What’s Your Investment Approach?

Part II

In What’s Your Investment Approach Part 1 we explored one dimension of the high level process of investing. Specifically we looked at two opposite complementary approaches to portfolio construction. We referred to selecting specific desired assets as the “additive” approach to synthesizing a portfolio, and starting with the universe of available assets and eliminating specific undesired as the “subtractive” approach to synthesizing a portfolio.

Here we examine another dimension of the overall portfolio construction process. In particular we look at how you expect to realize returns.

It’s usually assumed the investor will accumulate assets over the course of his investing career and then sell them to meet the costs of living in retirement. In fact vehicles for doing this are built into the tax code. These include the Individual Retirement Account (IRA) and the 401(k) in the US. You contribute before tax income during your working years, and are then expected to draw down or distribute the accumulated nest egg during retirement, paying income tax on it at that time. The term “Required Minimum Withdrawal” (RMD) highlights this; there are tax penalties for failing to do so.

It’s not without reason; it effectively aims to model an annuity, a stream of income that lasts as long as you live and leaves nothing left. That’s an efficient approach to getting the most out of your assets if you have no heirs. The popularity of such models is largely an attempt to replace increasing scarce pensions.

Often, however, investors treat assets held outside these vehicles the same way, selling them to meet expenses during retirement. Financial advisors promote accumulation and distribution plans based on this assumption. 

One example is based on the popular “4% Rule”. At retirement you withdraw 4% of your portfolio and each year index that amount to the CPI. Based on historical market performance, statistical life expectancy, etcetera, most people shouldn’t run out of money before they die.

Yet it’s not without controversy. Some authorities argue the risk of running out of money is greater than in the past due to increasing life expectancies or lower return prospects due to rich market valuations or both. To be on the safe side, some suggest a “3% Rule”. Some even recommend that instead of just figuring your annual withdrawals at one point in time and never adjusting them for anything but the CPI, incorporating some kind of feedback mechanism, such as just withdrawing 3% of the balance each year.

This structurally builds in safety since withdrawing a specified fraction always leaves a remainder.

But it still assumes you must sell. And if you buy the indexes, especially cap weighted US stock indexes, that assumption is correct. The yield on the S&P 500 for example is currently only 1.5%, reflecting those concerns about overvaluation. That particular group of stocks would need to sell for half the price for you to be able to sustainably withdraw 3% without selling.

At this point a voice in the back of your mind should be whispering doubts about the assumption that this is the only way to invest.

Of course it’s not. By emphasizing dividends, quality and value and expanding your investment universe beyond pricey US shores, it’s possible to assemble a solid portfolio that yields 3%. Or looked at the other way around (subtractive versus additive), reducing or avoiding exposure to supersized companies that pay no dividends, and overpriced and low quality stocks.

And because you’re reducing your reliance on having to sell to realize a return, you’re reducing your exposure to the risk that stock prices will be unfavorable in the future when you want to sell. Because of this, you can allocate more to stocks and less to bonds, reducing your exposure to the risk that inflation will eat you alive. This is the concept behind the Income Portfolios on the Financology Model Portfolios page.

No. Accumulating low or no yielding assets and selling them off is not the only way to invest for retirement. It may be appropriate for part of your nest egg, for example due to the tax considerations mentioned above, or more, especially if you don’t have heirs to whom you wish to leave a substantial legacy.  But if you do want to leave a legacy, or even because your life expectancy might be longer than average and you don’t want to gamble on the risk of running out, or even if depleting your assets just makes you uncomfortable, it doesn’t have to be all of it. It also may overlook that you already have substantial annuity assets, such as Social Security or a pension. Whether and how much you devote to each method is a personal decision, but it should be one made consciously and purposefully, not merely by default.

3 thoughts on “What’s Your Investment Approach?

  1. Mega says:

    Dig it Baby!

    Coal power station Drax to win approval for net zero carbon capture plan
    Energy Secretary to sign off multibillion-pound scheme despite green opposition

    Jonathan Leake
    6 January 2024 • 6:00pm
    drax power station
    Drax claims the scheme will allow it to remove more CO2 from the atmosphere than it produces CREDIT: Christopher Furlong/Getty Images Europe
    Drax, once the UK’s dirtiest coal-fired power station, is set to stoke renewed controversy as ministers prepare to approve a multibillion-pound CO2 capture scheme it claims would make it “carbon negative”.

    The scheme has infuriated greens already angered by Drax’s switch from coal to wood – burning eight million tonnes last year alone. They say Drax’s clear-cutting of forests in North America destroys the environment rather than supporting it.

    Next week, however, Energy Secretary Claire Coutinho is expected to secure Drax’s future by approving a scheme to bolt two massive carbon capture plants onto Drax’s four generating units, potentially stripping out almost all their CO2 emissions.

    Drax claims the scheme will allow it to remove more CO2 from the atmosphere than it produces – making it the world’s first carbon negative thermal power station. Greens claim it will destroy forests and cost consumers billions of pounds.

    Ms Coutinho is also due to launch a consultation into how best to extend the subsidy system under which Drax last year received £617m from consumer bills. The scheme terminates in 2027 so Coutinho will propose extending it into at least the 2030s, keeping Drax in business for at least several years.

    UK energy policy is fast becoming one of the hottest political pre-election issues. On Friday Chris Skidmore, a former energy minister, resigned the Conservative whip and stood down as an MP over separate legislation promoting North Sea oil and gas exploration.

    Energy Secretary Claire Coutinho
    Energy Secretary Claire Coutinho is expected to secure Drax’s future by approving a carbon capture scheme CREDIT: Leon Neal/Getty Images
    Schemes like Drax’s, known as bioenergy with carbon capture and storage, or Beccs, are highly controversial – green groups argue that cutting down forests to generate electricity destroys the environment rather than protecting it.

    However, the UK government has repeatedly supported the idea, suggesting it will become one of the key technologies enabling the UK to reach net zero.

    Its net zero strategy report argues that: “When coupled with carbon capture and storage, it is possible that sustainable biomass can not only enable production of low carbon fuels but could also deliver vital negative emissions.”

    Will Gardiner, chief executive of Drax Group, said: “Beccs is the only credible large-scale technology that can generate secure renewable power and deliver carbon removals.

    “Our Beccs plans in North Yorkshire would create one of the world’s largest engineered carbon removals projects and put the Humber and the UK on the map as the global centre of Beccs development.”

    Drax produces about 4pc of the UK’s electricity so ministers are keen to protect it on energy security grounds too.

    The idea underpinning Beccs schemes is that as plants and trees grow they capture CO2 from the air via photosynthesis.

    If they are burned then that CO2 is released back into the air so there is no overall loss or gain. This means wood-burning on its own can be described as “low carbon”.

    However, if the CO2 from burning wood is captured and permanently buried underground, as Drax proposes, then the process actually removes CO2 from the atmosphere permanently. This would make it “carbon negative”.

    Nina Skorupska, chief executive of the REA (Association for Renewable Energy and Clean Technology), said: “Future energy scenarios, whether from the Committee on Climate Change, the IPCC or the International Energy Agency, all identify a critical role for Beccs in delivering carbon removals in order to enable the UK, and the rest of world, meet its net zero ambitions by 2050.

    Drax’s plans have been opposed by a number of environmentalist groups
    Drax’s plans have faced opposition from environmentalist groups CREDIT: ANDY RAIN/REX
    “Utilising sustainable biomass with Beccs has the unique benefit of producing both low-carbon power and negative emissions.”

    Such claims infuriate environmentalists and Drax’s plans have been opposed by Friends of the Earth, Client Earth and Ember. They say that despite changing from coal to wood Drax remains the UK’s largest single source of CO2 emissions at more than 13 million tonnes a year.

    Tomos Harrison, an analyst at global energy think tank Ember, said: “UK energy bill-payers have already paid billions to Drax to burn wood for electricity, a practice which is unlikely to reduce the UK’s contribution to climate change and could actually be increasing it.

    “Beccs is an unproven and controversial technology that cannot be guaranteed to deliver negative emissions and will cost bill-payers even more.

    “Instead of continuing support for wood-burning in the UK we should be investing in wind and solar which bring down energy bills and make a genuine positive contribution to the UK’s climate change efforts.”

    A Department for Energy Security and Net Zero spokesman said: “Biomass plays a key role in delivering a more secure, clean energy sector in Britain.

    “Capturing emissions from this process can remove significant volumes of CO2 from the atmosphere and support our Net Zero ambitions. We will be consulting on the proposals in due course.”

    Mr Gardiner said: “We plan to invest billions in developing two Beccs units at Drax Power Station which could create up to 10,000 new jobs at the peak of construction.

    The UK government wants to deploy five million tonnes of carbon removals by 2030, we believe this can only be achieved through building Beccs at Drax Power Station.”

    1. Percy says:

      Plants are still the best “carbon capture” devices. They can store carbon until they’re either eaten or burned. They don’t ask for huge investments or government subsidies. Far as “permanent” goes, there’s no such thing. And even if there were, it’s not clear why any self-appointed deity should be making decisions that couldn’t be reconsidered by posterity.