All-ETF Portfolios From Agile Investing Applied 'Real-life'

[Note: This is the second of Geoff's two responses to the Agile model portfolio -- first is here.] One of the most important issues in portfolio planning is determining whether a portfolio is allocated to properly meet an individual’s specific needs. People frequently make allocation decisions that have very little connection to their personal situations. In particular, many investors do not understand how building more or less aggressive portfolios impacts their ability to provide for income in retirement.

Quite often, a portfolio with higher short-term risk will reduce your long-term risk of running short of funds in retirement. Finding the right risk-return balance requires that you build strategically diversified portfolios and analyze them in the context of your specific case.

To demonstrate this effect, I have taken three well-designed portfolios by Agile Investing and looked at how well they would serve one specific person. To examine this issue, I have used our Monte Carlo portfolio simulation tool. Our projections suggest that the future returns and volatility in these portfolios will be:

The Conservative case has substantially less short-term risk than the Aggressive case, as measured by the annualized standard deviation in return. Do these results suggest that a more risk-averse person will prefer the Moderate or Conservative portfolio? These portfolio designations are correct for describing short-term volatility, but must be considered with some care in light of long-term planning goals.

I looked at a test case of a 40-year old John Doe with $150,000 invested, and making annual contributions of $18,000 per year. John plans to draw $65K per year in income upon retirement (in 2005 dollars). If John looks at his probability of running out of money by a certain age in retirement, he can see which portfolio is riskier for him. In the Conservative case, John has 20% chance of running down his portfolio by age 85. If he follows the Aggressive allocation, he has a 20% chance of running down his portfolio only if he lives to 104. John Doe’s future is considerably less risky if he invests in the Aggressive portfolio than if he allocates according to the other two (less risky) portfolios.

For any individual, there will be an appropriate balance between risk and return that will maximize his or her chances of reaching financial goals while limiting the chances of substantial losses. Without examining a portfolio allocation for your specific situation, however, it will be very difficult to determine where the optimal balance of risk and return falls. Generic approaches based purely on age have some value, but do not account for a range of factors including the specifics of current portfolio size, ongoing contributions, etc. Similarly, looking only at short-term risk/return tradeoffs may lead to decisions that are not ideal for longer-term investing horizons.

[This is an executive summary of a larger paper: When More Risk is Less Risky (.pdf)]