Should I reduce my risk?
Q: I am very concerned about the risk in my portfolio. I’ll be 81 this year and my wife just turned 71. At my age, I cannot go back to work, so the savings we have today are all the savings we will ever have. In 2008 stocks fell 50% from their previous highs and took years to recover. If the market drops like that again, we may be forced to liquidate our investments before they have a chance to recover. I’m beginning to feel like I should move money out of stocks. Am I being overly pessimistic? Is it possible to be too conservative?
A: You are wise to be concerned about portfolio risk. Markets have a way of punishing investors who become complacent. But whether you are being too pessimistic or conservative is impossible to know based only on the facts you have given. The amount of risk that is appropriate for you depends on several factors, including your investment horizon and the amount of return you need your portfolio to generate.
There are a lot of different ways to think about portfolio risk. Many people focus on portfolio volatility, or the degree to which their portfolio’s value changes over a specific time interval. That kind of risk measure works well if you are a day trader. However, if you are a long term investor, it is more useful to think of risk as the possibility that your capital becomes permanently impaired.
As your question suggests, being forced to liquidate stocks in a down market is a real risk. It can permanently impair your capital. We call this “liquidation risk.” One way to mitigate liquidation risk is to diversify a portion of your portfolio into bonds. The amount of bonds you should own depends on two things: 1) how much money you expect to withdraw from your portfolio each year; 2) how long it takes for stocks to recover from a bear market. Financial planning can help answer the first question. A study of bear markets can help answer the second.
Since 1929, the U.S. stock market has suffered ten major bear markets, defined as a decline of at least 20 percent. In the longest bear market, the S&P 500 index took more than 15 years to recover to its pre-bear market level. The shortest recovery took only 17 months. On average, across all ten bear markets, the market took 4.6 years to fully recover. The recovery from the 2008 bear market took 4.5 years.
You can protect yourself from liquidation risk, by holding enough in bonds to fund your expected withdrawal during a bear market recovery. For example, let’s assume you have savings of $500,000 invested in a traditional IRA. As an 81 year-old, the IRS is going to require that you to take annual distributions from your IRA. Over the next five years—the average length of a major bear market recovery—your distributions will total approximately $155,000. Therefore, if you want protection for an average bear market recovery, you should have at least $155,000, or 31% of your portfolio, invested in bonds and cash.
If you want to protect yourself for a longer period of time, you can hold more in bonds. But remember, owning more bonds will reduce your portfolio’s expected portfolio. If your portfolio return is too low, you may not be able to achieve your longer-term goals. In that sense, it is possible to be too conservative in your portfolio strategy. A trusted financial advisor can help you balance the tradeoff between protection from liquidity risk and the need for an adequate return on your portfolio.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite #202, Monterey, CA 93940 or email them to: firstname.lastname@example.org