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Wednesday, January 28, 2015

Does Your Investment Approach/Withdrawal Strategy Pass the "Sinatra Test" ?

As Ol' Blue Eyes crooned about moving to "New York, New York," the chorus belted out "If I can make it there, I can make it anywhere."

Today the so-called "Sinatra Test" is a credential measure.  If you've got the security contract for Fort Knox, you can handle the security anywhere.  If you cater a White House function, you can cater anywhere - no more questions asked!  I came across this concept in an interesting little book,

"Made to Stick

 by Chip Heath & Dan Heath.

Well, what about your investment philosophy/withdrawal strategy?  I would argue that a good Sinatra Test would be looking at retirement in 2000.  Stocks dropped the first 3 years and later hit a huge air pocket in 2008 and early 2009, known today as the "Great Recession."  This was a  period where many investors left the market, never to return.  Some label the first 10 years as the "lost decade."

Many retirees effectively blew their retirement by trying to jump on the internet bandwagon and then getting aggressive as the market reached new highs in 2007.

A heart stopper for the year 2000 retiree was 3 consecutive down years right at the start--one of the worst fears of the newly retired.  The 2008 housing crisis debacle piled on angst for stock pickers, tactical asset allocators, and market timers as the financial system was brought to its knees, requiring unprecedented monetary policy stimulus in conjunction with super aggressive fiscal policy.

Thus, the period from 2000 to present represents a "Sinatra Test."  Investment philosophies and withdrawal strategies that made it through this period could make it through just about any period.

To explore the most widely used withdrawal rate rule-of-thumb and basic low-cost index strategy, I turned to my favorite chart -

BlackRock Asset Class Returns:  A 20-Year Snapshot

which lists annual returns for 7 asset classes, color-coded, along with a diversified portfolio which is essentially 65% stocks/35% bonds.  The actual makeup of the diversified portfolio is given on the chart as the very last footnote:  "35% of Barclays US Aggregate Bond Index, 10% of the MSCI EAFE Index, 10% of the Russell 2000 Index, 22.5% of the Russell 1000 Growth Index and 22.5% of the Russell 1000 Value Index."

I assumed a

4% withdrawal rate,

adjusted annually for inflation as measured by the Consumer Price Index year-over-year change.  The portfolio used was the diversified portfolio presented in the BlackRock chart.  Indexers know that the portfolio can easily be replicated using low-cost index exchange traded funds.  It should be noted that, with a little creativity using the BlackRock data, it is easy to change the asset allocation.

The exercise is shown in the following table:

Age Year Amount(t) w/d Invest Port. Return Amount (t+1) CPI
65 2000 1,000,000 40000 960,000 0.989 949,440 3.4
66 2001 949,440 41360 908,080 0.951 863,584 1.6
67 2002 863,584 42022 821,562 0.901 740,228 2.4
68 2003 740,228 43030 697,197 1.235 861,039 1.9
69 2004 861,039 43848 817,191 1.105 902,996 3.3
70 2005 902,996 45295 857,701 1.054 904,017 3.4
71 2006 904,017 46835 857,182 1.13 968,616 2.5
72 2007 968,616 48006 920,610 1.06 975,847 4.1
73 2008 975,847 49974 925,873 0.774 716,625 0.1
74 2009 716,625 50024 666,602 1.209 805,921 2.7
75 2010 805,921 51375 754,547 1.13 852,638 1.5
76 2011 852,638 52145 800,492 1.019 815,702 3
77 2012 815,702 53710 761,992 1.122 854,955 1.7
78 2013 854,955 54623 800,333 1.203 962,800 1.5
79 2014 962,800 55442 907,358 1.079 979,040 0.8

As you can see, for fun, I assumed the retiree was 65 years old in 2000.  He or she started with an assumed $1 million and the withdrawal ("w/d") started at $40,000 (the 4% rule).  The first withdrawal was taken on 1/1/2000, so the portfolio stood at $960,000 at the beginning.  The first yearly return for the diversified portfolio was -1.1%, which gives the .989 (1-.011).  So the end-of-year 1 (12/31/2000) portfolio value was 960,000*.989 = $949,440.  This, of course, is the starting value for the next year. The CPI numbers shown came from the Bureau of Labor Statistics site.

The bottom line is that the investment approach worked well.  As shown, at the end of the period, the 79-year-old retiree has a portfolio value almost equal to where it started.  The largest percentage amount draw down was in 2009, where almost 7% of the portfolio was withdrawn (50,024/716,625).  It is worth noting that one suggestion commonly made is to forego the inflation in down years for the market.  Another point of interest is that, if the retiree kept the assets in cash, the value of his or her holdings would have been $282,383 at the end of the period.


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