From Gerd Kommer and Maximilian Bartosch
This April 2022 post was updated in April 2024.
This blog post is about the investment goal of “avoiding consumption of capital (or substance)”. Another name for this investment objective is “ensuring capital preservation”. This goal is often expressed by private households that are approaching retirement or are already retired and are making withdrawals from their securities portfolio, for example in order to close a pension gap. The investment strategy should then be designed in such a way that, for a given withdrawal amount per month or per year, in principle the capital never falls below the starting amount.
In this article we will show why and in what way the goal of avoiding capital consumption (hereinafter, for the sake of brevity, “KVV”) involves numerous internal contradictions and cannot be reliably achieved in practice - at least not if financial economic standards are correctly applied.
We will explain the astonishingly numerous internal contradictions of KVV using mini case studies involving the young retired couple Klara and Kurt. Six arguments are raised.
Klara and Kurt, both 65, jointly own a securities portfolio worth one million euros. The couple have both just finished their careers and plan to finance their living expenses, including rent for their three-room apartment in a beautiful old building in downtown Hamburg, from pension and pension income, the income from a rented studio apartment and their securities portfolio. With regard to the securities portfolio, the couple would like their only child, daughter Katharina, to later pass on the current portfolio value of one million euros undiminished, i.e. to avoid wasting capital.
Using an app on the Internet, Klara and Kurt calculated their respective remaining life expectancies to be around 25 years. Statistically, Klara can expect to live to be around 90 years old, Kurt to be 88 years old.
In order to maintain their usual standard of living, the two want to withdraw 3,000 euros per month or 36,000 euros annually from the depot. This equates to a withdrawal rate of 3.6% per annum (= 36,000 euros ÷ 1,000,000 euros). The 36,000 euros should increase over time with inflation so that the couple's usual standard of living is maintained in the long term.
One more technical note before we get into the argument: From a purely economic, purely rational perspective, “payouts” (interest, dividends, fund distributions, rental income) that are not immediately reinvested are just as much “withdrawals” as share sales (sales of securities or fund shares). Anyone who reinvests such distributions immediately instead of consuming them would of course end up with a higher final asset value - no matter how long the period under consideration is.
Argument 1 – Avoiding capital consumption in the standard form of this concept is economic self-deception
Assume that the average annual inflation over the next 25 years is 2.5%, the same as in Germany on average since 1970. Then the one million euros that Klara and Kurt want to pass on to Katharina "unconsumed" in 25 years will only have a purchasing power of today's 540,000 euros. In other words: When viewed from an economically correct perspective, there can be no question of “avoiding capital consumption”. Assuming everything goes as the couple expects, then in 25 years they will use up almost half of the purchasing power of their current portfolio volume. Of course, Klara and Kurt do not hide or suppress the fact that their goal of leaving their child a million euros is, from an economic point of view, miles away from “real KVV”. However, that doesn't change the facts: an economically correct KVV perspective would have to be based on inflation-adjusted (real) figures, not nominal ones.
Argument 2 – Capital consumption is likely to occur in a portfolio aimed at increasing wealth even if there are no withdrawals
After Klara and Kurt have thought about argument 1, the two accept that if they leave their daughter a nominal one million euros in 25 years, in reality there will be a capital consumption of 46% (460,000 euros to 540,000 euros in real terms). But so be it. The two of them know that this won't make their daughter love them any less.
With the help of a so-called Monte Carlo simulation The statistical probability can be calculated that with a real withdrawal rate of 3.6% p.a., taking taxes and costs into account and a time horizon of 25 years, there will still be around one million euros nominally or 540,000 euros in real terms at the end.
For a relatively “aggressive” (risky) 70/30 stock-bond portfolio that is managed independently, without consulting fees, this probability is around 55% (as long as Klara & Kurt manage the portfolio correctly). In the other half of the cases, Klara and Kurt's KVV goal is not achieved after 25 years. There is a consumption of capital in relation to the target end assets, even compared to the already reduced target of passing on a real amount of 540,000 euros (instead of a real amount of one million euros) to her daughter.
However, the couple are satisfied with the 55% probability. With a more conservative portfolio with less equity, the chance of success defined in this way would be even lower. With a more aggressive (stock-heavy) portfolio, the chance of success would be higher, but the volatility (price fluctuations) of the portfolio would also be greater.
Stock volatility has an unpleasant characteristic: in the particularly unfavorable zone of the statistical probability distribution for portfolio values over time, it leads to strong initial capital consumption. A numerical example from our Monte Carlo simulation above: In the worst 10% of cases, the capital shrinks by 200,000 euros or more in the first year (including the 36,000 euro withdrawal). Even the temporary waiver of withdrawals would only mitigate this fundamental situation to a very limited extent.
Such market-related losses right from the start can happen in any stock-heavy, return-oriented portfolio, even if it is from Warren Buffett, Ray Dalio, Jim Simons or Flossbach from Storch is managed. And anyone who relies heavily on technology stocks in their portfolio has a particularly high probability of capital wastage, other things being equal.
As a first interim conclusion we can say: With regard to the different forms of capital consumption, one should differentiate between:
- Short-term, “shock-like”, often only temporary consumption of capital, which can and probably will occur in an equity-heavy portfolio, especially in the start-up phase.
- Long-term, slow and mostly final consumption of capital, which can occur particularly (but not only) in safety-oriented portfolios with a low equity ratio if the withdrawal rate is not trivially low.
Argument 3 – “Living only on the distributions” does not prevent temporary or even permanent loss of capital
For this situation, we modify the Klara-Kurt scenario outlined so far as follows: Instead of withdrawing a fixed amount of 36,000 euros per year, the two decide to “live only on the distributions”. This is a withdrawal philosophy that is often encountered in the KVV context. The idea behind this is that if you only withdraw the distributions or current income from an investment, you are not using up any capital or substance. With a 70/30 stock portfolio, these fluctuating distributions - dividends, interest - would be around 20,000 euros in an average year, well below the 36,000 euros that the couple originally aimed for.
What makes matters worse is that these 20,000 euros are just an average amount. Dividends and also dividends in a very broad stock portfolio fluctuate from year to year and also fluctuate significantly downwards. Dividend volatility is often underestimated by those who have no experience with it. (Incidentally, the intensity of fluctuations in dividends measured in absolute monetary units is significantly higher than the already considerable fluctuation in the percentage dividend yield.)
Back to the point: Is KVV at least in one Live-only-on-the-payouts scenario reliably achievable? No. What we said in argument 2 applies here in almost exactly the same way: the market-related, unavoidable price fluctuations of such a portfolio will lead to significant price losses in many individual years. If there are strong downward price fluctuations in the first few years, then it will happen in one Live-only-on-the-payouts scenario to consume the starting capital. Again, temporarily foregoing withdrawals would not fundamentally change this.
An additional unpleasant side effect in this constellation are the strong annual fluctuations in distributions (withdrawals) from year to year, which the portfolio holder does not control. Such fluctuations are particularly unpleasant for someone who actually depends on withdrawals.
Argument 4 – Capital consumption is likely to occur even in a super-conservative portfolio with no intention to increase wealth
For this argument, we assume that Klara and Kurt now have a portfolio that consists 100% of short-term German government bonds and corporate bonds of the highest credit rating - one could casually say "the safest investments in the world" - safer than a bank deposit. Again we assume a real annual withdrawal of 36,000 euros.
Such a portfolio has comfortable zero volatility. The initial capital consumption due to volatility described in arguments 2 and 3 cannot happen here. That's pleasant. What is unpleasant is that zero volatility very likely also brings with it a real zero return (return after inflation, taxes and costs) - and thus the greatly increased probability of one in this case long term consumption of capital.
In our Monte Carlo simulation, the couple with such a “0/100 portfolio” leaves their daughter with only around 60,000 euros in real terms after 25 years, even in the average of the best 10% of all statistical cases. Worse still: in around 50% of statistical cases, the couple runs out of money before they reach the age of 95.
The inflation-adjusted “risk-free” savings account return in 21 developed and emerging countries for which data is available has been the same over the 122 years since 1900 Below zero in almost 40% of all years.
Argument 5 – Capital consumption has no necessary connection with the sale of “capital” or “substance”
Some private investors equate “avoiding consumption of capital” with “not selling any capital or substance” – a strange logic for two reasons. Firstly, because KVV – as we have shown above – in no way excludes short-term or long-term reductions in capital, even without sales. Secondly, it means, in the logical reverse, that capital or substance is always consumed when substance or shares are sold. And that is exactly not the case.
To illustrate this, we are modifying Klara and Kurt's investment world again. This time her portfolio consists 100% of gold worth one million euros. We assume that gold has a nominal average return (return before inflation) of 4% p.a. and a real return of 2% p.a. (the latter figure roughly corresponds to the history since 1975). To keep our argument didactically simple, we unrealistically assume that these returns are completely constant. Klara and Kurt's withdrawal rate is now just one percent in real terms, or 10,000 euros per year (833 euros per month), which increases with inflation over time. Since gold does not produce current income, the couple inevitably has to finance its withdrawals from the portfolio through asset sales.
Quiz question: Will Klara and Kurt have sold 25% of their physical gold after 25 years? Answer No, only 22% and the value of the remaining 78% of the gold after these 25 years is approximately 1,282,000 euros.
If Klara and Kurt lived for 100 years instead of 25 years, then 47% of the original amount of gold would still be available when they died and its value in today's purchasing power would be 2.7 million euros (far more in nominal terms). After 500 years, the remaining 0.7% of gold would be worth 145 million euros in today's money.
In other words, no matter how much substance or capital is sold, Klara and Kurt would never become poorer based on the assumptions given here, even though they consume more and more of the physical substance of gold (i.e. "capital") over time. At the same time, based on the assumptions made here, the gold substance would never go to zero, not even in 1,000 years.
Ergo: Anyone who believes that there is a compelling connection between the consumption or sale of shares of an investment in a period and the question of the amount of final assets in this period is making a mathematical error. It should also be mentioned that, in addition to precious metals, there are a number of other forms of investment that do not generate any ongoing cash flow (current cash income) and to which the same logic therefore applies. For example, non-dividend tech stocks, zero-coupon bonds, vacant land, Bitcoin, art, and other collectibles.
Argument 6 – Capital consumption can also occur in real estate
Many supporters of the KVV concept believe that with a real estate investment - owner-occupied or rented - there is no loss of capital from the outset. It would be nice.
First, residential real estate values fluctuate over time in nominal and real terms, even if these fluctuations cannot be observed on the Internet in real time as with securities. A given property may be in a poor market environment over a period of two years or 20 years lose up to 50% or more of their value. For a property financed with 80% debt capital, a relatively harmless drop in value of 10% corresponds to a 50% loss of equity.
Arguments 2 and 3 stated above essentially also apply to real estate and even more so to the equity in partially loan-financed real estate investments, in contrast to the property value.
Secondly, every building is subject to time-related and use-related depletion of substance or capital. If you don't balance this consumption of substances permanently Maintenance expenses After a few years, the property can no longer be used, either for legal or physical reasons, and no longer generates income.
Incidentally, a major disadvantage of owner-occupied or rented real estate as an investment for retirees “with limited cash flow” is that the “substance” cannot be used up. Only the net rent (rent less maintenance costs and other ongoing costs) can be used, i.e. the rent collected for rental properties or the rent saved for a home. On the other hand, if you want to use up (“monetize”) the substance of a property, you have to sell it, re-mortgage it or enter into an expensive and legally complex “home retirement” process.
Conclusion
Anyone who wants to be honest with themselves will formulate a long-term goal of avoiding capital consumption from the outset, taking into account the negative purchasing power effect of inflation.
Super-safe, low-risk portfolios protect withdrawal portfolios from the risk of initial, “shock-like” capital consumption, but at the same time increase the probability (risk) that even modest final wealth goals will not be achieved, i.e. slow, long-term capital consumption will occur.
If you want to avoid long-term capital consumption in a withdrawal context in relation to an end asset goal, you cannot avoid a stock-heavy portfolio. However, the associated volatility of the portfolio value will often lead to initial capital consumption (and if you are particularly unlucky, not just in the first five to ten years). Even temporarily foregoing withdrawals will not cure this basic problem.
Rational investors with withdrawal intentions accept either the possibility of initial capital consumption combined with the high chance of achieving the final wealth goal or the possibility of slow long-term capital consumption without significant volatility and without sudden unpleasant surprises. Rejecting both types of capital consumption at the same time means an insoluble conflict of goals.
For investments that do not generate any cash flow, the idea of not consuming capital ends in factual logic nirvana from the outset. The same applies to the widespread view that capital consumption cannot actually occur in real estate investments.
Because KVV is an overall contradictory, ultimately useless financial concept that is often unclearly defined between those involved, it is advisable to avoid it. It would be better to concentrate on those levers that actually help control the return and risk of a portfolio with the intention of withdrawing funds.