's "Four Pillars" and Dimson & Marsh's "Triumph of the Optimists" for more details on the risk-reward curve with asset allocation and long-term trends. For example inflation has been about 3% over the last century, but over the last 30 years it's been closer to 5%.

Quote:

Originally Posted by Bailing-Bob Nords: Your approach assumes there will not be an extended period of returns south of 7%. You say your portfolio has worked but you did not say what your portfolio is...

I'm going to have to start a "Nords portfolio" thread...
http://early-retirement.org/forums/i...6300#msg206300

It's still a work in progress as we liquidate Tweedy, Browne and move toward ETFs. The next time there's a sale we'd probably buy more DVY and IJS. I'm not sure that I'm physically or psychologically capable of selling a share of Berkshire Hathaway.

I think two years is a reasonable compromise on the number of consecutive down years but of course it won't avoid the worst possible cases. If we did have to sell stocks during a down market then hopefully we'd be selling something that was down the least and working in favor of our asset allocation.

Quote:

Originally Posted by Bailing-Bob Are you saying don't touch the equities and use all cash to fund expenses when return is less then 7% and tap the equities to cover all expenses when return is greater then 7%....or is there some proration calc you are using to determine how much expense gets funded by cash and how much from equities?

Pretty much. The idea is to use the cash stash during down years and to replenish it during up years, and the goal is not to be forced to sell stocks when they're down.

Again it depends on how far out of balance the portfolio gets and how our spending varies. Most of the calculators don't allow for flexible annual spending but you're probably not going to plan a round-the-world cruise when the market's down 30%. (Look at other posts for Cut-Throat's "bare bones spending" tactics.) We don't pro-rate or tweak it down to the last $10. Other than replenishing the cash stash and buying when there's a bargain, we try not to be too rigid.

As for the "senior member of the forum", I'm delighted to point out that El Guapo has way more quantity than me!

[cute fuzzy bunny]

I'm better looking and can drink more beer too!

[Bikerdude]

Quote:

Originally Posted by Nords Go for higher returns with a high-equity portfolio, and deal with the volatility by keeping 2-5 years' expenses in cash. Consume the cash during years that the portfolio returns less than 7% and replenish it in up years.

I generally agree with you. However, what does one do in a 1966-1982 period when equities return near 0%? Just interested in your take.