Stress Testing A Basic 6 ETF Retirement Portfolio

 |  Includes: TIP, TLT, VEU, VNQ, VTI, VWO
by: Lowell Herr

The following analysis examines what happens if a negative three sigma event strikes an investor close to retirement. What is the potential impact and how does one protect against such an event wiping out retirement savings?

To set the stage, we assume the investor is 65 years-old and plans to retire in two years at age 67. One million dollars is invested in the six ETF portfolio shown below. As a reference point, we are assuming the S&P 500 will grow at 7.0% per year during the retirement years and inflation is set to 3.5%. The growth rate is certainly not a given, but one needs to set a baseline for the following analysis.

The projected return for the six ETF portfolio is nearly 7.9%, but the figure we focus on is the 14% standard deviation. Negative three sigma events are not uncommon over a lifetime of investing and they are particularly painful for retirees. If one is early in their working career and just starting a retirement portfolio, a declining stock market is great news as one can build a solid base when stocks are cheap. That is exactly what happened in the 1970s when many current retirees were starting their portfolios.

The following portfolio is modeled after the "Swensen Six" portfolio.

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The following screenshot is a Monte Carlo calculation showing the retirement outlook for this 65 year-old, still saving $1,000 per month. This worker is in good health so the plan is to pull out 4% per year or $40,000 in today's dollars. What are the odds of running out of money?

With only a 10% chance of running out of money at age 90, this investor is in good shape. But what happens if a three sigma event strikes and 3 x 14% or 42% is clipped off this million dollar portfolio?

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Recall the standard deviation for this portfolio is nearly 14% even though 30% of the portfolio is dedicated to U.S. Treasury instruments (TLT and TIP). Reducing the one million dollar portfolio to $580,000 ( 1 - 0.42 = 0.58) completely changes the retirement picture. The following screenshot shows the prospects of running out of money if the market crashed one year before retirement. Now the investor faces a 10% chance or running out of money at age 79. More troubling is the 50% possibility of coming up short at age 89. All these projections are based on withdrawing a modest $40,000 per year.

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Faced with these potential projections, what strategies might this investor employ to avoid possible financial strain? The key is to reduce major losses and here are two models to consider. 1) Study and use the Faber-Richardson "Systematic Tactical Asset Allocation" model explained in their book, The Ivy Portfolio. 2) Study and use the ITA Risk Reduction model explained at this site. The ITA model is a modification of the Faber-Richardson model and it is now being tested with five portfolios on the ITA Wealth Management site. For examples, look up the Kenilworth and Gauss. These portfolios were selected as they were trailing their customized benchmark. It will take several market cycles to test the viability of this model. So far losses in particular asset classes have been reduced.

Disclosure: I am long VTI, VEU, VWO, VNQ, TLT, TIP.