What are the Common Risks of Market Downturns?
Back in our February 2018 commentary (“Just Keep Swimming”), we briefly discussed the risks of market downturns for people nearly or recently retired. The main danger we identified was called sequence of returns risk. As some of our readers approach retirement, they may wonder: what is this risk and how should they protect from it?
Simply put, the sequence of returns risk is that of a significant stock market crash just a few years before or after one retires. Even if stocks do well over the long run (10 years or more), and belong to most retirees’ portfolios, a bear market within a couple of years of one’s retirement date could have a disproportionally devastating impact. For the same average long-term return, the timing or sequence of bear and bull markets matter depending on when one’s retirement starts.
The reason is that a new retiree will suddenly switch from contributing funds to her portfolio to withdrawing from it. Taking money out during severe bear markets depletes the portfolio at an accelerated rate, potentially impairing its long-term viability.
A Scary Example: 2007-2008
To illustrate, imagine an investor retiring in September 2007 with a $1 million portfolio invested in the S&P 500 index, a proxy for the U.S. stock market. He needs to take $40,000 per year to complement his pension income. This is a spending rate (4%) that most retirement experts would regard as having an excellent chance of lasting for his lifetime—even after adjusting for inflation.
Unfortunately, in October 2007, a bear market started, and the S&P 500 lost over 50% through March 2009 (including the reinvestment of dividends). Over the same 17-month period, our investor took about $57,000 from his portfolio to cover his living expenses. The value of his investment is now down to $443,000! If he keeps taking the usual $40,000 going forward, his spending rate would more than double to 9%. Such a high level is clearly not going to last his lifetime. If he decides to stick to the 4% rule instead, his spending will decline to just under $18,000/year, a stark choice.
This was clearly a cherry-picked example, but one that afflicted real people back in 2009. It vividly illustrates the impact that a severe market decline can have on one’s retirement plans. Since World War II, there were 11 bear markets (a 20% decline lasting 2 months or longer) in the U.S. On average, they occur in about 1 out of every 7 years and last less than 2 years.
What can you do to mitigate such risk? There are 4 strategies we employ and recommend:
strategy #1: Review your portfolio’s mix between stocks and bonds as you get closer to retirement:
The right combination will depend mainly on your projected spending rate (and on your tolerance for short-term volatility). By the time our clients are within a few years of retirement, we’re typically allocating at least 5 years of projected spending in bonds or bond funds. Focus on bonds with low credit risk (so-called “investment grade”) and short maturities (3 to 7 years) as they have historically provided the safety we seek.
strategy #2: Right size spending at the beginning:
Depending on your age at retirement, experts typically recommend a spending rate in the 3% to 4% range of the total value of your portfolio (for more on this subject, check our article “How Much Can I Safely Spend from My Portfolio?”) Spending more increases your vulnerability to a bear market;
strategy #3: Adjust spending during bear markets:
If you are unfortunate, and your investments’ value declines sharply early in your retirement, adjust spending down and cut expenses. This is where creating a budget is a beneficial exercise: categorize your planned expenses between “needs” such as food, rent, mortgage, or insurance, and “wants” such as travel, gifts, eating out, or large charitable donations. The latter can be reduced or delayed until the portfolio’s value has recovered;
strategy #4: Adjust where you take the money from:
During a severe stock market decline, spend funds from your bond allocation, and leave your stocks alone. The percentage of your allocation to stocks will increase, but the odds of the overall portfolio recovering faster will improve significantly. This is where our 5-year rule described above comes handy: Since World War II, following each of the bear markets previously mentioned, a portfolio invested in the S&P 500 index (including dividends) took less than 2 years on average to recover to its prior high. The range was from 3 months to almost 6 years (1973-74). The 2nd longest recovery (just over 5 years) was the one we just experienced, after the 2007-2008 financial crisis. Based on history, we feel confident that having at least 5 years of spending in bonds should leave adequate time for the stock portion to recover.
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