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Guess what? It may actually be different this time

It was late September 2008. I was in Provence with my husband and some extended family, enjoying my sabbatical in our perfect little rented house. But things weren’t all that tranquil. The market was tumbling, and one of the family members who had joined us was in a state of panic. Although she was still years from retirement, she was convinced that she wanted to sell all of her stock holdings. The news about the markets and the state of the global economy seemed to be going from bad to worse by the moment.

Finally my husband broke through. “Are you getting ready to retire? Will you need your money soon?” No and no, she answered. “Then stop worrying and enjoy your vacation!” And amazingly, that seemed to break the spell. We snapped off the TV with its dire news about the market’s drop, and our relative ignored the market and stood pat with her portfolio.

That sounds like a success story, and it was. But I wouldn’t necessarily give that same family member the same advice today. No, I don’t have any insight into whether the next few years will be bad for stocks. But I do know something about my relative: Now she is ready to retire and she will be drawing upon her portfolio for living expenses.

That means that the approach that made sense for her 10 years ago - don’t sell any stocks! - may in fact be ill-advised today. If she hasn’t taken steps to reduce her equity exposure in the interim, cutting the stake now in favour of safer investments could be the right course of action.

Selling into a downturn isn’t always a bad idea

The fact that investors can vary so much in their spending horizons is the key reason why I often cringe when I hear one-size-fits-all recommendations during volatile markets. Even as well-meaning market observers exhort everyone to “stay the course”, not everyone should. People getting close to retirement or those who are already retired are courting serious risks by standing pat with too-aggressive portfolios.

For one thing, hands-off portfolios have a way of becoming more aggressive over time. Take, for example, a portfolio that was 60% S&P 500/40% Bloomberg Barclays Aggregate Index 10 years ago. Even if an investor hadn’t been shovelling money into strong-performing stocks over the ensuing decade, that portfolio would be about 80% equity today

That ever-more aggressive positioning isn’t a problem for people who still have many years until retirement. In fact, it’s desirable, provided the investor knows not become unduly rattled (and therefore at risk of panic-selling) amid declines. While it’s not a given that stocks will outperform safer asset classes over long time periods of time, market history suggests that’s a reasonable bet.

When you’re young (and by that I mean under 50), not taking full advantage of the historical outperformance of riskier asset classes is a bigger risk than being too conservative.

But those risks flip once you get close to and enter drawdown mode. At that life stage, you’re much more vulnerable to 'sequence-of-return' (or sequencing) risk. That means that if you encounter a calamitous equity market early in retirement and need to spend from the declining equity portfolio, that much less of your investments will be left to recover when stocks finally do.

Your only choice to mitigate sequencing risk, assuming your stock portfolio is in the dumps and you don’t have enough safe investments to spend from, will be to dramatically ratchet down your spending. Needless to say, that’s not something most young retirees are in the mood to do.

And here’s another thing. Your past behaviour in market declines isn’t always a great indicator of how you’re apt to behave in the next big downturn. Even if you sailed through the 2007-2009 market meltdown without undue worry or panic selling, the next downturn could prove more visceral if retirement is closer at hand and starting to seem like a realistic possibility.

It’s not fun to see your portfolio drop to $225,000 from $500,000 when you’re 45. But it’s way worse to see your $1 million portfolio drop to $450,000 when you’re 55 and beginning to think serious thoughts about the when and how of your retirement. The losses are the same; the ages and dollar amounts are different. Retirement is no longer an abstraction, so it stands to reason that you could be at greater risk of selling yourself out of stocks at the worst possible time.

How much safety is enough?

Of course, people nearing or in retirement should be sure to hang on to some stocks, too. Returns from cash and bonds are unlikely to keep up with inflation over time given how low cash and bond yields are today. To help preserve a portfolio’s purchasing power, even older retirees need the growth potential that can accompany stocks. People who are sourcing a lot of their retirement income needs from nonportfolio sources like the age pension pensions can arguably maintain portfolios that skew heavily or even mostly toward stocks, because they’re hardly spending from their portfolios.

Risk tolerance is a factor; even if an equity-heavy posture makes sense on paper, it’s a bad idea if it puts the investor at risk of dumping all those stocks at an inopportune time.

Investors looking for benchmarks on appropriate asset allocation could look to Morningstar's Lifetime Allocation Indexes. However, those yardsticks don't factor in an investor's own retirement spending rate and need for liquidity.

By using expected cash flow needs to determine a portfolio's allocation, the 'bucket' approach to retirement-portfolio management can help investors determine a stock/bond/cash mix that's appropriate for their time horizons. I've created a number of bucket portfolios for retirement but the starting point when right-sizing those buckets is to figure out how much of your portfolio you'll be spending each year.

In addition, investors who are lightening up on equity exposure must be sure to watch the tax consequences, as it's possible to rebalance in a tax-efficient way. An additional tool when it comes to correcting overly-risky portfolios is withdrawing from the most appreciated and presumably highest-risk positions. 

 

Christine Benz is Morningstar’s Director of Personal Finance. Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar. This article does not consider the circumstances of any investor, and minor editing has been made to the original US version for an Australian audience.


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6 Comments
Lyn
February 18, 2021

Re last paragraph of article, one strategy to spread/lower CGT liability is take just the gain by selling only number of shares equal to gain which rebalances underlying value of portfolio and cash available if needed for living exp or save for buying another Lot at lower price down the track and view perhaps higher cost per share to sell small lot as a cost of doing business to achieve better position overall in future. Sensible advice from tax specialist 20yrs ago when needed car.

Jeff in Brisbane
February 14, 2021

Your last paragraph is the most important:

"In addition, investors who are lightening up on equity exposure must be sure to watch the tax consequences, as it's possible to rebalance in a tax-efficient way. An additional tool when it comes to correcting overly-risky portfolios is withdrawing from the most appreciated and presumably highest-risk positions. "

This would be a very interesting article on what options there are for mitigating capital gains on selling down of the most appreciated and high-risk assets (such as Afterpay). Small additions to Super is useful, but is often not enough to mitigate a large CGT bill.

MB
February 14, 2021

Nothing has really changed fundamentally. Shares continue to be the only asset class providing ANY returns after inflation and taxes. As long as retirees are well diversified and stick to their safe withdrawal strategy (incl. having at least a year’s worth cash reserve), their money will outlive them in retirement.

AussieFI
February 15, 2021

Yes agree here with the AT LEAST one year of expenses cash reserve. Preferably aim for two and this will go a long way to mitigating sequencing risk.

Harry
February 12, 2021

So true though. As we get closer to retirement, despite having accumulated more and more years of investing experience, the decisions seem to just get harder! Ongoing income has camouflaged some pretty poor choices in the past!

Jack
February 11, 2021

It's a pity there are no bonds or term deposits offering safety and a return if we do sell our shares.

 

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