Without any financial goals or future withdrawal needs, your allocation to stocks and bonds wouldn’t matter. Without a withdrawal rate, your portfolio would grow to whatever it grows to. The growth of an all-bond, all-stock, or combination portfolio can be projected and the difference between them measured. The temptation would be to pick the one that has the highest expected return, which would be the all-stock portfolio.
However, when portfolios are subjected to withdrawal needs, suddenly the sequence of returns matters greatly and it becomes much harder to project which portfolio has a greater expected growth. With positive returns, the all-stock portfolio might still win when subjected to a withdrawal rate. However, if the returns are less favorable and especially if you need to make large withdrawals in the years the stock market is down, the all-stock portfolio might run out of money.
While the appreciation allocation helps you achieve your financial goals, introducing a stability allocation into your portfolio can prevent your portfolio from running out of money.
This is why portfolio construction begins with the most basic allocation between investments that offer a greater chance of appreciation (stocks) and those that provide portfolio stability (bonds). Decisions made at this level are the most critical in determining how well behaved your portfolio returns will be.
There is an optimum allocation between stocks and bonds for a given withdrawal rate.
Having too much stability means that you might not have enough growth. When subjected to a withdrawal, many of the sequences of an all-bond portfolio end up running out of money. If the portfolio experiences poor bond returns early in the sequence, monthly withdrawals comprise a greater percentage of the portfolio and can spend it down quickly. If the portfolio experiences high inflation compared to the bond returns, then the portfolio falls behind on its purchasing power. Having everything in bonds risks not having enough appreciation to overcome poor bond returns early in the sequence.
There is a similar effect for the all-stock portfolio or a portfolio that is too aggressive. When the portfolio is burdened with withdrawals, some sequences of returns run out of money during the 30 years. Having everything in stocks risks having to take a large percentage of money out after poor market returns early in the sequence and therefore not having enough money remaining to grow when the markets recover.
How a Stability Allocation Helps During a Bear Market
A stability allocation helps you have enough money to meet your withdrawal needs by dampening the volatility of stock returns. An appreciation allocation helps you have enough growth in your portfolio to compound your savings into your financial goals.
One standard deviation of 7-year stock market movements is all positive. For this reason, we recommend having 5-7 years of your withdrawal needs invested in bonds. This way, you likely won’t have to sell your stocks when the market is down to live. Beyond that, having a slightly larger stability allocation than just your withdrawal needs poises you well for rebalancing.
As I’m writing this, we are in the midst of the 2020 COVID Bear Market with market returns down more than 20%. During this season of panic, investors have bought so much in bonds that the bonds are overvalued and investors have fled stock so much that the stock prices are undervalued. Once the fear settles and investors settle down for the long-term again, the market will settle as well. However, currently, bond prices are at a relative high while stock prices are at a relative low.
We have a saying around here: It is always a good time to have a balanced portfolio. Sell what is up, buy what is down.
Having more allocated to stability than you strictly needed means that now you can capitalize on market instability. By selling off some of your extra bonds while they are at relative price highs, you can buy more in your stocks while they are at relative price lows. This will rebalance your portfolio and position you well for the eventual recovery.
Selling bonds and buying stocks will increase your expected return but also increase your expected volatility. If you are currently withdrawing from your portfolio, consider leaving at least 7 years of your annual withdrawal rate in bonds regardless of if the percentage is still the same stability target. As the stock market trends upward, this dip in market prices can be perceived as stocks being discounted and is likely a great time to buy low.
What To Do If You Don’t Have a Stability Allocation
If you are entering this correction with an all-stock portfolio like I am, then you may be yearning for a stability allocation. Unfortunately, now is the worst time to get one. If you sell your stocks at these relative lows to buy bonds at these relative highs, you are locking in your stock’s losses and positioning yourself for further heartbreak in the bond market.
If you are currently withdrawing from an all-stock portfolio, I am sorry. The best you can do now is to practice extreme thrift and strive to cut back your standard of living as much as possible to limit your portfolio withdrawals. Perhaps try using Core Values Budgeting to identify budgeting changes or revisit your spending habits to see if you can cultivate a thriftier lifestyle.
If you are currently contributing to your portfolio, then you should evaluate the security of your income sources.
If you have an insecure job or earn money based on commission, set your budget based on the base salary you could command if you needed to switch careers to supplement your lifestyle or based on a salary that represents the minimum commission ever earned. This advice may result in your family living a more frugal lifestyle than is strictly necessary, but a frugal lifestyle is the most important component in building significant wealth. By earning commissions or wages above and beyond your budgeted lifestyle, you will make faster progress toward saving and investing and therefore financial freedom.
Similarly, if you receive a variable annual bonus, we would suggest setting your budget with the assumption that you will not receive any bonus. Bonuses are completely discretionary. If there is a downturn in the company’s business, a recession, or a change of heart by management, you can easily find yourself receiving less or none of what you expected. It is fun to anticipate great future windfalls. But it is prudent not to count your chickens until they have hatched.
If your job is secure and you have budgeted wisely so that you are saving appropriately, then you may not need to cultivate a stability allocation because your paycheck is serving as one.
One dollar is just the same as another dollar. Curiously though, our emotions do not perceive the world this way. To our emotions, our paycheck feels different from a gift card which feels different from a tax refund. However, this fallacious method of thinking is called a “two-pocket theory of money,” and once we overcome its sentimental ways, we open ourselves to more strategies for saving.
Most savers have at least three stores of money: retirement accounts, taxable savings accounts, and paychecks. Some investors like me are contributing to some accounts, such as their Roth 401(k) or IRA, while at the same time they are withdrawing from other accounts, such as their taxable savings. However, if your net contributions/withdrawals from across all your investment accounts is positive, you are contributing and do not have a withdrawal rate. Instead, the withdrawal on your taxable account is better thought of as a tax planning strategy, such as a Roth conversion.
Even though you may be selling stocks in your taxable account in order to support parts of your standard of living, you are buying more stocks in your 401(k) as a part of your direct deposit deferral. In effect, this likely serves as an automated tax-loss harvesting strategy, banking capital losses for your next tax return while still remaining fully invested to wait for the next recovery.
Your regular retirement deposit serves the same function in your portfolio that an excess stability allocation provides to a more conservative investor.
The market still trends upward. It has bear markets, recessions, and crashes along the way, but it still trends upward. The longer the time period, the less drops there seem to be. There has never been a 20-year period where the markets have been down. Long-term investors have time to recover. You can do this. If you don’t want to do it alone, this might be the time to reach out for help. Feel free to drop us a message or give us a call to get started today.
Photo by Jeremy Bishop on Unsplash