Risk Parity Basics series: All about withdrawal rates: what they are, the difference between Safe and Perpetual, and why they matter, especially for RP. In the embedded video, I'll show you how to find them using Portfolio Charts.
One of the differences between standard investing approaches and a Risk Parity approach is how to best describe a portfolio’s expected return. The standard approach is to focus on mean return, or more specifically, the Compound Annual Growth Rate (CAGR). It’s a nice, smoothed out way to describe what annual average growth something experienced over time. For investors in the accumulation phase, pursuing the highest expected CAGR at the highest risk level one can tolerate is appropriate.
For investors in the decumulation phase, though, the stability of that portfolio is of (at least) equal importance. Sure, winding up with explosive growth as you head into your 90s is great, but really, the investor living off their portfolio is more concerned with just figuring out what they consistently deduct in their 70s and 80s. In these non-working years, you don’t want to have to cut spending drastically, or get too close to the zero line before your final breath.
Enter Risk Parity, which is all about creating risk-balanced portfolios and maximizing the amount investors can withdraw from a portfolio. RP principles can definitely be used by investors in the accumulation phase but find their true calling as portfolios for decumulation. RP portfolios may not be the best performers in terms of CAGR, for sure, but what about their withdrawal rate - what percentage of our portfolio can we consistently take out for living expenses?
Why Withdrawal Rates are Difficult to Determine
Figuring out a portfolio’s withdrawal rate is not so cut-and-dried, though. The emotions with entering this phase are real - what if there is a market crash? What if I have to have long-term care that runs in the hundreds of thousands of dollars? What if I overshoot, have to go find work, but literally can’t? These are important issues, and it is crucial that we use sound judgment.
Analytically, it is difficult to calculate a withdrawal rate since there is so much we can’t know for sure. We don’t know: 1) how our assets will do in the future, 2) future inflation, and 3) how long we’ll live. With all this uncertainty, we’d still like to have a stable percentage that we know we could count on, without having to adopt complex rules every quarter or year based on how things are going.
While these are questions for the future that can never be accurately predicted, we do have estimates of withdrawal rates based on how different asset classes have done in the past. We can carry out Monte Carlo simulations to test how various portfolios might do in the future based on randomized combinations of how the individual assets within them have done in the past.
Two Types of Withdrawal Rates
There are two variations of withdrawal rate estimates we can look for, depending on what level of assets you’d like to always keep in your portfolio:
SWR is the one you’ll hear about more in the world of personal finance, but I prefer to focus on PWR. It's a more conservative number that has a built in margin of safety - the initial balance you started with. If you ever go below your initial nest-egg, you can reformulate your PWR, but if you rely on SWR alone, there could be some nerve-wracking years as you dip below your starting point and have to keep your fingers crossed that your portfolio will last. In addition, the PWR is not negatively impacted if you wind up living longer than your original estimation, making it more of a realistic figure for the retired investor.
How To Find the SWR and PWR for a Given Portfolio:
These are important numbers to know, and the good thing is, you don’t need to calculate them yourself. Because of all the focus on CAGR, they can be a bit harder to find, though.
Method #1: Portfolio Charts
Better to screencast it than to explain it in text, so see below! I’ll go over how to find them, and then offer some help with analyzing the charts. For the record, the video references three of this blog’s test portfolios: the Classic 60/40, the Golden Butterfly, and the RPC Income.
Method #2: Portfolio Visualizer
You can also see the PWR and SWR if you use Portfolio Visualizer. The advantage of this site is that you can be much more specific by typing in individual ticker symbols, unlike the asset class-only approach of PC. One drawback is that the backtests are often not very long as they will be limited by the age of the youngest element in the portfolio. Another drawback is that it’s not quite as visually appealing, though if you’re really into data analysis, you can get a lot more through Visualizer once you enter in your portfolio.
To find the withdrawal rates using Portfolio Visualizer, first go to either the “Backtest Asset Allocation” or “Backtest Portfolio” tools on the left. Then you just enter in your assets, following by clicking “Analyze Portfolio”. In the section labeled “Portfolio Analysis Results,” under the “Metrics” tab, you can find the PWR and the SWR down towards the bottom.
I mentioned this in the video, but what is really going on with the three different portfolios has to do with the key to portfolio construction: correlation. Simply put, correlation is the degree to which assets move in relation to one another, and is covered at length here:
Risk Parity portfolios make special effort to assemble portfolios with assets that are either not correlated with each other (pattern of one asset has nothing to do with another), or are negatively correlated (pattern of one asset moves opposite another). The result is portfolios with greater resilience, as measured by withdrawal rates (if you do it right! Past results are no guarantees of future returns!!).