By Philip Kozloff, firstname.lastname@example.org
Let’s pick up looking at a new approach to portfolio analysis where we left off last month in the April issue. We showed a hypothetical investment portfolio that might be typical of a young working investor. Although Exhibit 2 last month showed a pleasing upward trend, isolating internal investment growth from external contributions to the fund reveals a much more telling picture.
Extended over a further hypothetical 10 years, you can see from Exhibit 5 (continuing on the numbering from last month’s column) that the progress follows a much more erratic path, reflecting the additional information. The spacing between data points is variable, reflecting the differences in changes of portfolio value (either due to contributions and withdrawals or changes in value) each quarter. A larger distance between data points indicates that values changed more in that fixed period, a financial quarter of a year in this example.
To see in finer detail how this works, look at Exhibit 6. This extracted data represents the period from September 2006 to September 2007, of our hypothetical saver. Although the total portfolio grew from $4.9 million to $5.3 million in that period, Exhibit 6 allows one to see that much of the growth was from contributions to the investment account, whilst the actual investments did not do particularly well, growing at the rate of 1.9% only. Obviously, this needs to be judged in the context of alternative investment returns.
It becomes even more crucial to be able to make this distinction after retirement. For many, it becomes impossible to continue to add to savings from non-investment sources. A pension will have replaced your salary and bonuses and stock options. The pension, usually significantly less than the working salary, may not cover living and recreation expenses and taxes.
Cash withdrawals from your investment accounts in retirement are normal and appropriate. If the value of your investment portfolio is great enough to fund these withdrawals from internal growth, then you have no problem. Another way of stating this is if your uncovered cash outlays (that is, your expenses minus pension and other income) are less than your investment portfolio returns, you are OK.
However, it is not always easily apparent that internal returns from the portfolio are covering expenses or are up to your expectations. Cash outlays can fluctuate significantly in retirement. You might go on an expensive holiday or cruise, or you might purchase a new car. Tax time may throw your flows out of kilter.
Therefore, it is a good idea to track your post-retirement investment account performance with the same Bi-Modal Portfolio Analysis as before retirement. At a minimum, this will give you an idea of how well your portfolio is performing. Exhibit 7 is a table showing our hypothetical retiree’s investment portfolio, starting where Exhibit 4 from last month’s column ended. This is when our investor retires and will no longer be making contributions to his investment account.
In Exhibit 8, we see the Bi-Modal Portfolio Analysis for a retirement investment portfolio based upon the Exhibit 7 assumptions. This is a continuation of Exhibit 5, starting at the point of retirement. Do not be alarmed by the apparent downward trend of the line. This only reflects the activity of withdrawing funds from the portfolio, the decrease in y-axis values.
Recalling that the overall portfolio value is a multiple of the x and y values, you can compute that investment value remains robust even over this 10-year period; the overall portfolio remains about the same size (see Exhibit 7).
Exhibit 9 examines in more detail a brief period when there was a two-quarter correction in the Value Indicator, at the same time cash withdrawals from the nest egg continued apace. This would be alarming if that trend were to continue. But this format provides the investor with the ability to view this deterioration in value in the context of external market indicators.
Set up your own portfolio information along these lines. In the coming months, this column will use this methodology to suggest to you how to assess you portfolio performance and guide you towards understanding when your investment portfolio is comfortably positioned to accommodate your retirement.