This article was posted on June 1, 1999. Revised July 13, 1999
An emerging trend sees investors fleeing mutual funds and purchasing individual stocks and bonds. While this often reduces fees and commissions, some investors are making the switch to place a concentrated bet on a few issues. Is this wise? Can anyone play this game, or should it be left to the young? What does the increased volatility of a concentrated portfolio do to "safe" withdrawal rates in retirement?
Another poster observed, "diversification may preserve wealth, but concentration builds wealth." Warren Buffett himself said during an appearance at the University of Washington in 1998 that most people will only see 2 or 3 truly great investment opportunities in thier lifetime. When a good opportunity arises, "it's not the time to be reading a textbook on diversification."
There's no question about it. Investing in an S&P500 index fund means you won't beat the market. Of course, you won't lag the market averages either, like 85% to 90% of professional money managers. But, if you want superior performance, you'll have to buy the lottery ticket of a concentrated portfolio.
Safe Withdrawal Rates for Concentrated Portfolios
The biggest problem that concentrated portfolios pose for retirees is increased volatility. Increased volatility adds risk for an individual looking to withdraw annual distributions from a retirement portfolio. A concentrated portfolio may have superior total returns, but the increased volatility means annual withdrawals must be reduced as a percentage of assets to ensure survivability. This is necessary to insure that a stock market drop doesn't prematurely deplete the portfolio.
Most of the studies on safe withdrawal rates in retirement have used the S&P 500 index as the proxy for the equity portion of the retirement portfolio. However, many retirees prefer to hold a portfolio of individual stocks instead of an S&P 500 index fund. Is it safe to hold a concentrated portfolio in retirement? How does one calculate the "safe" withdrawal rate for a concentrated portfolio?
Diversification vs. Non-Market Risk
Nobel Laureate William F. Sharpe's 1972 paper on "Risk, Market Sensitivity, and Diversification" (Financial Analysts Journal, Jan/Feb 1972, pp. 74-79) appears to be the best place to start in evaluating the "safe" withdrawal rate for a concentrated portfolio. Sharpe derived the formula relating non-market risk to diversification:
where D = the effective diversification of the portfolio and,
where V = the relative value of each position in the portfolio, and
R = the relative non-market risk
Some readers may be familiar with Sharpe's well known plot relating non-market risk to number of securities. It's a graphical representation of 1/(SQRT D) and is reproduced below.
Using Sharpe's formulas, we can calculate the the effective diversification, D, for a $100,000 portfolio consisting of $23,000 in a money market fund and $77,000 in four Dow stocks (i.e., a Motley Fool Foolish Four portfolio.)
Effective Diversification, D = 1/(SUM (V x R)^2) = 1/(0.07557) = 13.2
Non-market Risk = 1/(SQRT (D)) = 1/(SQRT 13.2) = 27%
Safe Withdrawal Rates for Concentrated Portfolios
In using this relationship to examine the safe withdrawal for a concentrated portfolio, four assumptions are made:
Based on the four assumptions above, the equation for calculating the withdrawal rate for a concentrated portfolio is as follows:
This relationship is shown in the plot below. The left hand scale measures non-market risk while the right hand scale shows the corresponding "safe" withdrawal rate for that level of diversification.
Sample Calculation of Safe Withdrawal Rate for a Concentrated Portfolio.
Exercise: Determine the "95% safe" withdrawal rate for a retiree holding the Motley Fool Foolish Four portfolio in the example above. Our retiree has a 40 year pay out period.
Using the Retire Early Safe Withdrawal Formula for Concentrated Portfolios and substituting the known variables:
Wportfolio = (0.0444)-((0.2749-0.1414) / (1.00-0.1414))*(0.0444) = 0.0375 = 3.75%
Safe Withdrawal Rates for Some Famous Portfolios
Using the Retire Early Safe Withdrawal Formula for Concentrated Portfolios the "100% safe" inflation adjusted withdrawal rate was determined for several "famous" portfolios. Here's the results.
The most striking result of this tabulation is the comparison of the Foolish Four Portfolio with the Rule Breaker Portfolio. Even though the Foolish Four has 4 stocks and the Rule Breaker portfolio has 12, the effective diversification for the Rule Breaker portfolio is a dismal 2.0. This is because America On-Line (AOL) and Amazon.com (AMZN) make up over 50% of the Rule Breaker portfolio and are high volatility stocks (i.e., "high beta".) The Foolish Four portfolio, in contrast, has low volatility Dow stocks which actually increase the effective diversification of the portfolio.
This table also illustrates the effect of diversification on safe withdrawal rates. Portfolios with large positions in volatile stocks suffer much lower "safe" withdrawal rates. Indeed, a portfolio with a single low volatility Dow stock (e.g., Chevron or Eastman Kodak) is more diversified and offers a higher "safe" withdrawal rate than a portfolio with equal weightings of 7 internet stocks with betas of 2.0 or more.
What are the reasonable conclusions to draw from this?
Diversification is important for a retiree making annual withdrawals from a portfolio. If you decide to maintain a concentrated portfolio in retirement, reduce your annual withdrawal. If you can't survive on the lower withdrawal rate, then you need to diversify.
However, this doesn't mean you should automatically sell all your winners and buy an index fund when you retire. When I ran this calculation on my own portfolio I got a D = 1.8 and a "95% safe" withdrawal rate of 1.27% for a 50 year pay out period. Since I'm spending less than that, I figure I'm O.K. If you can live comfortably on a 1.50% withdrawal rate and don't mind the risk, you can logically (if, perhaps, not safely) hold the Motley Fool Rule Breaker Portfolio in retirement.
The Retire Early Diversification Spreadsheet
Retire Early has developed an easy to use Microsoft Excel spreadsheet for making the "safe" withdrawal rate calculation described in this article.
Retire Early Diversification Worksheet
(rediver.zip, filesize = 7k, expands to rediver.xls, filesize = 22k.)
You will need pkunzip.exe to expand the file once you download it. The instructions for performing and interpreting the diversification calculation appear in the upper left hand corner of the spreadsheet.
filename = concport.html
Copyright © 1999 John P. Greaney, All rights reserved.