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.
The Financial Crisis, as we’re all aware, hit investors hard from late-2007, accelerated through the end of 2008 and ultimately bottomed out in March 2009. From peak to trough, so to speak, the S&P 500 (a good barometer for US stocks) declined 55%, falling 37% during 2008 alone. The “drawdown” lasted over 500 days, or about a year and a half.
Now, had you been invested 100% in stocks, you would have felt all that negative performance (and some major indigestion). But if you had a typical moderate allocation of, say, 60% in stocks and 40% in high quality bonds, your portfolio would have fallen only 35% from top to bottom and only declined by 20% in 2008. That still hurts (a lot!) but it’s much better than it could have been.
By losing less when stocks are down you get a shallower hole to climb out of. And doing so takes less time. It took the S&P 500 about four years to recover from the Financial Crisis while the typical moderate portfolio recovered in about two if you rebalanced. This difference in depth and duration was due almost entirely to investing in bonds. While stocks were dropping in 2008 bonds were up over 5%. It was also due to holding your ground during a very tense and scary time. Investors who fearfully sold stocks during this time took much longer to recover. Some never did.
Okay, so what does all this mean for your next go-round with extended market volatility during retirement? Does it mean sell all your stocks and buy government bonds? Does it mean wait for the next “big one to hit” and then make changes? No. Simply put, you have to prepare now, both financially and psychologically, to draw from your savings even though your portfolio might be losing money. The idea is to insulate yourself, in advance, by structuring your allocation so you have cash to spend without having to sell stocks when they’re beaten down. This is where backing into your asset allocation comes in.
Unfortunately, there’s no silver bullet product you can buy to get you through this kind of event (no matter what the commercials or “free lunch” seminars tell you). Instead, it’s all about planning. For example, you might assume the next major market downturn lasts two years and your recovery takes another two, so you may opt to have four- or five-years’ worth of spending in bonds. What’s the right amount? Is this risk level affordable over the long-term? Does it allow enough growth potential to fund other parts of your plan (future care needs, home maintenance, other emergencies, etc)?
There’s a right way and a wrong way to do this. We’ll get into the details of Step 3 next week.
Have questions? Ask me. I can help.
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