Yesterday, we talked about the two kinds of investing failure: slow failure, where returns over time are too low to meet goals, and fast failure, which involves a sudden drawdown or loss. We’ll focus today on slow failure, as it’s the more insidious risk (and one that most people don’t think about in sufficient depth).You can’t consider slow failure in isolation; the analysis must be done in conjunction with a specific goal. Often, that goal is both time linked and monetary. Retirement, for example, has a more or less specific start date and a more or less specific return goal. To say that I need retirement savings of $1 million in 20 years sets a specific goal that can either be attained or missed.
Slow failure, then, is a mismatch between what we expect to achieve and what we actually do.
Here’s an example
To see how this could play out, we’ll look at some real-world data. The chart below shows returns for a 60-percent S&P 500 and 40-percent Barclays U.S. Aggregate fixed income portfolio, or 60-percent stocks and 40-percent bonds. The data covers 1984 to 2013, or 30 years.
The chart shows several holding periods—12, 36, 60, and 120 months—in that 30-year time frame. There is considerable overlap, of course, but the idea is that an investor could have started in any month, and this covers all possibilities.
You can clearly see that average returns, for all periods, ranged between 9 percent and 11 percent, with longer periods of 5 to 10 years averaging around 9.3 percent. On the face of it, it seems as though you could reasonably expect to get that 9 percent or so consistently. How can slow failure be a problem?
That’s exactly why I have included minimum and maximum returns as well. I’m not worried about the maximums, as we can all figure out ways to spend the extra money, but the minimums are a serious issue.
The one-year drawdown, of more than 27 percent, is an obvious problem. This would potentially cripple a retirement plan. Less obviously, but even worse, is the 7-percent loss over three years. With a 7-percent required return from inflation and withdrawals, this equates to a 42-percent loss in purchasing power over three years, which would hurt a retiree even more.
Taking it to the limit of the data presented above, a 10-year return of just over zero and a 7-percent requirement would lead to a 70-percent loss in purchasing power.
On an average basis, over the past 30 years, a typical retiree with a 60/40 portfolio would do just fine with a required 7-percent return. But there have been starting points during that time when the same retiree’s portfolio would have been crippled and his or her financial plans derailed.
Slow failure has happened often during the past 30 years, a time when the market has risen dramatically. Matching expectations with reality is key to planning over long time frames. In my next post, we’ll talk about ways to mitigate the risk of slow failure.