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Why diversification matters for income generation

This article is part of
How to use multi-asset portfolios for income generation

Mr Morris highlights a study from the University of York last year (2017), authored by several experts including Andrew Clare, in which it found that diversification across asset classes does lead to higher withdrawal rates than simple equity/bond portfolios.

The 36-page study, called Decumulation, Sequencing Risk and the Safe Withdrawal Rate: Why the 4 per cent Withdrawal Rule leaves Money on the Table, built upon earlier studies which aimed to work out the perfect withdrawal rate (PWR). 

It claimed in a perfect world, all advisers and investors would have to do is a simple equation that would allow them to find out exactly how much money could be taken from the fund each year, without detrimental effect.

The study said: "Quite simply, if one knew in advance the sequence of returns that would come up in the planning horizon, one would compute the PWR, withdraw that amount each year, and reach the desired final balance exactly and just in time."

However, we do not live in a perfect world but one of "unforecastable asset returns", which have a knock-on effect on any tactical glidepath to retirement returns, and resulting in costly failures to provide a well-balanced, risk-tolerant portfolio.

In essence, without proper diversification, taking down far too much income from a fund whose investment performance is unpredictable is a highly risky strategy, especially for people looking to live off the income from their portfolio.

The study also concluded: "Using UK data we find that multi-asset portfolios for the most part offer an improvement on 60-40 (equity to bond ratio) and 23 30-70 stock-bond investments with smaller probabilities of low safe withdrawal rates.

"The exception comes for those seeking the very highest PWRs where there is little choice but to accept a large equity component."

While the study believes a 4 per cent annual withdrawal can work in the investor's favour, what really matters is true diversification - not just in terms of the bond/equity allocation, but across a wider range of asset classes and with an attempt to minimise exposure to trends.

"The application of a trend following filter to the assets within each portfolio substantially improves the performance by reducing volatility and maximum drawdown without any loss of return," the study concluded.

According to Rathbones, there are several overarching risks that the multi-asset team keeps a close eye on, aiming to diversify the portfolio so the underlying holdings are unlikely to all be affected from either systemic or management risks.