In retirement, one of the scariest things, particularly when you are dependent on your investment portfolio for a large portion of your retirement income, is how to deal with the ups and downs of the stock market and the economy.
You may believe that, in order to do that, you have to be able to get into the market as it is going up and out of the market as it is going down. This is called market timing. Unfortunately, market timing is impossible to do. So, it is not an effective way for you to manage market volatility.
But not to worry, because there is a tried and true strategy that does not involve a crystal ball. Cash is your most effective tool for smoothing out the effect of market volatility on your retirement income. But, before I describe exactly how to do this, let’s first agree on a couple of assumptions.
First is that there is no such thing as the perfect investment. All investments, beyond those which pay a minimal risk-free rate of return, have risk. One definition of risk is the variability in outcome. Therefore, the more return you require in order to produce the income needed to pay your bills, the more variability, in those returns, you will have to tolerate and manage.
Second, we are going to assume that you have sufficient cash reserves already set aside before you reach retirement age. If not, that is an urgent priority. Do not retire without sufficient rainy day funds.
We recommend, to all of our clients, that they have at least twelve months of expenses put away in a safe, liquid emergency fund. This fund is only to be used to manage variances or disruption of income.
You also need a savings account. The money in your savings account is set aside specifically for non-recurring, one time expenses. This includes things like the dishwasher breaking, putting a new roof on your house, paying for vacations, and anything else that you know will occur on a regular basis, you just don’t know what it will be and when it will happen. This is separate and serves a different purpose than your emergency fund.
Assuming you understand the risk-reward trade-off and you have sufficient cash reserves set aside, the steps to managing stock market volatility are easy. Let’s use an example to demonstrate. Please note these numbers are not meant to represent any specific investment. They are strictly for illustrative purposes.
Imagine your expenses, in retirement, over and above Social Security and other sources of income, are $4,500 per month. You have a $1 million portfolio that produces an average annual return of 7%, over long periods of time. That works out to $5,833 per month, before compounding.
In normal times, you would withdraw $4,500 a month from your portfolio, leaving the remaining $1,833 per month in earnings in the portfolio. The reinvested dollars create the growth you need to keep up with inflation.
Now imagine that the economy and the stock market take a tumble. Your investment returns, for some period of time, drop to $2,000 per month. What do you do?
You do not sell off the assets at a loss. This is called eating your principal and it results in a very bad situation for retirees called reverse compounding.
Nor do you curse your broker, financial adviser or portfolio manager for not being able to foresee the upcoming market swoon and get you out in time. The market’s downturn is something that you know will occur periodically and for which you have planned.
Instead, you pull the $2,000, in earnings, from your investment portfolio. You make up the difference, between the $4,500 per month you need and the $2,000 a month the portfolio is currently producing, using your emergency funds. That is what you have set them aside for. Being savvy and thoughtful about your money, you know that this sort of variance will, at times, occur.
After some period of time, the market begins to improve somewhat and your portfolio returns increased to $3,500 per month. Now you are supplementing your portfolio returns with $1,000 per month from your emergency funds.
Eventually, because we do assume stock markets are mean reverting – meaning that they cannot exist in a state of extreme indefinitely – your portfolio returns come back in line with the expected rate of return for the portfolio. At that time, you are no longer supplementing your portfolio returns with your emergency funds.
The nature of mean reversion is that the pendulum swings both ways. So just as we had a period of under-performance, we expect there will also periods when the portfolio over-performs. The more reward you seek, the wider we expect those swings will be.
What do you do during these periods of over-performance? Do you spend the extra money on new cars and fancy vacations? No. You use those periods of time to replace what you took from your emergency funds so that when the next economic down turn occurs, you have sufficient reserves to smooth your portfolio income.
This system of managing portfolio variability in retirement is very easy and very effective. Planning, in almost any endeavor, is the key to success. As long as you understand the variations, over time, in your portfolio return and plan for them, stock market volatility doesn’t have to be the source of fear and anxiety it is for so many people.