Revisiting Portfolio Risk Tolerance…..Again
With the recent market volatility during 2022, I thought I would add a quick update to my blog site. What caused me to do this was a recent conversation I had with a family member. Like all of us, the recent down-draft in the stock and bond markets has been very unsettling to this person. And when you are in, or near retirement, this can cause the fear and anxiety to increase to the point that you feel like you need “to do something.” I do not use a financial planner as they are terribly expensive to employ to monitor and invest your assets (for a portfolio of $1 million, it is generally a 1% fee per year…or $10,000). However, in times like this, when we are in a stock bear market, I think a financial planner can be very helpful. The planner can help the investor-client control their market fear/anxiety, and, hopefully, not do any panic selling.
When an investor is having these anxious thoughts in bear markets, this usually indicates their portfolio risk is not calibrated properly to their own personal risk tolerance. At least, not close enough to properly manage their market fears.
To do a check on one’s personal market risk tolerance, one should reassess their portfolio equity allocation. What is meant by equity allocation? This is just the percentage of your total financial portfolio that is invested in stocks (as opposed to bonds or cash). I wrote a blog in February 2021 reviewing a simple process that anyone can use to do a personal assessment on their own stock market risk tolerance. You can read it here, so no need for me to go over it again.
For people already in retirement and withdrawing funds from their portfolio, there is another “old-adage” of retirement income planning to consider. It is the 4% Safe Withdrawal Rate (SWR) rule. I wrote another post in December 2020 on this topic. You can read it here. This post is a little out of date because of the past year’s spike in general market inflation and the subsequent rise in interest rates. However, the basic theme of the post, with over-valued markets and negative “real interest rates,” I believe still applies. My conclusion in that particular post is that, for conservative investors, I believe, if a choice must be made, it is better to lower your SWR below 4%, than to increase your equity allocation. I believe this for all the reasons I wrote about fear and anxiety above.
But, in this post, I wanted to address one more area of retirement planning. I am talking about the “buckets strategy.” The buckets strategy is a different approach to withdrawing assets from your portfolio in retirement from the 4% SWR. Years ago in this blog, I wrote several posts on the details of how to implement the buckets strategy. Today, however, rather than talk about the details of employing this strategy, I wanted to just discuss the buckets strategy in a more general way in the context of risk tolerance. For some retirees, the “buckets” approach may be more helpful in containing their market fears.
In 2018, when we had a temporary uptick in market interest rates, I actually changed our own portfolio withdrawal method from using the 4% SW rule to a very simple buckets strategy. I did this because, at the time, I did not think that interest rates would ever be that high again (at least not in my lifetime). I turned out to be wrong in my interest rate prediction, but I still like the buckets withdrawal strategy better for us than the 4% SWR because it is psychologically a better approach. (NOTE: Even using the buckets strategy, one should, periodically, still calculate their portfolio withdrawal rate to be sure that one is not drawing down their portfolio too quickly).
So, in completing this post, I will give a quick description of how I am using a simple version of the buckets strategy to withdraw retirement assets to help fund our annual spending needs. Of course, this withdrawal description only applies to your necessary portfolio drawdown to fund your spending needs over and above your social security benefits, any pension, or other guaranteed income you already have.
In late 2018, I set up what is essentially a “bond ladder.” But, rather than bonds, I used bank CDs. I used CDs because if we need to liquidate CDs prematurely, there is no risk to principle. In 2018 my credit union was offering 1-to-8-year CDs with APRs between 2.75% to 4.00%. After determining at what age we would each start collecting social security and allowing for our other rental income, I calculated (with a little buffer built in….in case of higher than anticipated inflation) how much funding we would need to draw from our portfolio to supplement our living expenses for each of the Years from 2019 to 2027.
Using the applicable available CD APRs and estimated future inflation, I discounted those future amounts back to the amounts needed to invest late 2018. We are now 3.5 years into spending the funds accumulated in these CDs. Which means, we have funds left for another 5.5 years of living expenses (sure glad I assumed a higher inflation rate than what existed at the time).
The total amount to purchase all the CDs in late 2018 (including one year of cash for the first year, 2019), was about 26%-28% of our entire portfolio. I know this seems like a lot. I believe this equated to, initially, about a 4.5% to 5% annual withdrawal rate. This percentage is high, but neither of us had started collecting social security at the time. With my wife just starting her social security benefits this year, our withdrawal rate has now fallen to about 3.2%.
I have covered too much detail in how I built our “fixed-income ladder.” The two relevant questions here are; Why did I do this? And how does it help with managing my market risk tolerance?
The answer to the first question was, I thought in 2018, that interest rates were going to continue to stay low for years. So, my intent was to spend some of my fixed-income assets first and let my dividend income investments “re-invest” and compound at a higher rate than if I just spent the dividend income. (To learn more about the benefits of “re-investing” dividend income, read this post here). Even though the interest rate environment has changed this year, I still believe it is better to re-invest your dividend income. I just do not believe that interest rates will get high enough to change that.
The answer to the second question is easy. Now I do not care if the stock market drops another 25% to 30% from here. I am not worried about it at all. Why? Because my remaining CDs mean I do not need to touch any equity investments for another 5 to 6 years. So, even if my equity investments drop a lot more from today’s levels, they are likely to have recovered in 5 to 6 years. If one is currently using the 4% SWR method today, one must make the difficult decision to sell some of their equity assets today while they are lower in price. This may end up not being a problem in the long term, but it is still a very difficult thing to do today. As always, everyone needs to decide what approach is best for themselves.
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