There are two over-riding considerations that affect investing during the 'withdrawal phase' and these are:
- Fixed income instruments have never (in the long run) beaten the returns of equities.
- Volatility is your enemy in the withdrawal phase.
First an example that will demonstrate why volatility during the withdrawal phase is much more damaging than in the accumulation phase (where it can actually be an advantage). Take a starting $1M portfolio and look at three different investment scenarios.
1) The withdrawal phase where you are making an annual $50,000 withdrawal.
2) The accumulation phase where you are making an addition of $50,000 annually to your portfolio (dollar cost averaging).
3) The accumulation phase where you are not saving or making withdrawals (static accumulation).
We will analyze these three investment scenarios against two different portfolio performances.
1) A volatile portfolio that loses 25% in year 1, gains 67% in the second year, and stays flat in the third year for a net gain of 25%
2) A non-volatile portfolio that gains 7.7% each year for a three-year net gain of 25%.
For simplicity of analysis I'll be assuming that all additions/withdrawals are made at the beginning of each year.
Ending portfolio value after three years
The static accumulation story reveals no sensitivity to the volatility of the portfolio (assuming the net gain is the same). The volatility was actually an advantage in the dollar cost averaging accumulation scenario. However, it was a distinct disadvantage in the withdrawal phase. Note that the difference in the ending portfolio values is roughly 15% of the total withdrawals made (or savings added) - this is not insignificant.
This leaves us with two principles that are in conflict - equities' returns are better than fixed income investments but equities are more volatile. This is the essence of the problem being analyzed - how do we optimize the balance between these two conflicting principles.