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Historical Drawdowns for Global Equity Portfolios


Globally diversified equity portfolios typically hold thousands of stocks across dozens of countries. This degree of diversification minimizes the risk of a single company, country, or sector. Because of this diversification, investors should be cautious about confusing temporary declines with permanent loss of capital like with single stocks.

Although it’s possible for such an equity portfolio to experience a decline that takes decades to recover, it’s improbable. Since we shouldn’t dismiss the improbable to be the same as the impossible, I’ll discuss how retirement investors can manage sequence risk with a moderate allocation to cash and high-quality bonds.

 

Many examples of historical equity market data focus on a single equity index, such as the S&P 500.  At my firm, we believe we can maximize the odds of earning an equity premium by investing globally instead of only holding US stocks, and by tilting the allocation within equities to known drivers of higher expected returns such as companies with low relative prices and high relative profitability. In order to simulate this type of portfolio, we’ll look at the Dimensional Equity Balanced Strategy Index from 1970 to June 2020. We primarily use Dimensional Funds to construct client portfolios.

 

From 1970 (the inception date of the index) to June 2020, this index had an annualized return of 12.79%. To analyze the historical risk, we’ll review the 10 worst drawdowns using monthly data. A drawdown is a peak to trough decline. For example, if $100 were to grow to $150, and then drop back down to $100 this would be a drawdown of 33.33%. The following data was created with a paid account at portfoliovisualizer.com.

 

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Click on the image to zoom

 

The average of the 10 worst drawdowns since 1970 was 27%. The average underwater period (peak to trough to new peak) was 20 months. The longest underwater period (period of time in between new highs) was less than four years. An investor who is in retirement distribution mode can use this data to inform asset allocation decisions and expectations, along with Monte Carlo simulations that generate probabilities of future outcomes by rearranging the historical monthly returns. This helps merge historical data with the reality that past performance by no means is a guarantee of future results.

 

Assuming a 5% portfolio withdrawal rate, an allocation of 75% to the equity index along with 25% to high quality bonds and cash would provide a buffer of five years of portfolio withdrawals in safe and stable assets to draw from during a severe and lengthy bear market drawdown. Systematic portfolio rebalancing automates this process, as cash and bonds would primarily be sold when withdrawals were taken in order to rebalance back to the target 75/25 allocation.

If an investor wanted to further increase their bear market buffer, a 60/40 allocation would equate to eight years of portfolio withdrawals in cash and safe bonds. Monte Carlo simulation suggests the chance of the equity index having negative returns over a 5-year period are about 5%, and the chances of negative returns over 10 years are about 1%. Portfolio allocations more conservative than 60/40 begin to introduce a different risk, which is the risk of insufficient long-term expected returns in order to sustain the desired withdrawal rate.

 

Summary

 

In the book Stocks for the Long Run, Jeremy Siegel concludes that “fear has a greater grasp on human action than does the impressive weight of historical evidence.” Investors could increase the odds of reaching their long-term goals by making decisions guided primarily by long-term data and probabilities than by relying on their feelings and near-term market outlook.

The global equity premium is well documented and can be easily captured with low cost mutual funds and ETF’s. For those in retirement distribution mode, historical data suggests that sequence of returns risk is real, but so is the risk of low returns when maintaining excessive allocations to cash and bonds. Portfolios ranging from 60-75% in global equities have historically provided retirement investors with a nice balance of risk and expected return.

 

Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™ professional. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University.

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