By splitting the portfolio into portions dedicated to performing specific tasks—providing income or providing growth—the asset dedication plan represents a sort of division of labor. Each por- tion of the portfolio does not interfere with the other portion’s purpose. The provision of income with bonds automatically reduces risk by holding the bonds to maturity. It also uses just enough bonds to do the trick—no more and no less. By keeping the cost of providing the income to the lowest possible level, the remaining funds dedicated to portfolio growth are pushed to the highest possible level.
By following the asset dedication approach and dedicating the assets that are not needed to provide income to growth for the length of the planning horizon, Ms. Smith will enhance her overall portfolio performance in at least four ways.
1. Total return earned. No withdrawals will be made from the growth portion. All dividends can be automatically reinvested. This means that this portion will earn what is called total return—appreciation plus dividends. Without automatic reinvestment, dividends sometimes end up in cash, earning little return.
Asset Dedication—How It Works 51
2. No rebalancing.No periodic rebalancing is needed because there is no predetermined XYZ fixed formula as the driv- ing force behind the investment strategy. If the stock por- tion is growing rapidly, the funds can be left there to continue to grow. Under the forced-rebalancing discipline of fixed-formula asset allocation, investors are told to pull money out of the fastest-growing assets and put it into slower-growing assets. In bull markets, this is obviously a harmful strategy. It demonstrates the fallibility of asset allocation and how it can harm those who follow it blindly.
3. Impact of volatility diminished.Volatility is no longer an issue (at least short-term volatility). Not only does asset dedication remove nearly all the risks associated with bonds, it also lowers the actual and perceived impact of volatility on the growth portion.
To understand why this happens, it is important to know that volatility in rates of return has historically been lower over longer terms because there are both good and bad years to even things out. This is one of the key advan- tages of asset dedication as an investment strategy. Longer periods are inherently less volatile and thus less risky. The volatility of quarterly or even annual returns becomes irrelevant to someone who has a 5-year perspective.
One of the simplest ways to see this is to examine the range of returns from best to worst over longer spans of time (see Table 3.3). The first two columns show the range of returns for the prices of large-company stocks for 77 years, from 1926 to 2002. The best and worst years occurred in two successive years in the early part of the Great Depression: a gain of 54.8 percent in1932–1933 and a loss of −45.8 percent in 1930–1931. Equivalent figures for small-company stocks were a maximum gain of 187.0 percent (1932–1933) and a loss of −52.8 percent (1936–1937).
Figure 3.5 plots the best and worst returns for all time spans from 1 to 34 years that were possible during the 77-year period 1926–2002. The primary observation to make from Figure 3.5 is the fact that the range from best to worst narrows as the time span gets longer. This is evident in the funnel effect as longer and longer spans are included. A narrower range means less volatility, less uncertainty, and therefore less risk the longer the invest- ment horizon or holding period.
Asset Dedication—How It Works 53
Source:© June 2004, CRSP® Center for Research in Security Prices, Graduate School of Business, The University of Chicago; used with permission. All rights reserved. www.crsp.uchicago.edu.
Table 3.3
Best and Worst Annualized Total Returns for Small- and Large-Cap Stocks, 1-Year to 34-Year Spans, 1926–2002
Range of Average Annualized Total Returns Large-Cap Stocks Small-Cap Stocks
Span Best Worst Best Worst
1 yr 54.8% −45.8% 187.0% −52.8%
2 yr 41.7% −36.8% 88.8% −48.5%
3 yr 31.5% −28.7% 82.5% −49.0%
4 yr 31.0% −23.9% 83.0% −38.2%
5 yr 29.1% −14.1% 65.2% −26.7%
6 yr 25.2% −10.7% 40.2% −21.7%
7 yr 24.2% −4.9% 35.1% −17.8%
8 yr 21.8% −4.7% 34.1% −3.9%
9 yr 21.1% −5.0% 34.1% −2.8%
10 yr 20.5% −2.0% 29.6% −0.4%
11 yr 19.7% −2.1% 28.3% −0.3%
12 yr 19.4% −2.9% 30.4% −1.3%
13 yr 19.0% −3.3% 33.8% −2.3%
14 yr 19.1% −1.8% 31.9% 0.5%
15 yr 19.1% −0.1% 28.3% 2.3%
16 yr 18.3% 1.1% 26.1% 1.5%
17 yr 18.5% 2.9% 24.6% 3.9%
18 yr 18.7% 2.2% 25.7% 5.4%
19 yr 17.9% 2.4% 24.8% 5.3%
20 yr 18.0% 2.5% 24.0% 6.1%
21 yr 18.1% 3.2% 23.1% 8.1%
22 yr 17.5% 4.4% 23.9% 6.1%
23 yr 16.7% 5.2% 23.8% 7.6%
24 yr 17.2% 5.7% 23.2% 7.7%
25 yr 17.4% 5.4% 22.3% 9.0%
26 yr 16.2% 6.5% 22.7% 8.5%
27 yr 15.1% 7.5% 22.8% 8.8%
28 yr 14.2% 7.7% 22.0% 8.3%
29 yr 14.2% 7.1% 21.7% 7.5%
30 yr 13.8% 8.1% 21.3% 9.2%
31 yr 13.8% 8.3% 19.9% 10.1%
32 yr 13.6% 8.1% 19.9% 9.3%
33 yr 13.6% 8.6% 20.4% 10.0%
34 yr 12.8% 8.0% 20.1% 9.2%
The second key observation from Figure 3.5 is that small-company stocks have a wider range than large-com- pany stocks, meaning they are somewhat more volatile, but the difference becomes very small for longer periods.
It seems a small concession to make for the higher returns that small stocks offer over longer periods. For spans longer than 18 years, the worst possible return that has ever happened to funds invested in small-company stocks (–3.9 percent) was higher than the worst possible for large-company stocks (–4.7 percent).
Table 3.4 and Figure 3.6 exclude the Great Depres- sion and World War II years. They cover the period 1947 to 2002. The fluctuations are less extreme when the most distant past is removed. Only 1- to 11-year spans are included to provide a closer view of the funnel effect. For large-cap stocks, the best single year gain was 52.8 percent (1953–1954) and the worst loss, -26.3 percent (1973–1974), or a range of 79.1 percent. For 5-year spans since 1947, the highest annualized return was 29.1 percent, and the worst loss was 2.3 percent per year (which totals an 11.1 percent Figure 3.5
Small- versus Large-Cap Stocks: Best and Worst Annualized Total Returns over 1- to 34-Year Spans, 1926–2002
-100%
-50%
0%
50%
100%
150%
200%
1 yr 3 yr 5 yr 7 yr 9 yr 11 yr 13 yr 15 yr 17 yr 19 yr 21 yr 23 yr 25 yr 27 yr 29 yr 31 yr 33 yr
Large Best Large Worst Small Best Small Worst
Source:Table 3.3.
Table 3.4 Best and Worst Annualized Total Returns for Small- and Large-Cap Stocks, 1- to 11-Year Spans, 1947–2002 Span Length (Planning Horizon) in Years StocksReturn1 Yr2 Yr3 Yr4 Yr5 Yr6 Yr7 Yr8 Yr9 Yr10 Yr11 Yr Large-capBest52.8%41.7%31.5%31.0%29.1%25.2%24.2%21.8%21.1%20.5%19.7% Large-capWorst−26.3%−20.8%−14.3%−6.4%−2.3%−3.3%−1.4%1.4%0.1%1.2%2.6% Small-capBest103.1%74.8%47.4%40.7%41.3%40.2%35.1%34.1%34.1%29.6%28.3% Small-capWorst−40.8%−34.3%−24.8%−15.8%−17.3%−19.0%−11.5%−3.9%−2.6%0.9%2.4%
55
erosion of capital over the entire 5 years, 1969–1974). It should be noted that over spans of 8 years or longer, there has never been a loss of principal (if inflation is ignored).
Therefore, longer spans of time are historically better in terms of volatility.17
For small-company stocks, shown in the two bottom rows of Table 3.4, the same is true. Overall, the volatility is higher than that of large-company stocks, but the nar- rowing effect is still unmistakable. The best 1-year return for small caps was 103.1 percent (1966–1967).
The worst was a loss or negative return of -40.8 percent (1972–1973). The range from best and worse is 140.9 per- cent. This is greater than the range for large-cap stocks, as expected. But the range gets smaller and smaller as the spans lengthen. There are no 10-year spans with neg- ative returns at all since 1947 in small-company stocks.
Ms. Smith should end up with at least as much in the growth portion of her portfolio as she started with even if she invested entirely in small-company stocks over a 10-year horizon (excluding inflation18).
Figure 3.6
Small- versus Large-Cap Stocks: Best and Worst Annualized Total Returns over 1- to 11-Year Spans, 1947–2002
Source:Table 3.4.
-100%
-50%
0%
50%
100%
150%
200%
1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 Yr 11 Yr
Large Best Large Worst Small Best Small Worst
It should be clear that investors using the asset ded- ication approach with 5- or 10-year planning horizons face much greater protection against volatility than investors who are worried about quarter-to-quarter or year-to-year horizons. This effect is true for all asset classes. Riskier investments can be made in the growth portion of the portfolio so that even conservative investors can capture higher returns.
4. Sequence risk reduced.There is another form of risk that asset dedication reduces that is often hidden by long-term averages: sequence risk. Few brokers take the time and trouble to explain it to their clients, even those who fully comprehend its danger. Sequence risk is covered in Chap- ter 14, but the main idea is not difficult to understand.
In a static situation, where no external funds are being added to or withdrawn from a $100,000 portfolio, the end result will be the same regardless of the sequence of returns. For example, it does not matter if the portfolio grows 10 percent the first year and 20 percent the second year or the reverse. Both will end up at $132,000. The present value will be higher under the “quick start” situa- tion, where the 20 percent return occurs in the first year, but the end value will be the same either way. The sequence of returns does not matter to the ending value.
Mathematicians call this the commutative law of algebra:
A times B equals B times A.
But in a dynamic situation, where funds are being withdrawn from the portfolio periodically (as they typically are in most retirement situations), then the sequence of returns can make a big difference. Consider a simple exam- ple of only 2 years. Assume that $50,000 is being withdrawn from the $100,000 portfolio each year. If 0 percent is earned the first year and 20 percent the second, then at the end of the second year, after the withdrawal of the second $50,000, the account will have $10,000 left in it. But if it grows 20 percent in the first year and 0 percent in the second, the ending value will be $20,000, double that in the first case.
The additional $10,000 comes from the extra money in the portfolio at the end of the first year produced by the higher initial return. Table 3.5 shows the calculations for this sim- ple example. Reversing the order makes quite a difference, even though the average growth rate is the same.
Asset Dedication—How It Works 57
The intuitive explanation of sequencing is simple:
You would rather have your money grow faster before you take it out, not after. The opposite is true when funds are being added. Younger investors who are still accumulat- ing their savings would rather have their money grow faster after they put it in, not before. Older investors who are withdrawing want their money to grow faster before they take it out, not after. For the older investors, this possibility of slower growth (or loss) before they take their money out is sequence risk.
Asset dedication reduces sequence risk because it insulates the growth portion of the portfolio from with- drawals. That is, the growth portion becomes a static environment, with no external withdrawals to create the sequence problem. The ending value will be the same whether gains occur early or late in the planning horizon.
Figure 3.7 illustrates in a visual manner how asset dedication manages volatility in a portfolio by making use of bonds to smooth out the fluctuations that stocks create. Stocks move in an irregular fashion, and the bonds serve as a bridge over the volatile fluctuations of stocks. The bonds provide a “safe passage” for income, while stocks romp around, but generally in an upward direction, to provide growth. This captures the essence of how asset dedication uses the best features of both stocks and bonds as financial instruments.
Table 3.5
Impact of Sequence Risk
Slow-Start Quick-Start
$5,000 Withdrawal at End of Each Year Growth Growth Portfolio value at start of first year $100,000 $100,000
First-year return 0% 20%
Portfolio value at end of first year $100,000 $120,000
Withdrawal $50,000 $50,000
Portfolio value at start of second year $50,000 $70,000
Second-year return 20% 0%
Portfolio value at end of second year $60,000 $70,000
Withdrawal $50,000 $50,000
Portfolio value at start of third year $10,000 $20,000
Asset dedication cannot remove sequence risk entirely because there will always be some probability, however slight, that a person may enter the market at the very beginning of a long down market that extends beyond the planning horizon. If the planning horizon is at least 8 years long (10 years for small-cap stocks), it is unlikely this will happen (at least it never has happened since 1947). If it does, then it will create financial problems for anyone who must withdraw funds before the market has a chance to recover its losses. An asset allocation strategy would face the same problem, of course.19
It should be noted that if the withdrawals are a strict percentage of the value of the portfolio, then sequence risk is not a problem. But restricting withdrawals to a flat percentage of the portfolio’s value is not very practical.
During bear markets, retirees would have to cut their spending to match the declines in their portfolio. From the year 2000 to 2002, this would have meant a 30 to 40 per- cent cut. Most monthly living expenses, such as housing payments, insurance, and so on, are fixed dollar amounts, not percentages. A strict percentage withdrawal rate would put retirees in a very tough spot. It is not a very realistic scenario.
Asset Dedication—How It Works 59
Figure 3.7
Asset Dedication Bridges the Volatility of Unpredictable Stock Market Fluctuations
Bond bridge for income
Stocks for growth