This is a post to determine whether a 100% small-cap value portfolio is ideal if we extract income from the portfolio repeatedly.
A reader of mine was discussing a research paper on long-only small-cap value and large-cap value with me, and this question came up.
There is empirical evidence that if we invest in smaller and cheaper companies, they are riskier, but we are compensated for taking on that extra risks. The evidence is persistent and pervasive overtime periods and regions.
Recently, I did two data piece regarding this topic:
- 98 Years of Data Shows the US Small Cap Value Premium over S&P 500
- 42 Years of data shows that Europe Small Cap Value premium over MSCI Europe
The returns of small-cap value can be lucrative. If we use Dimensional US Small Cap Value Research index, the compounded returns from 1927 to 2023 (95.8 years) is 13.3% a year. If we are using Fama/French US Small Value Research Index, the return is 14.2% a year.
But we know from my past articles that return is not the most important thing in retirement income planning.
- Usually, what is more, important than anything is the income you spend in the first year, relative to the portfolio value (we call this the initial safe withdrawal rate)
- Volatility drag is a big reason why returns are not everything. An investment can have good returns but can come with large drawdowns (significant falls from peaks)
We know the conclusion but how bad are things?
The 100% US Small Cap Long-Only Value Portfolio
We are going to invest my reader’s money in a 100% portfolio made up of US Small Cap value. We will use the Dimensional US Small Cap Value research index because it is long-only and not long cheaper companies, short expensive companies.
This should be closer to what he is looking for.
I am not going to create a spreadsheet to roll month-by-month but will make use of my existing year-by-year model. There might be some sequences that I will miss out on but we live with that.
There are at least 93 years of data, spanning through
- high inflation
- bull markets
- wars (but not in domestic United States)
I am going to embed a 0.60% a year total cost to the portfolio. This should match close to the total expense ratio my reader is getting plus the commissions that he is paying with some slight buffers.
Spending $40,000 in the initial year on a $1 million portfolio. Inflation-adjust the income based on the prevailing inflation rate every year after that. Can the portfolio last a 30-year retirement period?
This will be the 4% Rule but with a more risky and higher return portfolio.
There are 65 thirty-year periods from 1927 to 2021.
We can observe that in the three thirty-year periods starting in 1928, 1929 and 1930, spending an initial 4% then adjusting by the prevailing inflation, your portfolio will run out before thirty years.
The CAGR, or the compounded average growth of the portfolio after the 0.6% a year cost is crazy good.
In the last column, you can see the average inflation rates of the different thirty-year periods.
At the end of many thirty-year, your $1 million will grow to at least more than $10 million EVEN after spending inflation-adjusted income for thirty years (refer to Ending Portfolio Value).
End Income 1 shows the last-drawn income. Your $40,000 a year income in some cases grew to $187,000 a year in some high inflation years.
The small-cap value ended up tackling those high-inflation periods starting in 1960 to 1970 very well.
This presents an interesting problem:
- In 4.6% of the 65 thirty-year sequences, you run out of money.
- In the other 95.4% of those 65 thirty-year sequences, you end up with too much money!
So if you retire at this point, which thirty-year period will you live through?
This is the nuance part of the safe withdrawal rate study that people may fail to grasp.
I like to fxxk with people’s brains by diving into some of these nuances.
Let us take a look at one of those failures, the period of 1930 – 1959:
The initial three years are brutal.
The portfolio, without spending, will be down 78% after those three years. But in the next three years, the portfolio would return 207%.
Yet, if you retire in this time period, your portfolio would run out of money in 1948.
The highest the portfolio recovered to was $486k in 1936.
This is volatility drag.
Your portfolio is down 78%, but in those three years you are roughly spending like 10% more, your portfolio will be left with less to come back up. And the highest you can get up is less than half.
It helps that in the first three years, there is deflation rather than inflation. You actually spend less in income on a nominal basis.
The average inflation in this period is 1.8%, while CAGR is 10.9%.
Earning a high return relative to inflation doesn’t help the portfolio.
Now let us look at the investor who happens to retire one year later. The investor would live through 1931 to 1960:
This investor would suffer a 60% drawdown in the portfolio.
It is not like the portfolio does not suffer what financial planners will say is a negative sequence of return risk. He went through it.
He also has no cash buffer. This is a 100% small-cap value portfolio.
But in the end, this investor ends up with $13 million after a thirty-year retirement. He extracted $1.5 million from the portfolio income over thirty years on top of that.
The investor’s fate is dictated by the market.
Spending $25,000 in the initial year on a $1 million portfolio. Inflation-adjust the income based on the prevailing inflation rate every year after that. Can the portfolio last a 30-year retirement period?
Readers would know I would often use a 2.5% safe withdrawal rate as the rule of thumb to gauge the perpetual income you can get from a portfolio.
What if instead of $40,000 we start off drastically lower at $25,000?
Reducing the starting spending does help, but it doesn’t overcome some really drastic volatility drag.
Here is that one challenging sequence:
In the depths of the 1929 to 1958 retirement, the portfolio went down 86% and if you spend 5% more in those three years, your portfolio is left with like so little ($99k in end 1932) for it to participate in the 207% recovery.
The highest your portfolio reached is $283k.
This is the dilemma:
Given this info, do you stick to the portfolio and bring down your initial spending even less?
I am going to tell my reader what works (based on the data): 2% or $20,000 in the first year on a $1 million portfolio.
But is that the most optimized way to live?
Doesn’t feel like it.
Spending $25,000 in the initial year on a $1 million portfolio. Inflation-adjust the income based on the prevailing inflation rate every year after that. Can the portfolio last a 60-year retirement period?
Now I want to help him see whether a small-cap value portfolio can provide perpetual income.
To me, if a portfolio can:
- Last for 60 years
- After inflation-adjusted spending
- Have a very low ending withdrawal rate (ending income drawn divide by the ending portfolio value)
The money is almost perpetual.
So if my past data work says it is better to use about 2.5%, let’s do 2.5%:
There are 35 sixty-year sequences.
We know the 1929 sixty-year sequence fail but take a look at the other sixty-year sequences.
Your $1 million ended up in the billions!
The End Total Withdrawal Rate shows the End Income 1 divided by the Ending Portfolio Value.
Aside from 1929, your ending income is basically less than 0% of the ending portfolio!
In the 1942 sequence, you ended with $16 billion, and extracted $6.5 million in income in that lifespan.
There is a strong debate this investor has been under-spending!
Instead of 100% Small-Cap Value, We do 50% Small-Cap Value and 50% Large-Cap Value. Spend $25,000 in the initial year on a $1 million portfolio.
This might be a more ideal state for my reader.
A 50% US Small-Cap and 50% US Large-Cap allocation.
You can see… the results are better.
If 1929 is such a tough 60-year sequence to tackle, and you are afraid of that, then a less risky portfolio may be in order.
But I am going to tell my reader:
I couldn’t increase the initial spending higher than $25,000. If I increased it to $26,000, the 1929 sequence will also fail.
What does that mean?
There is a certain uniqueness to equity. They are inherently more volatile and changing 50% to large-cap value is still risky because that is still equities.
I will also tell him:
If we change the 50% Large-Cap Value to 50% five-year US treasury, the highest withdrawal rate is 4%. This means you can spend $40,000 on a $1 million portfolio, it will last through all of those 35 sixty year period with a much lower ending withdrawal rate such that the money can last for another sixty years.
The right take-away for him is the following:
- Small-cap value is some strong, potent return drug, based on empirical evidence.
- 100% small-cap value for FI might not be a good idea.
- Volatility drag is a real problem. Even if we have a 100% small-cap value portfolio, we have to really reduce our initial spending to get a good outcome.
- We have to accept that maybe 100% equities is not the most optimized portfolio mix. Equities are just volatile.
- But small-cap value and a five-year US treasury are a good mix.
I think he knows this, but this article is just letting him see the nuance.
If he is planning his FI:
- Examine his spending. Not all spending needs to be secured with such high certainty. Some do some don’t.
- Some spending has a different tenors.
- If he is able to break them up into different pots, it is more optimized. Not just that, he knows for some spending what is the maximum he can withdraw.
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Tuesday 30th of May 2023
"50% Small-Cap Value and 50% Large-Cap Value" what are the ETFs to get exposure to the above?
Sunday 9th of April 2023
This is great research. In this case, you have done this research yourself, so you are confident about it. But still it is a leap of faith, when it comes to equities. When you share this research to someone, it is already 2nd hand knowledge that this person is getting. So, it is a case of leap of faith on top of leap of faith.
From a classic book about Wall Street by Fred Schwed’s “Where Are the Customers’ Yachts?”, first published in 1940, is the often repeated line:
There are certain things that cannot be adequately explained to a virgin either by words or pictures. Nor can any description I might offer here even approximate what it feels like to lose a real chunk of money that you used to own
I think anyone who wants to try a new strategy, should always wait until a real sell off happens and for sure it will happen. You will get another Covid kind of crash sometime and prices will plummet a lot and take away like 10 years worth of gains. So, there is no need to FOMO and change strategy to aggressive during good times. The real test would to change strategy to aggressive during bad times. As Warren Buffet says, where there is blood on the streets, that is when you must invest.