I wanted to offer a refresher to refocus our attention on the big picture of what we’re trying to accomplish together.
The big picture (from a financial perspective) is to maximize the probability of achieving your financial goals. Everything I do, along with the sacrifices you make when putting money away, is oriented towards that objective.
For most my clients, their primary financial goal is becoming financially independent in retirement or remaining financially independent throughout retirement.
The traditional rule-of-thumb for how a portfolio should be invested over time has been to gradually reduce risk throughout your life so that you start your career invested very aggressively but end a long, full life invested very conservatively.
I’ve previously addressed why this is such a dangerous rule-of-thumb here. Many people nearing retirement, or recently retired, should be invested quite conservatively around their retirement start date but then can afford to get MORE aggressive later in life.
Note: When I refer to “aggressive” I’m implying high stock exposure while “conservative” implies low stock exposure with the balance of the portfolio invested in high-quality fixed income.
Although I’ve addressed the concept of Sequence of Returns Risk before, I want to do a quick refresher as strong stock markets the last two years seems to be tempting people to get more aggressive/add more stocks to their portfolio at exactly the wrong point in their lives.
The returns you experience shortly preceding or following your retirement start date have an enormous impact on your portfolio value, retirement lifestyle and final estate value available for beneficiaries.
In fact, in the previous commentary’s hypothetical I linked above, we saw a massive gap in wealth at retirement ranging from 3x final salary saved to 28x final salary saved. This gap occurred even though the assumed earnings, savings and average annual returns were exactly the same between all 151 hypothetical investors in the study.
The only difference between these hypothetical investors was the SEQUENCE of returns they experienced. So, although the long-term average return was 7% per year for all investors, the returns they experienced near their retirement start dates were different and THAT made all the difference.
“People are more vulnerable to the returns experienced when their portfolios are larger because a given percentage change has a bigger impact on absolute wealth. A big portfolio drop at the end could possibly wipe out all of the portfolio gains from the first 25 years of one’s career.”
Let me give a simple example.
Imagine you had $2 million saved for retirement and planned to withdraw 5% in the first year, or $100,000, and then increase that amount each year going forward to fund your retirement. Also imagine your portfolio targeted 40% in fixed income and 60% in equities, which seems to be the most common allocation I come across for 60-70 year-olds.
Assuming a routine bear market begins as you retire (i.e. 50% stock market market decline) implies a 30% loss in your 40/60 portfolio (assume fixed income investments held steady).
Including the $100,000 withdrawal at the beginning of the year for retirement spending, your portfolio ended that first year at $1,330,000 ($2,000,000 – $100,000 = $1,900,000 * .70%).
In the second year you must withdraw $103,000 to maintain your inflation-adjusted retirement lifestyle. That withdrawal equals almost 8% of the portfolio value! This withdrawal reduces the portfolio value to $1,227,000 after just the first year of retirement!
Even if you maintained and rebalanced back to your initial 60% equity allocation, which is unlikely for most investors in such a situation due to extreme fear driving investment decisions, AND stocks made 20% in year 2, your return for year 2 would be 12% (60% of portfolio returned 20% = 12%, assuming fixed income flat). That brings the value of your portfolio at the end of year 2 to $1,374,240.
Then, you withdraw $106,000 to maintain your desired lifestyle for year 3 and the portfolio starts year 3 with a value of about $1,268,240, or down over $730,000 from your starting point just two years earlier! In other words, in two years’ time your retirement nest egg has already been cut by over a third! Yet you have about 28 years left of retirement to go!
At that point, the withdrawal rates may simply not be sustainable. You might be forced to reduce your lifestyle or risk running out of money prematurely and/or leaving far less to your heirs / charities than you desired.
This is why it’s so important to be mindful Sequence of Returns Risk. This is why I tend to be quite conservative with my clients who are within that 10-year period surrounding their retirement start date. It’s all about maximizing the probability of success and minimizing the chance of jeopardizing everything you’ve worked and saved for your entire life. Then we can get more aggressive later on when even severe bear markets don’t jeopardize your financial independence.
Not only does the traditional rule-of-thumb mentioned at the beginning of this commentary jeopardize your retirement, it also prevents you from getting more aggressive later in life when you can actually afford to be more aggressive.
Briefly on Valuations
The consideration of Sequence of Returns Risk applies in most market environments but is ESPECIALLY applicable now given the fact that U.S. stock market is more overvalued than ever before in history.
This overvaluation condition in the U.S. increases the probability of a severe market decline and suppresses the potential returns on U.S. stocks over the next 10-12 years.
The U.S. stock market is more overvalued than it was in 1929 before the Dow went on to lose 89%, it’s more overvalued than in the late-60s before the lost decade of the stag-flationary 70s, it’s more overvalued than it was in 2000 at the dot-com bubble peak before tech stocks went on to lose about 80%, and it’s more overvalued than it was in 2007 before the Great Financial Crisis which saw the U.S. stock market lose over 55% from top to bottom.
I will revisit U.S. stock market valuations in more detail soon because it’s important and it is also independent of election results.
Obviously, every households’ circumstances are unique so this does not apply broadly to everybody. There are other factors that must be considered when determining an appropriate investment strategy.
Disclosures:
Past performance is no guarantee of future results. All investments maintain risk of loss in addition to gain.
Data from third-parties is believed to be reliable but accuracy is not guaranteed. Much of the data used to interpret the markets and forecast returns are often at odds with each other and can result in different conclusions. Many different factors impact prices including factors not mentioned here.
This is NOT investment advice but merely a general commentary. Individualized investment advice cannot be provided until a thorough review of your unique circumstances and financial goals is completed.
Views provided here are current only as of the moment of posting and are subject to change at any time without notification.
