For many of our clients, the purpose of accumulating wealth in a portfolio is to provide a sustainable income either now or in the future that is, at the very least, able to cover their basic needs and hopefully a bit more.
The level of portfolio-derived income required is unique to each client. Some of our clients have pensions from final salary schemes and possibly other income from other sources, such as property. Other clients need to rely more fully on their portfolios.
Portfolio income comes from the natural yield that a portfolio throws off in the form of dividends from companies and coupons (interest payments) from bonds, and capital makes up any shortfall. When markets rise, as they have done most years since the Global Financial Crisis a decade ago, portfolios may even grow after an income has been taken, although this will not always be the case. When markets fall, it can begin to feel a little uncomfortable as dividends may be cut and equity / share values may be down materially, as we have seen in the first quarter of 2020 (albeit, the upturn in April has helped).
The cardinal investment sin at these times is to sell equities when they are down and turn falls into losses. To avoid doing this, income required above a portfolio’s natural yield can be taken from bonds or cash reserves.
You first question might be, ‘How long might I have to do this for?’.
The figure below, helps to answer this question. It uses a range of regional (Europe, Asia-Pacific ex-Japan, Emerging and World) and major individual equity markets (US, UK, Japan) and plots the top 10 largest market falls for each and the time taken to recover back to the previous high, in, before-inflation terms.
Some overlaps obviously occur (e.g. the US is a material part of the World), but broad insights can be gleaned: most market falls recover within 5-6 years, some may take a up to a decade or so, and outliers can and do occur, such as Japan which took 27 years to recover (in GBP terms) from its market high in 1989.
Figure 1: How long will we have to wait?
Data source: Morningstar Direct © All rights reserved.
What is also evident is that, with the exception of Japan, these market falls all sat well within most investors’ true investment horizons. Whilst Japan provides a helpful lesson that investing outcomes are uncertain, widely diversified portfolios do help to mitigate country-specific risks. Even investors in their 80s should be planning to live to at least 100, giving them a 20-year investment horizon (today an 80-year-old woman has a 1-in-10 chance of reaching 98).
The question of how much cash or bonds an investor should hold will vary depending on how important it is for them to meet their basic income needs and how important it is having more discretionary spending. Using a sensible multiple of basic annual spending, and possibly additional discretionary spending, is a sensible starting point from which to reach a suitable minimum. For those to whom certainty of income is critical this could be significantly higher and for those to whom it is less critical, it might be lower. For all investors, it should be sufficient to ensure that they can sit out any market fall relatively comfortably, without having to sell their equities.
Sitting out an equity market fall is not so bad, when you know how long the wait might be and you come well prepared to sit it out.