Recent investment market corrections around the world have left many investors wondering what impact it will have on their accumulated savings, given they have seen
their portfolios fall in value by between 25 and 30 per cent since the beginning of the financial crisis.

We have prepared a case study to help provide some reassurance on the effect of market corrections on portfolios, which has two parts.  Part one looks back over the 20 year time frame from March 1989 to February 2009, to see what the worst one, three, five, tenand 20 year periods were, along with their corresponding returns.  These results are shown below in figure 1A.

Given that all of the worst 10 year periods over the past 20 years include the last 18 months, it is safe to conclude that this period really has been incredibly challenging. 

Part two applies the above periods and returns to a scenario to understand the effect on a portfolio.  Therefore, we are going to imagine that we have access to a time machine that we can use to travel back through time to calculate the effect on John and Betty’s portfolio as if they were living years in reverse, ie 2009 first, then 2008, then 2007 and so on.

Basic assumptions

• John and Betty are both 60 years old, and estimate they will live for at leastthe next 20 years or so.
• They have a $1m portfolio to last their retirement years.
• They estimate they need $40,000 per annum (indexed to inflation of 3 per cent) to live on, which they intend to withdraw annually in June each year.
• The long-term expected rate of return on their portfolio is 10 per cent per annum
• But, returns for the next 20 years will be those of the last 20 years in reverse, ie 1 year return from March 2008 to February 2009, becomes the 1 year return from February 2009 to January 2010, and so on.These results are shown below in figure 1B.

John and Betty go and see Tara, a financial adviser recommended by their accountant.  Tara sets them up with a well diversified portfolio, and starts them drawing down from their savings in February 2009, drawing out $40,000 per annum to live on.  They then experience the worst one year return in the last 20 years, and see their portfolio value fall by more than 27 per cent to around $687,000.  While this is a dramatic fall, it does need to be put into context. 

Firstly, until they actually sell, they haven’t lost anything; it’s all just a paper loss.  Yes, they can see the value having fallen by over $300,000, but they will only realise the loss if they sell. Secondly, deciding to sell out is only one partof the equation.  Once they’re in cash, then what do they do?  Stay in cash and watch as inflation erodes the interest they earn? Or jump back into markets when they look like recovering – read: after they have recovered! 

We know markets do rally after a big correction, we just don’t know when.  So to pull the $687,000 out after it has dropped by 27 per cent could be disastrous, and is akin to throwing the baby out with the bath water, as they could miss out on the recovery, when it comes.

So John and Betty speak to Tara, their financial adviser, who recommends that they maintain their long term strategy; advice which they take by retaining their long term asset allocation.  They want to maintain their lifestyle so they keep drawing out $40,000 each year, adjusted for inflation.  However, after three years, and after seeing their portfolio essentially do nothing, they once again question Tara as to what they should do.  Again, Tara advises them to maintain their long term strategy. Unfortunately for them, the five years from February 2009 happens to be the worst five year period in the last 20 years.   The compound rate of return over this period is only 3.28 per cent per annum.  However, even after this fairly dismal return, and having drawn out over $210,000 to live on, their portfolio has managed to climb back up to $881,000.  This is a reasonably good outcome, considering they started with a negative 27 per cent return in year one, which only left them with $687,000 invested.

John and Betty decide that remaining invested into the future maybe a wise choice, so they don’t make any changes to their portfolio (other than rebalancing).  At one of their meetings with Tara in ten years time, Tara shows them their long-term results; a compound rate of return of 6.15 per cent per annum – again the worst ten year period in the last 20 years.  However, after having drawn out nearly $450,000 for living expenses, they are still left with over $1m; the original sum invested. 

Aged 80, John and Betty are once more in a meeting with Tara.  After ensuring their wills and estate plans are up-to-date, Tara shows them their return since the portfolio was originally opened.  John and Betty are most surprised to find out that over the 20 years they have been invested, they have achieved a compound rate of return of just below ten per cent.  So after having drawn out nearly $1.1m, they are still left with more than $2.5m to leave to their children.

The lessons to take out of this case study are multiple.  The advice a good financial adviser provides is invaluable, as they can help you make emotionally uncomfortable decisions. Although it is entirely possible for markets to deliver painful short term results, if you can hang on and stay invested, markets do recover.  The longer you stay invested, the better your result will be, as short term volatility will eventually disappear, enabling you to enjoy a successful long term investment experience.


Dirk Dobbs
Senior Manager
ddobbs@moorestephens.com.au