Accumulating wealth almost always comes first. It is comparable to pushing a boulder, that gets bigger and bigger, up a hill that will take 30 years to summit. If you stop pushing the boulder up the hill your expenses in life will push it back down. Your goal is to get to the top, to a land called ‘Preservation’. But for now your head is down, you are goal oriented, persistent, and thinking of an easier time in the future.
Accumulating wealth is much harder than preserving it. When you’re in accumulation mode you must take more risks and wait for a longer pay off when you invest. And with the higher risks come more failures. Each failure requires a retrenchment and then an effort to hold the course and continue pushing higher. It’s not easy and can be increasingly stressful as retirement approaches.
Accumulating wealth is usually goal oriented, for example, to get to a "number”, or a total investable asset number. Everyone has a different number based on their lifestyle and expenses. For some people that’s $1 million. For others it is $10 or $100 million. Many of us are in the accumulation phase until we decide we don’t want to work anymore and retire, these are time-based, not asset-based decisions. The common thread is to maximize income while working and minimize expenses and persistently add to the retirement boulder.
A quick way to ballpark how big your retirement boulder will have to be is to estimate your annual living expenses upon retirement. Will you get a defined retirement benefit? Will you get Social Security? Subtract your living expenses from your retirement benefits and/or Social Security. The deficit, if there is one, can be made up from income from your retirement portfolio as well as selling assets in the portfolio. Take the annual deficit and divide it by .05 or 5% (more on why 5% is chosen later). This will give you a goal of how much you will need to save for your retirement nest egg (your boulder) so that it will be able to hold purchasing power while still cashing out 5% of its value each year.
A quick example:
Annual SS and pension benefits $45,000
Annual retirement expenses - $100,000
Annual Deficit - $55,000
Total needed for retirement $1,100,000 ($55,000/.05 = $1,100,000)
The portfolio composition of someone who is in the accumulation phase should be mostly in growth stocks diversified across many industries. The investor should also hold a healthy amount in cash for future opportunities (10-15%). Retirement contributions and savings into these accounts should be directed towards a cash/money market pool; from the cash pool new investments should be bought over time (one dollop a quarter) and in increments no bigger than 30% of a full position. This reduces excitement error.
Over time a portfolio of growth stocks will become concentrated by the weight of the winners and the lack of weight in the losing stocks. For example, if you had invested in 10 of the most successful growth stocks of the Dotcom era, today you would be grossly overweight Amazon and Priceline, with a large position in eBay and seven other investments that collectively are negligible.
Do not fight this overweighting, trimming losers is recommended but in growth-land, the few winners can run many multiples past where your hopes and expectations land—and it is this very area, the beyond expectations zone, that will carry the performance of the whole portfolio.
When in the accumulation phase, bonds and stocks that pay large dividends are not productive at growing the asset base faster than inflation and should be avoided. More risk must be accepted within the equity holdings with an understanding that several will fail completely but the winners (see above) should more than make up for any losing investments.
Preserving wealth is the easy part, right? I mean you are done pushing that lousy boulder, so we made it to the Preservation land, sounds like Promise land, and we can coast. Unfortunately, there are new worries, albeit better worries to have, in preserving wealth.
Unlike in the accumulation phase, which is goal oriented, the preservation phase is expense and inflation oriented. Specifically, rising expenses and/or inflation become the biggest risks.
The composition of a preserving wealth portfolio will consist of fewer risks from equity returns and more risks of maintaining purchasing power while withdrawals deplete total assets to invest. The equity positions should have a low beta, or volatility compared to the overall market. These positions should pay regular dividends that grow over time, a good indicator of this is the dividend growth over the last five years. The share price growth of the equity portion of your portfolio is the best inflation hedge, meaning as inflation rises over time, so should the value of the shares of stock.
A large portion of the portfolio should be invested in fixed income, or investments that have the similar traits of consistent payouts with very low volatility. Think high quality bonds: Government, Agency, or Corporate. Think ETFs for preferred stocks, REITs, banks, and the energy sector.
Between stock dividends, ETF dividends, bond interest payments, and income from money markets, minus any fees, is the free cash flow of the portfolio. Some of these income streams can be lumpy, so a one-year look back at total income is a good measure to smooth out the lumps and gauge an average per month.
This investment cash flow minus your living expenses leaves a sum. If it is a positive sum, you can reinvest the excess back into the portfolio to get further ahead of your expenses. If it is negative, that is, your investment income is less than expenses, then selling assets will make up the difference. Most people are in the second camp, and withdrawals exceed investment income. If the withdrawal rate doesn’t exceed 5-6%, the portfolio can maintain its overall value in the future. Over the last 100 years, the average return of a traditional 60/40 portfolio has been about 7-8%. To maintain a margin of safety, planned withdrawals should be lower, 5-6%. If withdrawals exceed this, it can be expected that the portfolio will eventually wind down.
And that is what a preservation portfolio is about, staying ahead of the wind down.
In a round-about way this is all about asset allocation. Early in life, when you have a long investment horizon and are far from your monetary goals, the appropriate asset allocation is to hold mostly stocks and take on more risk. As you age the asset allocation shifts to add more and more fixed income to your portfolio and reduce the risk. Accumulate then preserve. Risk then derisk.
Starboard Wealth Management