Dangers of Passive Index Investments

With investors becoming more aware of costs and expenses, many have decided to move to passive index investments. This move has allowed investors to reduce costs and obtain returns similar to the index. Passive investments or index funds can be great if used correctly and for the right person/situation. For example, a younger person who is contributing to their 401k and has a long time horizon is a great candidate. They can easily endure the ups and downs of the markets while dollar-cost averaging over their working life. For someone who is already retired or approaching retirement an index fund may not be the best option. The risk for a retiree/near-retiree is that they could hinder the longevity of their retirement capital since an index fund, by design, will match the index in both good and bad markets. A related risk involves an investor’s behavior especially during a down market. Please refer to our previous blogs about Sequence of Return Risk and Investor Behavior Gap to better understand these risks. 

Many investors do not realize the hidden dangers of investing in index funds. When it comes to indexes like the S&P 500, most of the passive funds are market-cap weighted - meaning that large companies like Apple make up a sizable portion of the index fund’s holdings. These companies have become so highly valued that the five largest companies (Apple, Microsoft, Alphabet (Google), Amazon, Facebook), account for 17.5% of the market-cap weighted S&P 500 Index. This is inconsistent with the whole idea of buying a cheap, broadly diversified index since just five technology-based stocks will have such a significant impact on the index’s performance.  To put this in perspective, as recently as 2012 the top 10 holdings in the index accounted for approximately 20% of it’s value and contained more than just technology stocks (names like Walmart, Exxon, and Pfizer). 

As a result of how they are structured, an index fund overweights stocks that have outperformed while underweighting those that have underperformed. The more those big five stocks go up the more the index funds have to buy them.  An investor that prefers to buy low and sell high will be forced to watch the exact opposite happen within their index fund. An investor is betting that whatever has been going up will continue to go up. History tells us that is a bad bet.  While growth stocks, like the technology companies mentioned above, have been the leaders for most of the past decade, history shows that rotations from growth stocks to value stocks will not be announced and can result in vast performance differences. The last time growth-oriented technology stocks substantially outperformed value-oriented stocks was in the 1990’s.  The following decade value stocks dramatically outperformed growth stocks.  

As with all things in life there are positives and negatives related to investing in passive index funds. Low costs and market matching performance work to an investor’s benefit especially during the accumulation phase of their financial lives.  That same market matching performance during the distribution phase of an investor’s financial life may work against them especially when the next bear market hits.

Sequence of Return Risk

As mentioned in our previous blog (Monte Carlo and Retirement Success), the sequence in which you earn returns plays an important role when planning for a successful retirement. A significant decline in the value of your portfolio near or at the beginning of retirement is among the most potentially destructive scenarios. This is due to withdrawals to fund your spending, the impact on future growth and a portfolio’s struggle to regain lost ground. It can cause a portfolio’s longevity to decline faster than the retirees. 

In the chart below, we show and compare the portfolio values of someone who is in the Accumulation phase (working) and someone who is in the Distribution phase and taking withdrawals (retired). Each portfolio had a starting value of $1.25 million with the Distribution phase portfolios withdrawing $50,000 per year indexed for inflation. We ran two scenarios using returns from 2008 through 2017.  In the Accumulation 1 and Distribution 1 scenarios we used the actual returns for a balanced portfolio (60% stocks/40% bonds) which reflects a loss of 22% in 2008. While the Accumulation 2 and Distribution 2 scenarios reflect the exact inverse with a loss of 22% in 2017. We can clearly see that in the Accumulation phase the sequence of returns has no impact on the final outcome since there were no withdrawals.  On the other hand, there is a sizable effect during the Distribution phase. The gap over a 25-30 year retirement would be even wider.

Nov Blog

According to data and analysis done by PIMCO, consider a retiree who had a $1 million portfolio which allocated 60% to stocks and 40% to bonds in 2007. Despite the 51% drop from October 2007 to March 2009, the portfolio would have recovered fully by 2011 and grown to about $2 million by 2017 if it had been left untouched.  In a similar scenario in which the retiree was withdrawing $50,000 each year the outcome would be far different. Even today, 12 years later, their portfolio would be worth only $1.2 million.

Another issue that can arise from a market downturn near or early in retirement is de-risking or scaling back equity exposure at market bottoms. Although this might feel better in the short- term, it can lead to longer term issues. Taking the same time period as the previous example (2007-2019), if someone had de-risked to 40% stocks and 60% bonds in 2009, the value of their portfolio would be $920,000 rather than $1.2 million. If a retiree had responded in a more extreme way and allocated their entire portfolio to cash to hide from further market erosion the portfolio value would only be $306,000.  In both de-risking scenarios, the retiree has converted temporary losses into permanent losses. 


According to Cerulli Associates, nearly 60% of individuals with advisors lack a retirement income plan and that number rises to 80% for individuals without an advisor. There are many ways to lessen the impact of potential negative returns when you are approaching or in retirement.

  1. Creating a long-term retirement funding and investment plan to which you will adhere.
  2. Tactical rebalancing (buy low, sell high/take profits).
  3. Adjusting spending in response to changes in your portfolio value. 
  4. Overweighting undervalued assets (assets that have performed worse relative to other asset classes) and underweight or take profits on those that have outperformed.
  5. Understanding the upside and downside capture of your investments, mutual funds and overall portfolio. How much does your portfolio follow the broader market on the way up and the way down? 
  6. Owning a truly diversified portfolio. Did you know that 10 stocks account for 21.5% of the S&P 500’s value and the top four (Microsoft, Apple, Amazon, Facebook) make up 12.75%.

A stock market meltdown leading up to retirement or in the early years of retirement can have destructive long-term effects.  Understanding the potential scenarios along with proactive planning and sensible strategies for mitigating the impacts are paramount to long-term success.  

Monte Carlo and Retirement Success

  • What's the likelihood that your retirement assets will allow you to maintain your lifestyle in retirement?
  • What rate of return do you need to earn in retirement to maintain your lifestyle?
  • What asset allocation is consistent with your need to generate retirement income while providing growth to protect your future purchasing power?
  • When is the optimal time for you to start Social Security?

The average person works 80-90 thousand hours in their lifetime, but spends less than 10 hours planning for their retirement. That seems unbelievable, but it is true. Monte Carlo analysis is a detailed way to test the probability that your retirement assets will last the rest of your life while maintaining your lifestyle. Key factors in this analysis are your income sources, expenses, rate of inflation, life expectancy, and the expected long-term return for your investments. Some of these factors are controllable or dependable like expenditures and Social Security while others can be forecast with some level of confidence. 

Income in retirement usually consists of Social Security and retirement account distributions although pensions still exist for some people.  Social Security can start as early as 62, but the full retirement age is currently around 67. If Social Security is taken before 67 you will receive a discounted payment while delaying your payments will increase your benefits. Generally speaking, you would need to live until age 82 or 83 to justify delaying your Social Security benefits to age 70.    

SS breakeven

For most retirees distributions from retirement accounts (IRA’s, 401k, 403b) will serve as another major source of income.  Investing your retirement accounts to produce income while providing growth to protect your future purchasing power requires a properly diversified portfolio that is structured to meet BOTH objectives.  Tactical rebalancing of your portfolio to control risk and capture profits to fund distributions will also play an important role in determining your long-term viability.  Required Minimum Distributions (RMD’s) from retirement accounts (ROTH IRA’s are the exception) are currently required by law beginning at age 70 ½. Current legislation called the SECURE Act could increase the age to 72. 

Your expenditures/withdrawal rate are the most controllable portion of this analysis and can have a significant impact on the probability that your money will last the rest of your life. Inflation and life expectancy are uncontrollable variables that can still be forecast with some level of confidence. See http://www.vonholt-fa.com/our-blog/51-risks-retirees-face.html for a further explanation of these topics.

How Monte Carlo works

Fixed income sources such as Social Security and pensions can be forecast with a high degree of confidence.  A strong understanding of past spending patterns and forecasts of non-recurring expenses such as travel or renovations are the only variables that are under your direct control.  An assumption with regards to longevity should be conservative rather than using an average so that you do not outlive your assets. Long-term forecasts for inflation and rates of return can be made with a fairly high degree of certainty although the sequence and variability can substantially impact your chances for success.  

To address the concerns about the sequence and variability of inflation and rates of return a Monte Carlo simulation should be completed. Monte Carlo attempts to show what might happen in a situation where inflation varies and the returns on assets are positive in some years and negative in others. The simulation runs 10,000 iterations through life expectancy to test the sequence and variability of inflation and returns to provide an average outcome and the probability of maintaining your lifestyle through certain ages. 

Below is an example of a Monte Carlo simulation which shows a client’s probability of living their desired lifestyle to certain ages. Monte Carlo analysis should be updated to reflect material changes in your life situation or goals and can include multiple alternatives. 

Monte carlo

Anyone less than 10 years from expected retirement should complete this type of analysis and understand the impact key variables may have on their chances for a financially successful retirement. This analysis is a good way to start the process of retirement planning to ensure that a lifetime of work leads to a long and comfortable retirement.

Risks Retirees Face Continued

In June, we addressed the three major risks retirees face - inflation, withdrawal rate and longevity.  This month we will discuss four additional risks that affect retirees.

June blog

Retirement Spending – In retirement, spending habits and needs will change. As discussed in the previous blog, medical expenses will increase for retirees, but there are offsets. For example, having your mortgage paid off or downsizing could offset some increases in medical costs. What retirees need to pay attention to is how they will replace the income that they are losing by retiring. The three pillars of retirement income include Social Security, pensions, and personal investments and retirement accounts like 401k/403b or an IRA.  A retiree needs to keep in mind that, for example, they don’t have $1mm to spend rather they have $1mm from which to create an income.

Market Volatility – During the Accumulation Phase (while working) market volatility is not as harmful to investors because it allows them to dollar-cost average into the stock market picking up more shares when stocks are on sale which lowers the average cost per share. That all changes in retirement. While in retirement (Distribution Phase), the opportunity to purchase additional shares is limited to tactical rebalancing. The challenge is that an investor will need to have the emotional fortitude to sell bonds and buy stocks just when things are at their worst.  Another means for reducing portfolio volatility is a greater allocation to bonds and/or income producing assets.

Savings - In retirement it is widely recommended to maintain 18 months to two years worth of savings in safe investments like CDs, money markets, and savings or checking accounts.  These assets can be drawn upon to fund spending during down markets rather than selling equity investments when they are temporarily depressed. At Von Holt Financial Advisors, we follow this rule in a slightly different way. For retirees in the Distribution Phase, we maintain several years worth of spending in low duration and high-quality bonds as a safety net with the added benefits of increased returns and regular income production.  Although the bonds have higher volatility, we actively monitor the portfolio so as to manage the additional risk. It is our opinion that it is worth the extra risk in order to capture the higher yields and income for a long-term investor. 

Solvency - Private pensions that are offered by companies have been decreasing rapidly over the last few decades so for most retirees their primary fixed source for retirement income will be Social Security.  As Social Security runs into funding issues personal investments and retirement accounts will be front and center for anyone that wants to have a financially secure retirement. With estimates that the Social Security Trust Fund will be depleted by 2034 retirees are expected to receive only 77% of their anticipated benefits after 2034.  As a result, personal investment and retirement accounts will account for a growing portion of a retirees income sources. This argues for starting to save for retirement earlier and saving a larger portion of your income to offset these other risks.

Risks Retirees Face

This blog will be presented in two parts. In the first part, I will discuss the three most substantial risks retirees face, and the second part will discuss four other risks.

June blog

Inflation – As discussed in a previous blog about real return, inflation plays a large role in the ability to maintain your standard of living in retirement. Historically, average annual inflation has been from 3.0% to 4.0% depending on the time frame considered. We are currently using a long-term inflation rate of 3.25% when forecasting client total expenses. The rule of 72 is a simple calculation to show how long it would take your money’s value to halve due to inflation or double based on returns. You just divide 72 by the rate of inflation (or return) to see how many years it would take to halve (or double) in value.

Withdrawal rate – The rate at which you withdraw from your retirement assets is a primary factor when determining how long your assets will last. Below is a graphic showing the probability of your money lasting through a 25 year retirement at different withdrawal rates and asset allocations. We usually assume a life expectancy of 97 so we tend to invest slightly more in stocks to produce additional growth to protect our client’s purchasing power.

 June blog 2

Longevity – With advancements in medical treatments and technology retirees are living healthier and longer lives. This means that your money will need to last through a longer and more active retirement. With a longer life expectancy, the rate of inflation and your withdrawal rate will play an even greater role in determining your chances for long-term financial security. At the same time, medical advances will increase your total medical expenses which have generally outpaced the rate of overall inflation. Below is a chart showing the probabilities of a 65 year old living to various ages.

The inflation rate, your withdrawal rate and your longevity are linked together and will play a major role in determining your long-term financial success.  

June blog 3

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