"I just don't want to lose 40% of my money in retirement." I've heard a version of this from clients and prospective clients more times than I can remember over the last two decades.
All investors, but retirees, in particular, are fearful of bear markets (technically defined as a loss of -20% or more) in stocks. For a good reason--seeing a quarter or more of your stock portfolio go away conjures up worries of running out of money or having to reduce your spending dramatically. The question is, can you avoid bear markets in retirement? I'm going to surprise you by saying yes, you can.
Just not the way you think.
The "Crystal Ball" Approach
The most common approach to avoiding bear markets entails trying to predict ahead of time when the bear will strike, and selling your stocks right before that happens. Unfortunately, we don't know how to do that. I don't, you don't, and the professional money managers don't either. The "crystal ball" approach doesn't work. Studies on the returns of actively-managed mutual funds versus their index proves this fact.
The graphic below reports the total number of actively-managed mutual funds that were in existence 20 years ago in 2001, and follows their results through 2020. You might be surprised to learn that less than 50% of the stock and bond funds that started the period even survived! The average professional manager does so poorly their fund is often closed or merged into another fund (after poor returns) within two decades. Not only can they not time the market effectively, the average professional manager struggles just to stay in business!
How many successfully picked just the right stocks/bonds, or the right times to be in and out of the market? In the stock category, only 19% of managers (one in five) outperformed their stock index, and even fewer bond fund managers, 11%, managed to outperform their bond index. Those are terrible odds.
The "Plan Ahead" Approach
Fortunately, you can scrap the crystal ball approach because there is another method that works better. It's simply called "planning ahead."
Planning ahead requires the knowledge of how often bear markets in stocks happen, how severe the losses are, and how long they last. Then, instead of trying to guess when the next bear market is going to hit, you plan ahead by setting aside enough years of your future income in a short-term bond fund so that you can spend from it (instead of your stock funds) while stocks are going down. Once stocks eventually recover, as they always have, you can return to selling shares of stock mutual funds to meet your ongoing income needs.
This approach is reminiscent of the famous quote from Henry Wadsworth Longfellow, "For after all, the best thing one can do when it is raining, is to let it rain."
Of course, to do this, you need a perspective on bear markets, which I have provided below. The graphic reports the long-term bull and bear market cycles for the S&P 500 Index from 1926 through 2020. At the bottom of the graphic, you see all 17 bear markets where stocks dropped -20% or more. What can we learn?
First, 17 bear markets in 95 years isn't a lot. You should expect to see your stock portfolio drop -20% or more about once every five years. That's been the price of 10% per year compound returns--you have to put up with temporary, and sometimes sharp, declines for the chance to see your investments grow considerably over time.
Second, bear markets don't last long. We can measure most bear markets in a matter of months; only seven of the 17 bear markets lasted a year or more, and only one lasted more than two years (just two years and three months).
Last week I showed a perspective on bear markets over the last 25 years; going back almost a century does not change our findings. Having an income reserve equivalent to about two years of your future spending in bonds is sufficient to ensure you'll be able to avoid selling stocks in the teeth of a bear market.
As for the prospects of losing -40% of your portfolio in retirement, there's good news and bad news.
The bad news: A -40% decline will probably happen once or twice over the remainder of your retirement years, and you won't be able to predict it in advance. -30% to -39% declines have happened four times, and we've seen four other times when losses were greater than -40%. You should expect each one to happen every decade or two.
The good news: You can avoid bear markets, or avoid selling during bear markets (which is the same as avoiding them), as long as you have planned for and set aside two years of your future withdrawals in a short-term bond fund. You'll be selling shares of your stock funds most of the time to meet your withdrawal needs, but when stocks do inevitably decline, turning instead to your bond fund for withdrawals can buy you the time to avoid selling stocks when they're at their worst.
Using this approach, you don't have to predict the next bear market, you'll be prepared for it when it comes. It's the only way I know of how to avoid bear markets in retirement.
Past performance is not a guarantee of future results. Index and mutual fund performance includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and should not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.