Volatility and the timing of cash flows make a
bigger difference on long-term returns.

    Portfolio optimization has been the cornerstone of financial planning for decades. That some 94% of an investor's success comes from the asset allocation decision is the first article of faith for most in the financial planning profession. The financial press has served gallons of this mantra to individual investors, convincing them that it is as precious as blood. But, there is something far more important to successful financial planning.
Unlike institutional investors, whose context and needs were used to prove the mechanics of Modern Portfolio Theory (MPT), individual investors are primarily loss-averse, rather than "risk"-averse (MPT tends to view risk as synonymous with volatility). In addition, whereas institutions treat risk and reward as having an inverse relationship, according to Nobel Laureate Daniel Kahneman, individual investors are more likely to take on greater risk to avoid recognizing losses than they are to pursue gains. In particular, Kahneman points to the reluctance of individual investors to dispose of investments with unrealized losses and their propensity to point with pride to their realized and unrealized gains.
    When viewed in the context of MPT, which typically ignores cash flows in and out of a portfolio (and collateral effects such as income taxes), the individual investor's propensities are generally self-defeating. For example, it is hard to convince many people to sell off their "gainers" and replace them with losers. However, they are more easily motivated to sell "gainers" if doing so allows them to accelerate spending on short-term goals when markets are up or to defer spending on short-term goals when markets are underperforming. As we shall see, these behaviors have a far greater impact on successful financial planning than techniques such as asset allocation.

Focus On Danger Zones
    Let's examine the tale of three portfolios. All of them have the same asset allocation, the same rebalancing, the same cash flows, the same goals, the same tax rate; in fact, they are the same in every way except for their outcomes-and the historical data series that were used to project future returns.
    Each simulation uses a 50-year data series consisting of historical returns for asset classes for the following sequences:
    The first simulation uses data from the years 1960 to 2005, then from 1927 to 1930.
    The second simulation uses data from the years 1980 to 2005, then 1927 to 1950.
    The third simulation uses data from the years 1930 to 1979.
    The performance statistics shown in Table 1 that were produced by these data series cannot account for most of the capital accumulation differences illustrated in Figure 1.

    Based on constant mean return differentials between the portfolios, the second simulation should have produced a value approximately twice as large as the other two at the end of 50 years. Instead, the second simulation produced an end value that was approximately 90 times larger than the first simulation and 20 times larger than the third. Clearly, the magnitude and consistency of average returns only explains a small portion on the dynamics that work to produce wealth, yet they are the cornerstone concepts that drive most financial planning.
    Two remaining inseparable variables explain the bulk of the differences among the three portfolios: the volatility of returns and the timing of cash flows in and, especially, out of the portfolios. Figure 2 illustrates the volatility of returns for the three portfolios. Figure 3 illustrates the frequency of downward movements in monthly returns in a generic balanced portfolio. Figures 4, 5 and 6 illustrate the convergence of the timing of volatility of returns and timing of cash flows. They plot the net cash flows in and out of the portfolios against the annual returns earned by the asset allocation that was applied uniformly to the portfolios.


   In spite of the fact that the asset allocation strategy used across these portfolios is diversified in an attempt to achieve consistency of returns, volatility persists. Interestingly, all three portfolios have approximately the same number of peaks and valleys with apparent differences in timing, direction and magnitude.
    The performance of these portfolios cannot be considered as uncommon. We only think it is abnormal because of what we believe about portfolio optimization. However, asset allocation only works to dampen average volatility when investment strategies are examined from the perspective of long-term holding periods. When examined in "real time" even balanced portfolios experience frequent downward movement in returns.
Figure 3 shows monthly changes in returns for each month between 1926 and 2002 for a portfolio that was evenly distributed among nine asset classes, including fixed income (four categories of bonds) and equities (five categories of stocks). The portfolio returns moved downward (e.g. the return for the previous month was higher) 53% of the months, which means that more than half of the time an individual investor was exposed to the risk of spending at the wrong time.
    The timing of drawdowns on portfolio assets relative to the occurrence of downward movement in portfolio returns is more significant to the success of financial planning than is asset allocation. Figures 4, 5 and 6 illustrate the "Draw Down Danger Zones" (circled in red) that occurred for each simulation. A danger zone occurs when cash flows go out of a portfolio at the same time that portfolio returns move downward.
    These are considered to be danger zones because a spending event that takes place in a down market exhausts a higher percentage of a portfolio than it would if it took place when the portfolio value was higher. Spending events have the same effect as negative returns in that they require higher positive returns in subsequent periods to restore a portfolio's value.
    For example, if you lose 20% of your $1,000 portfolio you have a remaining balance of $800. To get back to $1,000 the next period you have to earn 25%, not just 20%. If you spend $200 from an $800 portfolio it is the same as incurring a 25% loss. But, if you spend $200 from a $1,000 portfolio it is the same as a 20% loss.
    In the first simulation (Figure 4) ten danger zones occurred and were distributed throughout the simulation period (1960 to 2005 plus 1927 to 1930). Overall wealth accumulation could be improved by either accelerating or deferring cash out flows from the portfolio into a higher earning period.
It is no coincidence that the second simulation (Figure 5, with a simulation period running from 1980 to 2005 plus 1927 to 1950) ended with a much greater value than the other two, since only seven danger zones occurred and the average magnitude of the drawdowns was relatively small. Since these danger zones occurred early in the simulation, deferring cash outflows would have significantly improved wealth accumulation.
    Ten danger zones occurred in the third simulation period as well (Figure 6, with a simulation period running from 1930 to 1979). In this case wealth accumulation could be improved by deferring cash outflows from the first four danger zones to a period of improved returns.

Strategies To Cope With
Drawdown Risks
    Since short-term downward movement in portfolio returns occurs frequently, even in balanced portfolios, the risks of untimely drawdowns will be high for most individual investors. Consequently, successful financial planning will include anticipating these risks and having strategies in place to mitigate them. The following are suggestions on how to focus your planning in the direction of drawdown risks.
    Integrate cash flow and portfolio growth projections. These projections will help you anticipate the relative timing of cash outflow events and downward moving returns and they help pin-point the causes of, and therefore the responses to, danger zones. For planning purposes projections should be prepared using short intervals (monthly or shorter). Short-term intervals make it easier to see the danger zones which can be caused by any event or combination of events that result in negative cash flows from a portfolio. These events can include spending in excess of income and cash reserves, including paying taxes or management fees, as well as portfolio rebalancing.
    Use planning projections to manage the danger zones. Execute drawdowns when the "current portfolio return" moves upward. The "current portfolio return" is the percentage change in value of a portfolio from one point in time to a following point in time. For management purposes the interval between points is not as important as the direction of the current return. That is because your goal should be to execute events on an uptick rather than a downtick.
    Use planning projections to identify "safe portfolio values." These are the values at which the portfolio has enough funds that future spending goals and lifestyle needs can be achieved without exhausting the portfolio, even with very adverse market performance. These "safe portfolio values" can be used as targets at which point money can be withdrawn from a portfolio in advance of a need, to be held in cash reserves for future spending. Although the cash reserves would likely earn a lower return than the same money might earn in the portfolio, the danger zone risks would be avoided and the success of the financial plan could be assured.
    Leverage your clients' real world instincts. Help them adopt behaviors that are useful in mitigating the risks associated with "Draw Down Danger Zones." Their aversion to recognizing losses can make it easier for them to defer spending when markets are underperforming. Their pride in being savvy investors can be preserved in the tangible evidence of achieving goals ahead of schedule, made possible by selling winners during market upticks.
Successful financial planning by individual investors will depend largely on their ability to anticipate and manage drawdown risks. Anticipating these risks will be aided by integrated financial projections that pinpoint "Draw Down Danger Zones." Managing these risks will require understanding the events that cause the danger zones to occur and implementing appropriate strategies.