Among biologists, it’s called “the extinction problem.” It happens when a species suffers a major disaster, one that kills off most of its population. After the disaster the species continues to reproduce as usual, but recovery is impossible. This happens because the population is so low that more die every year than are born. After a few years, the last of the species dies.
For us humans, the possibility of extinction is a constant in entertainment. Where would we be without mindless zombies, killer viruses or ruthless interstellar invaders?
But we can also experience the extinction problem in a way that isn’t remotely entertaining. It can happen to our savings. Portfolio extinction doesn’t get the attention the disappearance of a species gets. And Brad Pitt isn’t likely to make a film about it, as he did with zombies in World War Z.
One reason is that the death of a portfolio is pretty bloodless. Also, it doesn’t help that investment types call the problem “variance sink,” which isn’t nearly as foreboding as “the extinction problem.” But for what it’s worth, the underlying mathematics is virtually identical.
So let’s ask (and answer) some troubling questions:
Is your portfolio heading for extinction? The answer to this depends on your age and whether you are still employed. If you are young and working, portfolio extinction isn’t one of your problems. Indeed, big market diebacks are great for the young. If you’re still working and saving, you can add to your portfolio as fast as all but the nastiest market viruses can reduce it. The worst that can happen is you can wonder why you are saving, since the money seems to just disappear, and it would be more fun to buy a new car.
In fact, we all tend to press on. The latest research reports show that the average 401(k) balance has fully recovered from the market crash of 2008-2009.
It’s a different story for retirees. For those about to retire or already retired, the recent crash was a true disaster, a generational event. Basically, those who aren’t young and are still working have few choices: You can work longer and rebuild your savings, or you could cut your retirement spending plans. If retired, you could cut your spending. Or face going broke.
Do you understand the fatal arithmetic of portfolio extinction? In 1970 and 1999, a lot of people thought markets only rose. So it was safe to take, say, 10 percent a year from the starting value of their portfolios and be 100 percent invested in stocks. Now let’s see what can happen:
In Year One, you start with $100, assume your portfolio will grow by $10 and withdraw $10. Unfortunately, the market tanks and loses half its value. At year-end you have $40 left, because $50 disappeared and you spent $10.
In Year Two, you start with $40. Make the same 10 percent growth assumption, and it might add $4 while you are withdrawing $10. So you finished the year with $34.
In Year Three, you start with $34, assume you can earn $3.40 and spend $10, ending the year with $27.40.
In Year Four, you start with $27.40, assume you can earn $2.74 and spend $10, ending the year with $20.14. Since what you withdraw exceeds what your portfolio earns, your portfolio is heading for extinction.
How long will it take? In this example, it will take a bit more than two additional years, for a total of six years and a few months. As a practical matter, the process can be a slower and more subtle, filled with agonizing years of hopeful near-recovery.
Understanding and measuring portfolio extinction can also get a lot more complicated. Financial planner William Bengen exhorted his colleagues to use probabilistic analysis when considering retirement portfolios nearly 20 years ago. Today, researchers and practitioners such as financial planner Michael Kitces and professor Wade D. Pfau at The American College of Financial Services continue to explore how we might adapt to or deal with the problem.
But in the end, whether you call it the extinction problem or variance sink, the problem is truly deadly. Many of the people who retired after the bull market of the 1960s or the soaring 1990s saw their portfolios become extinct over the next 10 years — or drastically reduced their standard of living.
Is World War Z coming to your portfolio? If you are retired, it already has. Indeed, I’ve written many columns about how and where it is impacting the folks I call “solvent seniors.”
I think of it as World War ZIRP, the assault that savers have been under since our Federal Reserve (and other central banks throughout the world) adopted ZIRP, the Zero Interest Rate Policy that has brought yields on savings close to zero and lower than the rate of inflation. Basically, this is a war on personal saving and investment.
And it’s a war of extinction.
SCOTT BURNS is a principal of Plano-based investment firm AssetBuilder Inc.
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