Dory, a character created by Pixar Animation and played by Ellen DeGeneres in the movie Finding Nemo, is a wide-eyed, blue tang fish who suffers from short-term memory loss. At one point in the movie, she finds herself lost and gets out of trouble by not panicking and telling herself to just keep swimming.
The reactions to last week’s stock and bond market selloffs provided us with similar circumstances: as soon as markets turned volatile, the internet and the media in general was full of alarming headlines. But in our 30-year experience in the investment markets, the recent lack of sell-offs was the unusual bit. Witness the chart below extracted from JP Morgan’s annual Guide to the Markets: for each calendar year since 1980, the red numbers indicate the maximum intra-year decline in the S&P 500, while the gray bar indicates what the market return was for the whole year.
Since 1980, despite an average intra-year maximum decline of 13.8%, the S&P 500 saw positive returns in 29 of the past 38 years. Since 1900, market declines of 10% or more, such as the one we just experienced, happened about once a year on average–and we had not had one for 18 months. Declines of 5% or more happened about 3 times per year yet we had not experienced one since August 2015. In other words, market declines of 5% to 10% are supposed to happen more frequently than they have recently, but like Dory we all forgot. Let’s not panic and “just keep swimming”.
What about new retirees?
Even if stocks do well over the long run (10 years or more), and belong to most retirees’ portfolios, a bear market early on could jeopardize a new retiree’s investment plan. Experts call this sequencerisk: for the same average long-term return, the sequence of bear and bull markets matter. Stock market declines during the early years have potentially more devastating consequences than those happening in later years.
There are ways to cope and manage such risks. Some lie in portfolio management and asset allocation, but investors’ psychology also plays a role.
The former is relatively easy to understand: as you approach retirement, say within 3 to 5 years, your portfolio’s allocation to stocks needs to be lowered to reduce the volatility and the impact of a bear market. The appropriate proportion depends on an investor’s circumstances, but we can illustrate with an example. Let’s take a hypothetical 65-year-old investor who plans to retire in 3 to 5 years with a $1 million portfolio currently invested entirely in stocks. She estimates that she will need about $40,000 per year from her portfolio to complement her social security and pension income, or a 4% spending rate. Our recommendation would be to progressively reallocate up to 10 years’ worth of spending–or about 30% to 40% of the portfolio–from stocks to high quality bonds. This would reduce the downside risk of the portfolio but also allow for our investor to draw from the bond allocation during an extended bear market and leave time for stock prices to recover. That’s the portfolio management part.
The psychological part of coping with sequence risk is two-fold: first and most important is to not panic during bear markets. Liquidating your stock holdings could permanently jeopardize your investment plan and see you outlive your assets. Retirees who sold all their stocks some time in 2008 were very unlikely to get back in the market in time to recover their losses, while those who held on did within just a few years. The second psychological part is how much one is willing to adjust his or her spending if necessary during a prolonged downturn. If an investor is unwilling or unable to reduce withdrawals, then other remediation tools need to be contemplated from the start. They include starting with a lower spending level, working a little longer to increase the portfolio’s size, buying an income annuity, or any combination thereof.
The bottom line is that the few years just before and after retirement create some unique challenges that need to be looked at carefully, especially for investors with high projected rates of spending in relation to their savings. Better to be safe than sorry.