There has obviously been some volatility in the U.S. stock market the last month and a half. The S&P 500 is down over 11% since the February 19th peak as I write this and down about 7% year-to-date.
This is not a terrible decline by any means compared to what can happen or even compared to the stock market gains of 2023 and 2024 but certainly folks are starting to get concerned.
Fortunately, my clients have two wonderful tools I’ve built for them and incorporated into their Financial Plans that will help ease their mind in times of market stress. I urge clients to refer to these tools whenever they’re feeling anxious about market volatility.
The first is the Bear Market Stress Test.
The second is my Spending Guardrails analysis, which shows the tolerance for portfolio losses before spending / lifestyle is affected. This one only applies for nearly-retired / retired clients.
Bear Market Stress Test
Within the Financial Plan I include a bear market stress test, which shows the impact of a hypothetical severe market downturn on various investment strategies across the risk spectrum, and, in turn, the impact on my clients’ probability of achieving their financial goals.
The purpose is to help us identify the most appropriate investment strategy for each household’s unique situation as well as to contextualize risk and volatility in more concrete terms to help make better decisions and set realistic expectations for what risk can truly mean.
It looks like this:
You’ll notice the assumptions I use for this stress test (1) stocks lose 60% peak to trough and (2) bonds only make 5% during that same period (likely would make more in such an environment).
So then I apply those hypothetical losses to investment strategies across the risk spectrum to determine the implied portfolio loss for each strategy. Then I rerun the financial projections for each Strategy with those losses coming off the top to determine the new hypothetical probability of success after experiencing such a loss.
This exercise helps us back into an appropriate investment strategy that won’t jeopardize our financial goals even in a severe drawdown.
This exercise also sets expectations for potential dollar losses in such an environment so that we’re not investing blindly or ignorant of risks that exist.
In this particular example with a $4.3 million portfolio, let’s assume we settled on a 60% bond / 40% stock portfolio for this particular client. Well, YTD, the 60/40 is actually up on the year so even though the U.S. stock market is down and experiencing volatility this client can rest easy because they know they can tolerate a $900,000 loss, or 21% decline, and STILL remain in great shape.
This exercise gives comfort in times of stress and also helps to make sure we’re being proactive instead of reactive by positioning the portfolio properly out of the gate BEFORE we hit the inevitable turbulence and downturns.
Spending Guardrail Analysis
The purpose of the “guardrails” is to guide a proactive approach to spending in retirement that balances the need to avoid running out of money prematurely with the desire to avoid sacrificing lifestyle (or gifting) unnecessarily. After all, we can’t take it with us, right?
I’d like to see clients’ probability of success stay between 75% and 95% with a target of about 85%.
Anything below 75% for too long, and I start to get concerned about running out of money prematurely, in which case we would reduce spending to bring clients’ probability back up to 85%.
Anything above 95% for too long, and I get concerned we’re sacrificing lifestyle unnecessarily, in which case we could increase spending to bring clients’ probability back down to 85% giving them permission to experience more, gift more, whatever their heart desires.
So here’s an example from a new client’s Financial Plan Summary:
“If your portfolio were to experience a $450,000, or 35%, decline in a short period of time (highly unlikely given the investment strategy) that would push your probability of success down to ~75%. In that scenario, I may recommend just a $2,000 reduction in annual spending to increase your probability of success back to the 85% target and keep you on a sustainable path.
Conversely, because your current probability of success is 99%, you could increase your annual spending by around $28,000 and maintain a comfortable 85% probability of success.”
So, here again, we see we’ve provided context for losses and how they actually impact clients’ lives as opposed to making risk / volatility some abstract concept that means nothing to us. Instead I frame risk so that we understand how it actually impacts our financial goals, if at all.
In this client’s case, they could suffer a 35% decline in the portfolio and they’d only have to reduce spending by $2,000 per year to kick themselves back on a sustainable path.
By the way, for this particular client, a 35% loss is EXTREMELY unlikely because of the very conservative investment strategy we’re pursuing. Their bear market stress test indicates more like a 10% loss would be the decline in a severe market downturn that saw stocks lose 60% and bonds make 5%.
So this client can turn on CNBC or Fox Business and not get remotely concerned about the current volatility especially since they may actually be making money in this environment given how well the bonds are doing.
So, when stressed, simply pull out the Financial Plan Summary in your custom financial planning binder and refer to the Market Stress Test and the Spending Guardrails analysis (retired clients).
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.
