Investment Scenarios

Why Investment Scenarios Are Helpful

In the previous chapter, we walked through the process of financial planning. As a result of that plan, we were able to identify potential financial gaps, and the probability of reaching our financial goals. And while this is useful information, it does not directly translate into guidance for making investment decisions.

In this chapter, we will be looking at three investment scenarios, which I consider the archetypes of investing:

• Investing toward a goal: This scenario is about saving towards a critical financial goal and maximizing the probability of achieving it. For most people this goal is retirement, but it does not have to be.
• Investing for income: This scenario is about creating income from your savings and not outliving them. This is the typical situation during retirement.
• Investing excess funds: This scenario is about maximizing profit for funds that we may spend on optional goals or pass on to the next generation.

Many investors believe that high returns, possibly beating the market, are all it takes to achieve financial success. Unfortunately, this is untrue. Instead, each of the investment scenarios has its specific characteristics, and requires a dedicated investment approach. Therefore, progressing from the financial plan to allocating the existing wealth toward the relevant investment scenarios is a big step forward in defining an optimal investment strategy.

Before exploring the characteristics of the three investment scenarios, we need to decide which ones best represent our current situation. With the insight gained from the financial plan, this is straightforward.

The illustration above shows the three scenarios playing together. Investing toward a goal and investing for income are mutually exclusive and cover all the funds we have committed toward important or critical financial goals. In our financial plan example, these were the goals in the needs and wants categories (retirement and children’s education). We want to maximize our chances of meeting these goals, and we will see below that this objective does not necessarily coincide with maximizing returns.

The remaining funds are either earmarked for optional blue-sky wishes from our financial plan or are wealth we consider passing on to the next generation. Here, the objective is different: we want to put this money to work and maximize its profits. Of course, not all investors are lucky enough to have any excess funds to invest, and our financial plan helps us determine the size of this partition.

The illustration above also shows a fourth block: tied up assets. This block stands for assets we own but can’t invest freely. Examples include equity in our primary residence, stock options we received from our employer, or similar. Because these assets are tied up, they are outside the scope of this book. However, we should not forget about them. If push comes to shove, there might be ways to extract additional cashflow from these assets. For example, if we are at risk of outliving our savings, a reverse-mortgage on our home might help bridge the gap.

Of course, the real world is slightly more complicated than these archetypes. However, I believe that a combination of these basic investment scenarios is enough to sufficiently describe virtually all relevant financial situations.

Investing Toward a Goal

This scenario is synonymous with all situations where we are saving towards a critical financial goal that we must not miss. Retirement is an excellent example here, as it applies to almost everyone. However, other goals are equally valid. In the chapter about financial planning, we have seen how the Model family was struggling to fund their children’s college education, which would put them into this same scenario.

There are never any guarantees in investing. Therefore, we focus on the next best thing: Maximizing the likelihood of reaching our goal. This is equivalent to optimizing the ‘reasonably pessimistic’ outcome of our investments.

Reasonably pessimistic is a very vague term. Unfortunately, we cannot make statements about the worst-case outcome because investments are unpredictable. Further, it is typically not a good idea to stretch the pessimistic view too much. Instead, investing requires some faith in the future, and without that, the only rational decision is to hold cash. We will dive deeper into this in our chapter about charts and metrics.

When we think about the possible outcomes of our investments, we find two forces at work: a long-term trend, and volatility. The long-term trend for most assets classes is upwards. This bias is deeply engrained in our system, and the end of stock market growth is most likely synonymous to the end of capitalism and the western world order as we know it.

But investing is not smooth sailing, and in the shorter term, volatility takes over. The markets show daily ups and downs, driven by a complicated web of interactions between government, companies, investors, and news agencies, both on the domestic and international scene. Many of these players tend to overreact, driven by fear or greed. As a result, we find daily market fluctuations which carry almost no information but are predominantly random.

It is obvious that the magnitude of our trend scales with time: The longer we invest, the more of the long-term trend we can capture. At the same time, our daily swings are mostly independent of time. As a result, we find that the returns of short-term investments are dominated by volatility, while in the long term, trend becomes the major force.

We can visualize the relationship between investment returns, volatility, and time as a cone, which gets wider over time. The area inside the cone describes the range of likely investment outcomes. We will take a deep dive into the construction of this cone in our chapter about charts and metrics. For now, it is sufficient to know that there is a high probability of our investment outcome landing somewhere inside the cone.

The top of the cone describes the optimistic investment outcome. I cannot think of any investment scenario where this line serves a useful purpose, other than providing an upper limit on the returns we may achieve when all the stars line up. Right through the center of the cone goes the average return of our investment. For many investments this is the only quantitative figure available, but it is also irrelevant while investing toward a goal, because half of the time, our returns will be lower than this. At the bottom of the cone, we find the outcome under pessimistic conditions.

When investing toward a goal, our interest is focused on reaching that goal, even when things go bad. We have only one chance, and there are no do-overs when we fall short. Consequently, the only figure of interest is the amount of savings we can confidently rely upon. To maximize this number, we must plan pessimistically, and optimize the outcome under such conditions. This approach has profound implications for our investment strategy.

To better understand this, it is worth thinking about the shape of that cone some more. The cone’s nose is rather wide, due to the effect volatility has on shorter investment periods. But over time, when the long-term trend takes over, the cone widens at a slower pace. We can therefore say that time is on our side. This is true for multiple reasons. For once, with longer investment periods we have a better chance of saving enough to satisfy our goal. And further, because with more time, the returns become more predictable.

When looking at this pessimistic edge of the cone, we also notice that, at the cone’s nose, the investment outcome is a potential loss. This is a direct effect of volatility drowning the asset’s growth trend. An immediate implication is that investments bear a substantial risk of loss when the observed investment period is too short to absorb the asset’s volatility.

It is easily conceivable that the cone becomes wider when the trading range of an investment, or its volatility, increases. A wider cone is most often synonymous with lower pessimistic returns, at least when looking at typical investment periods of less than 25 years. In other words, when investing toward a goal, volatility is our enemy.

When comparing two investments, they each form their own cone. It is evident that investments with higher returns have a steeper slope. But most of the time, these investments are also riskier, leading to a wider cone. Consequently, when looking at the pessimistic outcome, the riskier investment might not pay off. For many years, its return might actually trail the less risky alternatives.

The example above compares the outcomes of an investment in stocks and an investment in bonds. We can see that, on average, stocks have a much higher return than bonds, as the cone for stock investments is much more slanted. At the same time, we can also see that stocks have much higher volatility than bonds, as the cone for stock investments is much wider. If we look at the pessimistic outcome, then we notice that an investment in a pure stock portfolio will only surpass an investment in bonds after an investment period of 13 or more years. Investors tend to underestimate this period – by a lot!

The main takeaway is that when we are aiming to hit a critical financial goal, the objective of beating the market most likely does more harm than good. When looking at the pessimistic outcome, investments with lower volatility often outperform riskier investments with higher average performance. This is especially important for those investors that feel anxious to make up for lost time and are contemplating aggressive investment strategies.

In summary, we can characterize investing toward a goal as follows:

• Time is on our side
  • Because we participate more in the overall upwards trend
  • Because is dampens the effect of volatility
• Volatility is our enemy
  • Because it widens the range of possible outcomes and reduces the pessimistic outcome
• Investments should be optimized for their pessimistic outcome
  • Because there are no do-overs

Investing for Income

Investing for income is a scenario in which an investor has saved a considerable amount of assets and is now seeking to convert these assets into an income stream. Typically, this income stream will slowly but steadily deplete the savings, limiting the duration the savings can support the income stream. This depletion is actually desirable, as long as the savings last long enough to cover our retirement with sufficient safety margin.

We explicitly don’t want these savings to continue appreciating. To understand this, we need to remind ourselves of the concept of goal-oriented investing. What is the purpose of accumulating even more wealth, while we are already retired? Most likely, we will pass this wealth on to the next generation. While there is nothing wrong with doing so, investing excess funds is a separate investment scenario with very different characteristics.

Other books about investing often aim to establish a safe withdrawal rate that can be sustained in perpetuity. I disagree with that approach, because in my opinion all funds should be earmarked for their purpose and invested accordingly. Misclassifying generational wealth as income makes it harder to pick suitable investment objectives and leads to missed opportunities.

It is immediately clear that we should also have pessimistic expectations when investing for income. This is the only way we can make sure that we won’t outlive our savings. If our investments perform better than that, closer to average, we can grant ourselves some extra wishes from our financial plan or pass the remainder on to the next generation. Of course, it is possible to scale back expenses when investments don’t perform as planned. However, during retirement this is much harder than while working. We are no longer in full control of our spending, especially when considering higher costs due to health concerns.

The chart above shows the cones of probable outcomes for an investment in stocks and bonds, while withdrawing the same amount of moderate income. Under these conditions, and with a pessimistic point of view, we notice that the investment in bonds lasts at least 25 years, while the investment in stocks lasts significantly longer.

This makes sense, as the stock investment has, on average, a higher rate of return. However, for investment periods shorter than 16 years, we can see that, due to the lower volatility, the investment in bonds outperforms the stock investment. This outperformance is equivalent to either a higher probability of success, or a higher standard of living. As we have seen in the investing toward a goal scenario, the higher risk often does not pay off, when contemplating shorter investment horizons.

It is important to understand the impact of volatility under these conditions. Because the income stream is withdrawn as constant monthly payments, drawdowns have very negative consequences. If the portfolio lost 50% of its value at any time, the monthly rate of withdrawal would double, leading to an accelerated depletion of the savings. Similarly, and for the same reason, we see the rate of withdrawal accelerate while we draw from the account.

It is evident that neither time nor volatility are on our side. The more time passes in this period, the more the rate of withdrawal accelerates. Also, the higher the volatility, the more likely we experience deep drawdowns, leading to a period of excessive withdrawal rate. And even worse, the longer the investment horizon, the more likely we will experience such a deep drawdown.

Again, this is especially important for those investors concerned that they might be running out of money. Investing more aggressively will, most likely, not improve the situation but instead make matters worse.

This chart above shows how this effect becomes more pronounced when withdrawing a higher income. Here, we can see that under pessimistic conditions, the riskier investment in stocks depletes even faster than the safer investment in bonds.

As with the previous investment scenario, investing toward a goal, the idea of beating the market is turned on its head. Because we are looking at the pessimistic outcome of our investments, investments with lower volatility often outperform riskier investments with higher returns.

In summary, we can characterize investing for income scenario as follows:

• Time is against us
  • Because we deplete our savings
  • Because it increases the likelihood of experiencing deep drawdowns
• Volatility is our enemy
  • Because it widens the range of possible outcomes
  • Because the rate of withdrawal accelerates during drawdowns
• Investments should be optimized for their pessimistic outcome
  • Because there are no do-overs
  • Because scaling back expenses during retirement might be difficult

Investing Excess Funds

This scenario describes a situation where an investor is certain to cover all financial goals and only invests to pass the wealth on to the next generation, or possibly fulfill an optional wish. Typically, this scenario is a bonus that is applied to a part of the total wealth, while using one of the two other scenarios for the remainder.

The idea is that we invest those funds earmarked for income or reaching a goal conservatively, to maximize the likelihood of reaching these goals. For the remaining funds we are more flexible and can invest more aggressively. This split approach makes sure we make the best out of our hard-earned dollars, while at the same time being prudent investors and mindful of risk.

The absence of hard constraints makes this scenario fundamentally different from the others. We are no longer required to consider the pessimistic outcome, but we can now focus on maximizing the expected return of the investment. This is identical to optimizing for the average rate of return, a number which is often provided for historical returns.

Theoretically, an investment’s volatility is irrelevant when investing excess funds. Therefore, investors are free to use any method to drive up the rate of return, including leverage. However, in reality this is likely not true. Instead, the maximum volatility of an investment is limited by the investor’s ability to stomach drawdowns.

Unfortunately, investors often overestimate their appetite for risk. Then, when faced with the reality of having lost a significant portion of their savings, they feel the urge to correct their mistake and de-risk their investments. Doing so is typically a mistake because it combines the worst of two worlds. First, the investor suffers a drawdown that is deeper than what a more docile asset would have resulted in. But instead of recovering from this loss over time, the investor now locks in that loss and recovers at the slower rate of the less risky investment.

The chart shows the range of probable outcomes for an investor starting out with an all-stocks investment. Then, after four years and experiencing a deep and prolonged drawdown, the investor de-risks to an all-bonds portfolio. In doing so, basically a new cone opens at that point, which is identical to the cone for an all-bonds investment. However, this new cone sits significantly lower than that for the less volatile investment, with no chance of ever catching up.

The takeaway should be that, even when investing for legacy, it is imperative to carefully think about the personal appetite for risk and its limits. If you are tempted to second-guess your portfolio at any point of the investment journey, you should definitely opt for less risky investments. Only if you are sure to be able to hold the course, even in turbulent investment times, should you consider all-stocks or even leveraged investments.

It is also worth noting that we did not discuss the question of de-risking in the context of the other investment scenarios. This is because when optimizing for the pessimistic outcome there are natural limits to volatility, which make it much less likely for investors to second-guess their decisions.

The aspect we haven’t discussed so far is time. Just like investing toward a goal, time is clearly on our side. But unlike with the other two scenarios, time may be undefined when investing for legacy. This is true for multiple reasons. For once, when truly investing to pass wealth to the next generation, time is not in our control. When investing to fulfill a wish, the investment period is likely hinged on the investment performance. If the investments do well, the wish is granted, otherwise it is deferred to a later time. In doing so, the effects of volatility are mitigated gracefully.

In summary, we can characterize investing excess funds as follows:

• Time is on our side
  • But the investment horizon is often undefined
• Volatility is irrelevant
  • Because we are optimizing for the best average outcome
  • Nonetheless, we should be careful not to exceed our personal risk tolerance
• Investments should be optimized for their average outcome
  • Because we have no constraints that would prohibit possible underperformance

Conclusion

In this chapter, we analyzed the three archetypes of investing scenarios. We now know the important issues to watch out for when investing, a helpful first step to translate the findings from financial planning into suitable asset allocations.

In short, we can compare the three investing scenarios as follows:

	Investing Toward a Goal	Investing for Income	Investing Excess Funds
Time	Is on our side, and at least partially under the investor’s control.	Is against us and often out of the investor’s control.	Is on our side, but often undefined.
Volatility	Is against us, but its role diminishes with longer investment horizons.	Is our biggest enemy because it accelerates the rate of withdrawal.	Is irrelevant and only limited by the investor’s risk appetite.
Investments	Should be optimized for their pessimistically expected returns, carefully balancing volatility with returns.	Should be optimized for their pessimistically expected returns, with a preference towards lower volatility.	Should be optimized for the average expected returns, considering the investors stance on risk.

The key takeaway is that the most-often cited number to characterize investments, their average annualized return, is irrelevant for two of the three scenarios. Instead, the expected returns under pessimistic assumptions are the parameter to optimize for, which is a very different objective than attempting to beat the market. In the coming chapters, I will introduce a framework that quantifies the relationship between returns, volatility, and the investment horizon, allowing investors to make better investment decisions.

Next Chapter: Charts and Metrics