Ridgeview Update

During this challenging time I wanted to update you on our status. As with much of Sonoma county, my family was evacuated over the weekend but we're now set up at a family member's house out of the area. Brayden, my assistant, is staying out of the area as well. Our office building is also in the mandatory evacuation zone. Fortunately, most of our business is in "the cloud" and being in a different location is only an inconvenience. So, it's business mostly as usual until we get the all clear.

My family and I wish you and yours a safe next several days, or however long this latest fire event lasts. In the meantime, please know that you can reach out with any questions.

Please take care and stay safe.

The Staff at Ridgeview Financial Planning

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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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Getting to Know Future You

One of the things I love about financial planning as a profession is that there’s no shortage of good stuff to read and ponder over, and call it work. One day it’s investing topics, the next its emerging insights from behavioral finance and neuroscience. That’s probably what I’d do with that 25th hour of the day – read more. It would certainly be better than watching the news!

Along these lines I recently read a book that, in part, invited the reader to create a relationship with their “future self”. Not some stylized version of who you hope to be, but an older version of yourself five, ten, twenty years in the future. You’d then develop a regular dialogue with Future You. Even daily.

The idea is that Future You would help you understand what to do (or not do) today to stay on track for accomplishing things that were ultimately (according to Future You) the most important. Maybe its eating better and exercising, spending more time with family, or even getting in to see your dentist more often. And Future You isn’t going to blow smoke, right? They would be honest, and even plead with you to do what you probably think is right anyway.

It turns out this concept is a growing field of research that has direct implications for financial planning. This makes good sense because having a healthy picture of one’s future self informs decisions involving delayed gratification, such as saving for retirement, for example.

The following are excerpts (emphasis and additions mine) from an article on the topic. I’m including a link to the full article below. The content is meant for financial advisors, so you’ll see some references to the target audience.

Future self-continuity (FSC) is the connection and perceived association between who you are today and who you will be in the future. The idea and theory of future self-continuity were developed out of research focused on understanding and curing the problem of future discounting, which is the human tendency to place less importance on future rewards when compared to current rewards. And because of this tendency, it can become very easy to put off (or even ignore) behaviors associated with future rewards, from simple ‘bird in the hand’ scenarios (e.g., taking $50 today instead of $60 next week), or (not) saving and investing for retirement.

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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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