Step 4 - Hypothetical vs Actual

Before we begin, I wanted to let you know about an important development. A week or so ago TD Ameritrade joined Schwab in the so-called “race to zero”. Fidelity jumped on the bandwagon in recent days too. The result is that all three major online brokerage firms now charge zero trade commissions to buy and sell stocks and exchange traded funds. This is great news for investors.

This week’s post is part of a series about backing into your asset allocation, a multi-step process to 1) determine your annual spending needs in retirement; 2) use history as a guide to get a feel for how long a stock market downturn could last; 3) figure out how much to invest outside of the stock market to provide spending power during a downturn; and 4) how to reconcile all of this with the reality of your portfolio and tolerance for risk.

As a reminder, our simplified example looks at a couple of retirees with a planned $15,000 spending deficit next year. They were planning to spend $90,000 total, including basic needs of about $75,000 plus $15,000 for discretionary spending (travel, painting the house and landscaping). They were expecting $75,000 of income. They’ve looked ahead and assume this spending rate will continue for the foreseeable future but want to cover themselves should the stock market go through a multi-year whacky phase.

Our couple decided they’d like to hold four years’ worth of spending deficits outside of the stock market. They opted not to use four years of total spending ($90K X4 = $360K) in their calculation because it was way too high relative to their $500,000 investment portfolio. But they also felt four years of $15,000 deficits (or $60K) was too low, leading them to round up to a target of $100,000, or 20% of their current portfolio.

Comparing this to their actual portfolio they find they currently have 40% invested outside of the stock market. This was the result of a “moderate” score during a risk tolerance questionnaire they completed suggesting a portfolio mix of 60% in stocks and 40% in bonds and cash. This is different from their work to back into their allocation. Which process is correct?

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Quarterly Update

If you simply looked at the closing numbers for the third quarter of 2019 (Q3), you might have thought the prior three months were pretty quiet. Stocks here at home and abroad generated pedestrian returns, and bonds put up low single digits. But looking back we see that it really was a raucous quarter.

Q3 saw the first interest rate decrease by the Fed in over ten years, followed by a second cut in September. Another part of the yield curve, an important recession indicator, inverted. The U.K. installed a new Prime Minister which led to a ramp up in Brexit headlines. Oil markets had a major price shock (but then quickly came back to earth) when two Saudi oil refineries were hit by a missile attack. Of course, it wouldn’t be a normal quarter without trade-related tweets and headlines. And then, near the end of the quarter, House Democrats began the formal process of trying to impeach the president. Each of these issues moved markets, often at the same time.

Here’s a summary of how major market indexes ended the quarter and year-to-date, respectively (as a reminder, the YTD numbers look very strong, but this is off deep lows last December):

  • S&P 500: up 1%, up 20%
  • Russell 2000 (small company stocks): down 2%, up 14%
  • MSCI EAFE (foreign stocks): down 1%, up 14%
  • MSCI EM (emerging markets): down 4%, up 6%
  • U.S. Aggregate Bonds: up 2%, up 8%

If one event seemed to set the tone for Q3 it was the Fed’s decision in July to lower interest rates for the first time in a decade. Heading into this meeting there had been much discussion and forecasting in global markets about the path of interest rates. Bond investors had been expecting the Fed to indicate a series of rate decreases into 2020. This helped send bond prices higher ahead of the meeting. The Fed didn’t deliver completely on market expectations, even though it lowered its benchmark rate by 0.25%.

This, a slew of commentary about the Fed from the POTUS Twitter account, and lingering uncertainty about the health of global manufacturing, unsettled investors and caused stocks to fall about 5% in August. Stocks eventually made up much of the decline, but the damage was done for the quarter and led to the low return numbers referenced above.  

A beneficiary of this slide was the bond market. Bonds of various types went into rally mode during August as stocks fell. The Barclays U.S. Aggregate Bond Index (the primary bond benchmark) gained about 3% during the month before tapering off a bit into the end of the quarter. This was a big move for bonds that would typically expect 3% in a year.

The increase in bond prices caused the yield, the main measure of a bond’s investment return, to fall to historically low levels during Q3. The yield on the 10-year Treasury (another important benchmark) dropped below 1.4%. These yield movements also caused the yield curve to invert further, adding fuel to commentary about the likelihood and timing of our next recession.

The Fed’s rate cut in July and the second in September were seen by some as “insurance cuts”, or preemptive rate reductions meant to stimulate the economy before it showed more meaningful signs of slowing. Even though consumers are still buying, the job market is strong and so is housing (largely driven by record-low interest rates), bond investors currently expect the Fed to lower rates again in December.

As we end Q3, several different yield curves are inverted, but the 2yr/10yr curve is no longer inverted. This curve was one of the last to invert and was also one of the most noteworthy. A second inversion would likely be an ominous sign, implying a recession to be closer than originally anticipated.

If the last quarter showed us anything it’s how perilous it can be to trade the headlines. Market predictions are especially hard these days when something as simple as tweets can move markets. Accordingly, it’s better (and less complicated) to focus on fundamentals like investment selection, keeping costs under control, rebalancing and, above all, planning for market volatility. Doing so will help keep you sane when it seems like bad news is coming at you from every corner of the compass.

Have questions? Ask me. I can help.

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Step 1 - Determining Your Spending Needs

If you have a runner in your family, you know how they can sometimes be a little obsessive about lacing ‘em up and heading out. It could be “too hot” or maybe it’s cold, dark and rainy, but still they have to get some miles in. “Why?” is a question often asked that rarely has a good answer.

I received the following from a Patagonia promotional email headed “Where can you go in an hour?” and wanted to share. It may be the clearest answer to the question I’ve ever heard.

Sometimes, an hour is all you get. Sometimes, an hour is all you need. But you need it–fundamentally, excruciatingly, and for those 60 minutes every question gets answered, and new ones get asked. Knots get untangled, and everything makes sense, even if you’ve forgotten it all by the time you get home.

Running has had a huge impact on my life. One way, in fact, was that I did a lot of knot-untangling about starting Ridgeview Financial Planning during long runs on our local roads and trails. There’s just something about solitude and natural beauty that inspires creativity and optimism (or maybe delusions of grandeur). But enough about that… let’s talk about investing in retirement…

Last week I laid out a framework for several posts about backing into your retirement asset allocation. As wonky as this sounds, if done right, the process will help get you through different parts of the market cycle while keeping your spending goals intact.

Asset allocation, or the process of finding and managing your optimal blend of stocks, bonds and cash, is challenging during retirement. The reason is that you’ve entered the decumulation phase after spending decades accumulating retirement savings. Everything seems backwards and it’s a difficult and complicated psychological transition.

The first step we’ll look at is projecting your spending needs for a typical year in retirement. Ideally, this would come from reviewing recent bank and credit card statements, or perhaps money management software like Quicken. You want this projection to be as accurate as possible because a lot will ride on it.

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Step 3 – Filling Your Buckets

After a brief interlude last week to update you about the third quarter, let’s return to the steps associated with backing into your asset allocation during retirement.

This post is part of series covering a multi-step process to 1) determine your annual spending needs in retirement; 2) use history as a guide to get a feel for how long a stock market downturn could last; 3) figure out how much to invest outside of the stock market to provide spending power during a downturn; and 4) how to reconcile all of this with the reality of your portfolio and tolerance for risk.

In our simplified example from Step 1 a few weeks ago we looked at a couple of retirees with a $15,000 spending deficit in the next year. They were planning to spend $90,000, including basic needs of about $75,000 plus $15,000 for discretionary spending (travel, painting the house and landscaping). They were expecting $75,000 of income. They’ve looked ahead and assume this spending rate will continue for the foreseeable future.

In Step 2 we looked at a downturn scenario where the stock market fell for almost two years and then took another two to recover. If our hypothetical couple wanted to be able to weather this kind of storm without altering their spending plans or going back to work, how could they do it?

This leads to Step 3, determining how much of your portfolio to keep out of stocks, and what to do with it.

The first decision for our couple is how conservative they want to be when planning for deficits. Do they want to use the actual amount of the deficit ($15,000) or their annual spending amount ($90,000)? This has direct implications on how much cash and other non-stock investments they plan to hold. For example, say they’d like to hold four years’ worth of spending needs outside of the stock market. Should it be four years of deficits totaling $60,000 or four years of spending needs totaling $360,000. The difference is huge, so let’s look at some of the considerations.

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Step 2 - Using History as a Guide

As you’ll recall from prior posts, asset allocation is mostly about trying to efficiently control risk and return in your portfolio. But during retirement it’s also about structuring income and planning for times when the stock market seems to be working against you. The idea is to ensure you have adequate money available to spend while keeping your plan on track for the long-term.

Last week we discussed evaluating your spending habits to help create more accurate spending goals in retirement. This was the first step in backing into your allocation. But now for the second step we’re going to get a little more esoteric and educate ourselves about how your portfolio could fare during a market downturn.

This step is often overlooked by investors who, understandably, tend to think about growth potential first but then sort of gloss over the risks they may encounter along the way. You can get by with this if you’re still working and saving and retirement is way off in the distance. But risk management becomes much more serious when you’re retired, so it’s a valuable part of your plan.

This week we’ll look at the Financial Crisis as a test case for how the next downturn might impact your portfolio. This kind of stress testing is important for obvious reasons that we’ll get to later.

Instead of getting deep into the weeds of market data we’ll focus on two downturn metrics: depth and duration. Depth, because it’s important to understand how much a typical portfolio dropped when the market was bad. Duration, because we want to know how long it took to recover. From this we can make some educated guesses about what to expect in the future.

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Backing into Asset Allocation

Asset allocation is all about trying to control what can be controlled when it comes to investing. We know, for example, that we have no control over how markets react to a topsy-turvy world full of headlines. We can’t control what the Fed does with interest rates or when the economy goes into recession. And we know we can’t control a publicly traded company’s success or failure.

But we also know we can’t simply avoid investing in stocks just because they’re risky (and sometimes pretty scary…). So, we turn to asset allocation, or the process of finding our optimal blend of stocks, bonds, cash and “other” investment categories, to help us be productive investors in an uncertain world.

Now, asset allocation for younger folks is fairly straightforward. You’d typically complete some sort of questionnaire to determine how much risk you can tolerate, match your responses to a suggested mix of investments, and then focus on saving. It’s hard enough to save anyway, right?

This works for your 20’s, 30’s and 40’s when you’re mostly focused on accumulating retirement savings, but starts getting more complicated in your 50’s. There’s another step up in complexity in your late-50’s and early-60’s as the retirement concept starts seeming a little more real. Then asset allocation takes on a whole new meaning when you’re actually retired. It’s at this stage where we leave the hypothetical conversations about risk tolerance and spend more time talking about “risk capacity”, the risk you can afford to take and need to take for your long-term plans to be successful.

I mention all this because the economic and market situation is starting to look a little gloomy. Talk of potential recession abounds and we all remember just how nasty the last one was. If the next one is even close to that bad, how will that impact our retirement plans? Those living in retirement or those close to retirement are understandably nervous. Is it time to head for the hills until all this blows over? Hopefully (and obviously) the answer is a resounding no.  

Instead, it’s time to refocus on shoring up your asset allocation and even starting to think about the subject more broadly. What I mean is that instead of simply thinking about your allocation as a natural outcome of taking a risk tolerance questionnaire, you should also back into it based on the details of your own plan. This kind of stress testing will help give you the best shot at surviving a prolonged market downturn.

This is a detailed conversation, so my thinking is to lay out the concept in this post and then elaborate over the coming weeks. Here are some of the issues we’ll cover:

  • Stress testing your allocation using the Great Recession and a garden variety downturn as benchmarks. If stocks are down and market sentiment is too, but you still want to take that trip or buy the car you planned on, where should the money come from?
  • When and how to take profits when the market is up. Strange as it may sound, this is often a difficult subject for people.
  • Different methods for calculating your “emergency fund” needs during retirement.
  • How to use bonds as insulation against prolonged bouts of market volatility. Yes, bonds are boring, but they could save your tuchus if used correctly.
  • How to reconcile these areas with your current allocation. In other words, what to do if you realize your investment mix is all wrong.

Hopefully by the end of these next few weeks you’ll be better informed about how to get your asset allocation “retirement ready”. And remember that it’s not all doom and gloom, it’s appropriate planning that makes the difference.

Have questions? Ask me. I can help.

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