Volatility can be your friend....or not.

    Annual Investment

     

    $1,000

    $1,000

    $1,000

    $1,000

    $1,000

    Fund Price

     

    $50

    $40

    $50

    $40

    $50

    Shares Purchased

     

    20

    25

    20

    25

    20

    Share Balance

       

    45

    65

    90

    110

    Amount Invested

     

    $1,000

    $2,000

    $3,000

    $4,000

    $5,000

    Account Value

     

    $1,000

    $1,800

    $3,250

    $3,600

    $5,500


    Source: Joseph Steiniger; Senior Vice President-Investment Officer This information is hypothetical and is provided for informational purposes only. It is not intended to represent any specific return, yield, or investment, nor is it indicative of future results

    In this example, an investor commits $1,000 per year to purchase a fund, every year for five years. The fund price in year one is $50. The price goes up and down, between $50 and $40, every year for each of the five years, ending up at the same $50 starting price. When the fund price is $50, 20 shares are purchased. In year two, the price drops to $40, so 25 shares can be purchased with the same $1,000 investment. Over the five year time frame, 110 shares are purchased, and the closing fund price per share is the same $50. At the end of the exercise, $5,000 has been invested, but the account is worth $5,500, a 10% gain, even though the return on the fund has been 0%.  During the accumulation phase of an account, volatility can enhance a dollar cost averaging program.

    When accounts change to distribution mode, all of that changes. It is important to remember that accounts that are paying out distributions may still be accumulating capital on a net basis, if the portfolio income exceeds withdrawals.  For retirement “nesteggs”, this is a most important calculation. Some retirees will never need to invade their capital to fund their retirement cash flow. They have the luxury of being able to live off their dividends, or other retirement income, and no principal withdrawals are necessary. The IRS may mandate that money be moved from and IRA starting at age 70 ½, but that money is typically reinvested in another account. The “nestegg” remains intact. For those investors, no change of investment strategy is required. In fact I often treat those accounts as though they were “dual purpose” trust accounts. The income is for the retirees; the principal is really managed for “the remainderman”, typically the children.

    Other retirees must use their nestegg’s capital to supplement their retirement income. For those portfolios, a careful analysis of investment volatility is required. The reason for the concern is not just that older investors should be more conservative, or that retirees should own more bonds, or that they cannot afford to absorb losses. The reason has nothing to do with fear or greed. If accounts are cash flow negative, there is an arithmetic reality that will mandate that portfolio volatility be mitigated. I call this scenario “reverse dollar cost averaging”.   

    Just as dollar cost averaging works in the favor of (younger) investors who are adding to their accounts, accounts that are now in distribution mode are now penalized by “reverse dollar cost averaging”.  When markets are down, they must sell more shares to fund their necessary cash flow. When prices are up, they sell less, exactly the opposite of the beneficial dollar cost averaging enjoyed by younger investors.

    The chart below tells the story:

    Systematic Distributions over a Five Year Period

    Annual Withdrawal   $1,000 $1,000 $1,000 $1,000 $1,000
    Fund Price   $50 $40 $50 $40 $50
    Shares Sold   20 25 20 25 20
    Share Balance 100 80 55 35 10 -10
    Amount Sold   $1,000 $2,000 $3,000 $4,000 $4,500
    Account Value $5,000 $4,000 $2,200 $1,750 $400 -$500

    Source: Joseph Steiniger; Senior Vice President-Investment Officer This information is hypothetical and is provided for informational purposes only. It is not intended to represent any specific return, yield, or investment, nor is it indicative of future results.

    In the above five year sequence of cash flows, the account principal is exhausted before the end of year five.  The reason that most post retirement accounts which are cash flow negative (using principal for distributions), should reduce volatility is grounded purely in the math. The negative effect of volatility can be mitigated by prudent asset allocation and cash flow management, but the headwinds are working against the account. A systematic liquidation of the most volatile assets, or a pro-rata distribution of all assets in the account, would not be as effective as managing liquidations by asset class selection.

    For all of the above reasons, an in depth analysis of retirement cash flows is necessary to save investors from making costly mistakes. While volatility can be utilized to enhance returns in portfolios which are still growing, accounts that are being drawn down systematically to support retirement budgets or make payments to beneficiaries must be viewed though a different prism.
     
    Important Disclosures

    Wells Fargo Advisors did not assist in the preparation of this report, and its accuracy and completeness are not guaranteed.  The opinions expressed in this report are those of the author and are not necessarily those of Wells Fargo Advisors or its affiliates.  This material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy and sell securities or instruments or to participate in any trading strategy. Wells Fargo Advisors does not provide tax or legal advice.

    Past performance is no guarantee of future results.  Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns. Diversification does not guarantee profit or protect against loss in declining markets. Dividends are not guaranteed and are subject to change or elimination.

    Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations.

    Investing in fixed income securities involves certain risks such as market risk if sold prior to maturity and credit risk especially if investing in high yield bonds, which have lower ratings and are subject to greater volatility. All fixed income investments may be worth less than original cost upon redemption or maturity.  Bond laddering does not assure a profit or protect against loss in a declining market.
     
    A periodic investment plan such as dollar cost averaging does not assure a profit or protect against a loss in declining markets. Since such a strategy involves continuous investment, the investor should consider his or her ability to continue purchases through periods of low price levels.

    Wells Fargo Advisors gathered this information from sources that we believe to be reliable, but makes no guarantee with regard to accuracy or completeness.  Wells Fargo Advisors does not offer tax or legal advice.  Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC (WFCS), Member SIPC, a registered broker-dealer and non-bank affiliate of Wells Fargo & Company .

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