What's the secret of staying rich? Here's a hint: it is not about how you invest.
Most wealthy individuals are perplexed to hear this. They assume that if they make smart investments, and implement a disciplined, conservative asset-allocation strategy, their investment portfolios can support their lifestyle, philanthropy, and spending habits indefinitely.
Nothing could be further from the truth.
In reality, the percentage of your portfolio allocated to cash, bonds, equities, and other assets is important. But the secret to staying rich is how you spend. Simply put, it doesn't matter if you have $10-million, $100-million or more: if you're not paying attention to how much you're spending, you stand a significant chance of burning through your capital and reducing your lifestyle in the long term.
Spending matters. A 2006 study from J.P. Morgan Private Bank makes the point clear. Entitled "Wealth Preservation: The rate at which you spend matters - even more than your asset allocation," the study shows that an individual living solely off a fixed pool of assets, spending 5 per cent of the net worth annually, has a 33-per-cent chance of suffering at least a 20-per-cent reduction in real wealth over the course of two decades. I expect the current market turmoil has only increased these odds.
What's more, the study goes on to say that asset allocation cannot compensate for a rapid consumption of wealth. It doesn't matter whether your portfolio is allocated to 30-per-cent equities, 50-per-cent equities, or 70-per-cent equities. Assuming a 5-per-cent withdrawal rate and 2.25-per-cent rate of inflation, all three portfolios would lose up to 50 per cent of their value over a typical 20-year investment horizon. At higher rates of withdrawal, the depletion would be even faster.
A more recent study conducted this year by Chicago-based independent investment firm Morningstar highlights the danger of high withdrawal rates, no matter what a portfolio contains.
Using market data up to and including last year, the firm calculated the performance of a portfolio divided into various allocations of equities and bonds over a typical 25-year retirement.
That performance was then fed into a number of withdrawal scenarios. The result is a "survivability matrix" that tracks the probability of a given portfolio being depleted over the course of an individual's retirement.
Looking quickly at the matrix, two broad findings become immediately obvious:
Asset allocation is important - how you allocate your portfolio plays a factor in whether your portfolio will meet your income needs. Note that a portfolio that has at least some equity exposure stands a better chance of surviving at almost all withdrawal rates.
But withdrawal rates are more important - note that even a 100-per-cent stock portfolio stands a significant chance of failure at higher withdrawal rates. The break seems to be around the 5-per-cent mark: withdraw more than that, and you stand a greater than 50-per-cent chance of outliving your money.
Given this information, how can you ensure you don't "burn through" your capital? It's simple: you must determine whether your current rate of expenditure is eroding your long-term financial health.
This is even more important for high net worth individuals, who often live off their portfolios, and often tend to overestimate the ability of those portfolios to keep up with their spending, especially with luxury items inflating at prices well above the general economy's inflation rate.
I advise clients to target a 3- to 4-per-cent rate of spending, depending on the size of the portfolio, and the age of the client. Every year, we revisit spending assumptions, along with changes to the client's portfolio and lifestyle goals, and adjust that recommendation as necessary.
It's not always easy to have this conversation with a client; most multimillionaires are surprised to hear there are perils of too high a consumption rate.
But in the end, a more conservative withdrawal rate approach is in the best interests of all investors, irrespective of wealth levels.
Probability of meeting income needs
| Various withdrawal rates and portfolio allocations over a 25-year retirement |
|
WITHDRAWAL RATE |
100% BONDS |
75% BONDS/ 25% STOCKS |
50% BONDS/ 50% STOCKS |
25% BONDS/ 75% STOCKS |
100% STOCKS |
| 4% | 71% | 89% | 92% | 88% | 84% |
| 5% | 36% | 55% | 67% | 68% | 66% |
| 6% | 12% | 20% | 35% | 44% | 48% |
| 7% | 3% | 4% | 12% | 25% | 33% |
| 8% | 0% | 0% | 3% | 11% | 20% |
| Source: Morningstar |
Thane Stenner is founder of Stenner Investment Partners within GMP Private Client L.P., as well as Managing Director, Private Client. He is also bestselling author of ´True Wealth: an expert guide for high-net-worth individuals (and their advisors). He can be reached at thane.stenner@gmppc.com. The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of GMP Private Client L.P. or its affiliates.
