Irrational Exuberance?

 

 

(Photo Credit:  Yahoo Finance S&P 500 historical graph through today.)

As I mentioned in my previous post, the big consolation prize of this election has been its effect on the stock market.  I’m not sure this is what the voters who elected this administration had in mind, enriching a young retiree who basically sits at the piano all day long.  But hey, I’ll enjoy it while I can.

And that’s the point of this post.  A cautionary tale to enjoy it while you can but prepare yourself for the inevitable recession.  I can’t tell you when or how deep it will be, but there will be another recession.  We are currently enjoying the third-longest expansionary period in U.S. history.   And it’s pretty close to pulling into second place.

I retired in 2008 just before a whopper of a recession and in retrospect, I had too much of my portfolio in equities to be able to rest comfortably.  At the time, I had a 70% allocation to stock mutual funds and 30% allocation to bond funds and cash.  As it happens, that was enough to get me through the downturn without having to sell stock funds at bargain basement prices, but it was a little too close for comfort.   After the market recovered, which took almost seven years by the way, I switched to a 60/40 allocation.  So next time we ride the rollercoaster down, I won’t be quite so queasy. 

Of course the market may continue marching upward for years before the inevitable downturn, but if I were retiring for the first time right now, I’d be assuming the market is more likely to go down in the not-too-distant future than to go up.  And I’d have an allocation right now that would allow me peace of mind even if it took seven or more years to recover. 

It’s tough to know exactly what that allocation is without living through a rough patch.  But I encourage you to run some numbers now.  See how your finances would look if your stock funds lost 46% of their value.  That is not a hypothetical, that’s how much the market went down the first year I was retired. 

If you are getting ready to pull the trigger on retirement, here’s my advice:

1. Take a look at your current nest egg.  Divide that number by your living expenses that will not be covered by other income sources such as Social Security or pensions.  If you are 65 years old, that number should be right around 25.  The larger it is, the better shape you are in.  That represents how many years’ living expenses you have before accounting for inflation and earnings on that nest egg.  History shows that should take you no less than 33 years through retirement, even if our markets experience markets matching the worst 33 years in the last century.
2. Now, take a look at your stable liquid assets--cash, CD’s, short-term bond funds. Divide that number by your living expenses that will not be covered by other income sources.  As a point of reference, it took the stock market almost seven years to reach the peak level it achieved in 2007 before the recession.  Do you have enough to live on if it takes that long again or will you be forced to sell some of your stocks at huge discounts to keep your head above water?  Any stock you sell at the bottom represents gains you will never see again when the market goes back up.  You’ve made those losses permanent.
3. Take your portfolio and multiply the equity side of it by 46%. Now subtract that number from your total portfolio.  Divide the result by your annual expenses not covered by other sources.  How different is that than the number you came up with in #1--the one that was hopefully around 25?  Try one more thing.  Divide this reduced portfolio by the number you came up with in #1.  Can you figure out a way to live on the resulting number instead of the number you were counting on?
4. Historically, if you retired with 25 times your expenses at age 65, you’d likely be ok even without adjusting your spending. But how does the hypothetical situation in #3 FEEL to you?  Doesn’t it make you FEEL like making some cutbacks?  It made me feel like cutting back expenses in 2008 (and 2009 and 2010!)

Despite the fact that I had three years of cash available to me in 2008 and another few years in short-term bond funds, I’ll remind you, I was nervous.  My 70/30 allocation was too aggressive to allow me to rest well.  But a large part of our budget was discretionary spending.  So we made adjustments.  We held off on big vacations and when we did travel, we used airline miles and home-exchange.  We took it easy on the entertainment and eating out.   We lived significantly under budget for the first three years of our retirement.

What else might you consider in a protracted downturn?  Do you have a plan for downsizing, picking up part-time work, or a reasonable expectation of inheriting money in future?  How would you make it work if you had to weather that kind of a storm?

One more exercise I would suggest.   Try all of the above again with a portfolio allocation more heavily weighted toward cash and bonds.  How does that feel?  Maybe you need a more conservative allocation.  It has to feel right to you.

I’m not saying I expect to endure that severe of a recession again, but why not be prepared just in case.  Don’t just base your retirement plan on your “number” today.  It might not be that number anymore tomorrow, or next year, or the year after that. 

Maybe we will be the lucky ones, the ones with the longest expansion in history.  Nothing lost for you then.  You were prepared for the worst and then got to enjoy the best. 

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Related Posts:

    Building a Resilient Retirement

    How to Juice up Your Retirement Returns

    Retirement:  Cheaper Than You Think?

 

 

 

 

 

Comments

[Mr. Freaky Frugal]

I retired in 2012 and have been riding the bull market every since. If you told me then that we still be in a bull market now, I would have said you're dreaming.

But now I realize this time is different! Wait, where have I heard that phrase before? :)

[mwr]

I retired in 2013 and am happy with the decision. We lived within our means, saved intelligently and it has literally and figuratively paid off.

[CedyAtHome]

Like you, we retired early in mid-2008. And like you, we had some sleepless nights.

A couple of points I'd like to make. Your point 1 is valid as long as the portfolio has at least 40-70% in equities (according to William Bengen's study). These studies were done using indexes (like the S&P500 and the Bond Index) so no portfolio expenses were taken into account. If you have expensive Mutual Funds or pay a financial advisor, those expenses have to be added to your annual expense. I think these finer, but no less important, points are often missed when talking about having 25x your annual expenses.

Secondly, these studies assume that you re-balance back to your original allocation (stocks / bonds) each year. If you do this, you will rarely have to sell stock if the market goes down a lot. Your stock will be much lower than your allocation, so you'll have to sell bonds to fund your expenses and BUY stock to re-balance your portfolio.

Good to see you back in the blogosphere.

[Angela]

Welcome back Sydney! Glad to see you here again!
I went back tomorrow post about knowing when you've found the right asset allocation. You wrote... "As some of you that have been with me since the beginning of my retirement know, I retired in March of 2008, right as the market was melting down and we were entering the worst recession in my lifetime. I wrote several posts about my declining nest egg over that first year of my retirement. But I never panicked. I just hung on and kept rebalancing my portfolio to it’s 70/30 stock to fixed income ratio over the next five years.
And it took almost that long to get back to where I started when I retired."
I took that to mean you only had to wait about four years to get your money back. Was it really seven, according to your newest post?
I want to make sure I get this right!
Thanks!

[Tom Sightings]

I got 28 for #1, so I squeak by; but only 5.5 for #2, so maybe I'd better get a little more conservative. My answer for #3 is 20 -- dunno how that measures up. But I'm prepared to cut back some if the economy crashes. I don't need quite so many vacations or restaurant dinners. Anyway, that graph seems kinda scary -- doesn't it? -- and yet it looked scary a year or two ago, too, and still the market goes up. So go figure.

[Angela]

I meant to write... "I went back to your old post... " Not, "I went back tomorrow post..." Grr...

[Rick]

For anyone interested we find an IPS (investment policy statement) valuable. Ours is quite simple. Five sentences, including our investment allocation (generally speaking, 50/50). Significantly, we can't change the IPS (or the allocations) unless we commit to do so and then have a three month waiting period --- this keeps the two main gremlins of good investing at bay -- greed and fear.

Funny thing .... I watched our investments quite carefully when targeting for "early retirement." Then, when I transitioned at age 53 (five years ago), the numbers barely registered on my mental radar screen. Sure, it's much easier to ignore the portfolio and just dig into life when you know the numbers are heading north, but our allocation is such that we should sleep easy when they head south (altough I know from investing since college in the late 70s that heading south -- and sometime heading that way rather rapidly -- isn't much fun.

Anyway, just wanted to offer that up to the group in case anyone might also find an IPS valuable.

Best regards.

p.s. to Syd and Doug ..... our "family" allocation used to be 5 in Nebraska .... now, with and expanding family and another one heading to SF we have a two way tie for second place as we are at 2 Nebraska -- 3 Texas -- 2 California, haha ...

[Retired Syd]

Sorry for the delay in responding to all your great comments. Wednesday is piano lesson and jazz singing class, so between cramming for lessons and going to lessons, Wednesdays are kind of like a full-time job.

Rick: That is a great suggestion. And the truth is, I have an IPS but never realized it. So now I will have to write a blog post about that too! (Maybe those California kids can convert the rest of you at some point . . .)

Angela: You are right, while it took the stock market seven years to get back to it's 2007 levels, it took me four years of retirement (which really was 5 years from the 2007 highs to get back to those levels). I attribute that to two factors. One is that to keep my portfolio in its 60/40 balance I had to BUY stock funds over those four years, which means as the market was going up, I was getting gains on shares I purchased at large discounts (one of the inherent benefits of rebalancing). The second, and it shouldn't go unmentioned, is that I had a part-time job for two of those years. While the job didn't really add to the nest egg, it did prevent us from drawing down on that nest egg over those years of my working. So that's probably why I personally experienced a quicker climb out of the hole.

Tom: Yes, that's why I posted that graph--worth 1,00 words huh? As a point of comparison, my number went from 30 to 25 that first year but is now at 35 after this run-up. So while it will fluctuate over the years, I encourage looking at it just as a means of figuring out your own tolerance for risk before you actually live through such a thing. Interestingly, my tolerance for risk is actually going DOWN as my number goes up. I figure at higher levels, I don't have to chase high returns, I will do ok with a more conservative allocation going forward. More about that in a future post . . .

Cedy: Excellent points (although if memory serves me correctly, I think the lowest stock allocation that worked was a 50% under Bengen's research). There are a few different schools of thought on when to re-balance, I do it more frequently than annually when the market runs up or down so quickly. Basically any time my allocation exceeds a percentage point off kilter. But many people don't find this exercise fun, annually is probably enough. Remember I was an accountant, so some of us have a warped sense of fun!

Mr. Freaky and mwr: Congratulations on your retirements. This is an especially good exercise for you both because you haven't been retired during a recession yet. It's been steady UP since 2012 and 13. Your timing was better than mine!

[Dickson]

When I early retired in 1999, rather unexpectedly, my nest egg was pretty much all in stocks, save for some emergency cash and the equity in my house. I put together a retirement budget and spreadsheet that showed me having enough money to last until age 65 using very conservative projections. Since I could live comfortably on Social Security alone, that was good enough to take the gamble. I then sold a chunk of my stocks and bought TIPS, which were little understood in those days and paid 3.7% plus inflation. That, plus long experience with stock market fluctuations, allowed me to weather the 2000 and 2008 bear markets without difficulty. My frustration with the 2008 bear market was that I didn't have enough cash to be able to buy in a big way when stocks were "on sale" and everyone else was panicking, but I did buy some shares of GE at $12-$13 in Feb 2009 just so I could feel as if I was taking SOME advantage of the bear market. It is a different sort of mindset than having sleepless nights!

I do try to sell into stock market rallies to keep several years of cash on hand in case the market goes down. I also have Series I Savings Bonds, now worth more than two years of living expenses, to serve as my emergency reserve, although they are at such high interest rates I'd really not like to sell them before they mature.

Now, eighteen years later, my rather small portfolio is worth more than it was back when I started, despite all those years of living on it, so my projections back in 1999 really did turn out to be conservative. I'm holding out on taking Social Security until age 70, at which point I would get more than I live on now, by a lot — it helps to be thrifty. So far so good.

The hope is that I can keep my nest egg growing after age 70 and, perhaps, have enough to fund assisted living should it be necessary. But that sort of thing is crazy expensive, as I've found out from the recent experience of my parents, so I don't know if I can pull it off. Perhaps I will be lucky and croak suddenly, as opposed to needing a care community for many years. That remains to be seen. Having always been single, I don't have a spouse or children to help out (or hinder, as the case may be).