Risk and Return

In this post we look at the relationship between the riskiness of a portfolio and the corresponding expected spending patterns in  retirement. This will help with answering the question of what percentage of a portfolio should be in risky assets such as shares and what percentage should be in cash.

As usual I look at ourselves as a case study. In this post I look at one model of spending only. I assume we are a couple until 90, and then if we are still alive, we go onto the age pension only. At the end of each year, we work out the spending level for the next year by calculating the spending level for the remaining years that will make assets at 90 equal to zero, assuming the return on the portfolio for the remaining years is equal to the expected return, and spending is the same for each subsequent year (or in accordance with a specified spending pattern). This model has been discussed in previous posts.

If I have time, I will update the post to include mortality-based spending for the single person and the couple.

Portfolio Returns

For simplicity, in this post I assume that your portfolio is made up of shares and cash only. That is, there is no opportunity for further diversification into property etc.

In order to work out the returns and volatility of a portfolio with a certain percentage of shares and a certain percentage of cash, we need to know the returns and volatility for each of these asset classes.

For cash, I have assumed a real return of 0.5%, and a volatility of zero. That is, the bank will always give you 0.5% above inflation.

For shares, we need to look at historic returns. We did this back in the Retirement Calculations Post. Here is a graph that shows a 30 year moving average of real geometric returns (including dividends) for returns of the Australian Share market since 1953:

You can see that there is no overall trend for returns, and the average is around 8%.

And here is a similar graph showing a moving average for volatility:

You can see that volatility is increasing over time, and the average is around 17%.

If we have a mix of n% shares and m% cash, the return will be  0.08n + 0.005m, and the volatility will be n*.17.

Portfolios and Spending

We can now see what happens in our particular case if we invest  the proceeds of Super into various proportions of Shares and Cash.

Like the previous post, we use the staring position described in the Tweaks and Mathematical Diversions post, however now we use post-January 2017 age pension rates rather than pre-January 2017 age pension rates, and we will also use a more realistic spending drop of 1% per year from 65 through to 85.

The diagram below is an animation showing the spending patterns (note that in order to generate each individual graph, we only did 1000 runs, so it is not so smooth).

What is interesting here is that the average spend per year goes up quite a bit when we increase the proportion of shares, and there isn’t much downside. That is the likelihood of a low spend does not increase that much when we increase the proportion of shares.

The below graph should help with understanding this better. Note that the expected percentage of retirement below threshold statistic is a straight-forward average to 90 – that is it does not incorporate mortality data.

You can see in the graph that average spend increase quite a bit by increasing the percentage of shares (it nearly doubles if we increase the percentage of shares from 0% to 100%) and in most cases the expected proportion of retirement spent below various thresholds decreases when we increase the share ratio. An exception to this is the ASFA threshold, but there is only a minor increase.

The other interesting thing is that the expected percentage of retirement below the thresholds in the above diagram decreases sharply from a 0% to a  50% share percentage, and then drop off much more slowly.

Conclusions

In this post we have shown, under the assumption that share market returns for each year are normally distributed and independent, and follow historic averages, that it is sensible to have our Super assets invested in a portfolio with 100% shares. This portfolio mix provides the highest average spend, and offers very little downside over alternatives. This is a surprising result as most investment advisors advise reducing exposure to shares as you get older.