Ten years ago (September 15, 2008), Lehman Brothers, a prominent Wall Street investment bank filed for Chapter 11 bankruptcy. The financial system had been deteriorating for months and the federal government had already stepped in on several occasions to provide support. But the government decided to allow to Lehman to fail. That decision helped to send the US economy deeper into the Great Recession and caused the stock market, which had peaked in October of 2007, to accelerate its descent. The Dow Jones Industrial Average would eventually fall from a peak of over 14,000 in 2007 to a low of 6,500 in March of 2009. It was so bad that, in the spring of 2009, there was concern among some anxious investors that the Dow could drop to 3,000.
Recently we have received calls and emails from some clients expressing concern about the stock market. There is worry that stock prices are, once again, at an all-time high and there are signs that the incredible bull market may be out of breath and about to falter. Is it time to get out of the stock market before it crashes? If we don’t, what will we do if the market does crash? How can we avoid another crash?
While we always respond to these concerns individually, there are some common themes or ideas we share, and we would like to do so here.
Let’s image that you are retired and that your income consists of Social Security payments and distributions from your portfolio. You need $100,000 to live your desired lifestyle. Social Security provides $30,000. So, you need to take $70,000 each year from your $2 million portfolio. We will consider you to be moderately comfortable with the risk of the stock market and, as a result, your portfolio is 50% invested in stocks and 50% in bonds and cash.
One way to think about a stock market correction is to consider how long it would take before the portion of your portfolio invested in stocks would fully recover. Since we would prefer to avoid selling stocks at a loss to generate your retirement income, we would want to make certain that any dollars meant for distribution aren’t invested in the stock market.
So, let’s go back to the stock market during Great Recession. How long did it take before the stock market recovered to its pre-crisis high? In February of 2013, the Dow hit 14,000 again. So, from peak (October of 2007) to trough (March 2009) to peak again took 5 years and 4 months. To be extra safe, we could ensure that dollars you need over the next ten years, rather than just five years, are not in the stock market.
Interest rates are rising. When that happens, the value of bonds drops. So, to address this, we could keep the bond portion of your portfolio in very short-term, high quality investments (US government bonds and AAA-rated corporate bonds), which are less sensitive to interest rate changes. Also, we would like to keep the dollars you’ll need distributed to you over the next 12 months in cash or cash equivalents. We can park those distributions in a prime money market account paying approximately 2%. Recall that you’ll need $70,000 from your portfolio ($100,000 – $30,000 from Social Security). We’ll keep 2% of your portfolio in cash for fees, expenses, and emergencies.
Now let’s do some very basic math to understand how your portfolio would be allocated. Your portfolio would have the following broad allocation: 25% US stocks, 25% international stocks, 45% in short-term bonds, 3% in the money market account and 2% cash. In dollars, you would have $500,000 in US stocks, $500,000 in international stocks, $900,000 in short-term bonds, $60,000 in the money market account and $40,000 in cash.
If the stock market corrects this week and both US and international markets decline by 50% (rare, but not unheard of), the stock portion of your portfolio will decline from $1 million to $500,000. We would expect the bonds to hold steady or rise slightly, the money market fund to retain its value and the cash to do nothing. So, instead of $2 million, you now have $1.5 million. Your paper loss would be 25%, or $500,000.
While you are undoubtedly not happy about the state of the affairs, is your lifestyle in jeopardy? No. Why? Because, if we assume you will need to withdraw $700,000 over the next decade ($70,000 a year for 10 years, and ignoring inflation to keep this example simple), you won’t need to access the stock portion of your portfolio. You will take your distributions from the bond portion of the portfolio. You have $900,000 in bonds, which more than covers your distribution needs for the next 10 years. This is ample time to allow the stock portion of your portfolio to recover.
Some advisors describe this approach using a metaphor of “buckets”. Bucket number 1 holds your short-term dollars (1 year needs). This bucket should have no market risk. Bucket number 2 holds your intermediate-term dollars (2-10 year’s needs). This bucket should have little or no stock market risk and minimal risk from other factors (e.g. interest rates). Bucket number 3 holds your long-term dollars (10+ year’s needs). This bucket has your stock market exposure and, consequently, provides long-term growth potential.
So, make sure that you can ride through another market downturn without having to touch the stock portion of your portfolio (Bucket number 3) for a full market cycle (as long as 10 years). If your buckets are set up that way, you’ll be able to rest easier knowing that, while the stock portion of your portfolio is temporarily down in value (a paper loss), it won’t affect your lifestyle, and that portion of your portfolio will eventually recover.
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