Investing in the stock market? You need a lifeboat drill

The worst thing that can happen to any retiree is a nasty bear market early in retirement. While there’s never a good time for a bear market, early in retirement is the worst time!

In retirement you sell shares of your investments for income. A bear market early in retirement means you’ll be forced to sell more shares of your stock market investments at lower prices.

Since you’re retired you have no earnings capability. You simply can’t recover from this scenario by saving more or working longer. The fact that it’s early in retirement means you’ll have to cut back for a longer period of time.

Can you survive a bear market right now? The only way to know would be to do a lifeboat drill.

 

Why you should love a good bear market

It’s odd to say but you really should appreciate bear markets. Take a minute and really think about this. If there were NO bear markets the stock market would earn about the rate of inflation or bonds. That’s closer to 3% on average versus the 10%+ the stock market has earned over the last few decades.

It’s weird but true. If the stock market had a nice slow steady ride up it would return about the rate of inflation or bonds at best. If there was no volatility there would be no higher long term returns!

Notice I said volatility, NOT RISK. Risk is something you can lose. The only losses during these nasty little drops are on paper. Foolish investors turn those paper losses into risk by locking in their losses. Wise investors view them as normal stock market “volatility”.

It’s because of the volatility that we get great stock market returns over long periods… not in spite of it! In fact volatility is the best transferor of wealth from foolish investors to wise investors. 

Foolish investors with no financial plan in place are left to chance and randomness. They sell when the wealthy hang on and actually buy! This makes bear markets the best tool for transferring what wealth foolish investors have to wise investors.

 

Intra-year stock market declines

Here’s your lifejacket. Understanding the volatility the stock market has had will help prepare you for the eventual market drops. Take a look at the attached chart:

Investing in the stock market isn't easy! Be prepared for the volatility.

Investing in the stock market brings volatility along with gains.

stock-market-investing-volatility

What you’re looking at is a chart of stock market returns illustrated by the S&P 500. Green bars are the yearly returns, red bars are the intra-year paper losses.

The important thing is to realize that:

  • On average the stock market drops 14% every year during the year
  • On average the stock market returned 10% per year for the last 34 years

You must embrace the 14% drops to get the 10% returns! I fact you shouldn’t simply tolerate the drops, you must cherish them! Those drops are why stocks have earned 10% on average.

 

The concept of a lifeboat drill

Now that you understand stock market volatility is normal and expected, can you weather it? A lifeboat drill is used simply to see if your financial plan can handle a big short term drop.

You can do a lifeboat drill by cutting the value of your investments by some percentage to see if your income draw holds up at a reasonable rate. For example, a 60% stock and 40% bond portfolio would have dropped about 25% in 2008. If you were drawing $20,000 per year from your $500,000 portfolio that’s a 4% draw. A 4% draw is very reasonable and the long term retirement success rate is very high.

In 2008 a 60/40 portfolio dropped to $375,000 (25% less than $500,000). Your $20,000 income draw from your $375,000 portfolio value is a 5.3% income draw. Anything over 5% really pushes your financial plan’s envelop!

 

What to do if your lifeboat sinks!

While a 4% portfolio draw rate is relatively normal, draw rates much higher than that may be doomed to failure. Volatility is a fact of life so the more you draw the higher the risk of drawing down large chunks of it in a bad market.

If your simple lifeboat drill pushes your withdrawals over 6% you need to consider some changes. A contingency plan is the best way to combat this potential problem. In some cases we call that contingency plan a “bear bucket”. In others it’s a different strategy called a “bear slider”.

 

What’s a bear bucket?

What’s the biggest reason you shouldn’t push your income draws too high as a percentage of your portfolio? Because you’ll be selling more shares at lower prices should a bear market occur. A bear bucket prevents this.

A bear bucket is simply a nice safe conservative chunk of money you’ll draw income from when a bear market occurs. How much money? That depends on you and your retirement plan.

Generally a cash stash of 6 to 12 months is enough to weather the majority if not all of a bear market. The average bear market throughout history was about 11 months long. Having enough assets set aside to provide safe income through most or all of that period is the goal.

If your portfolio income is $4,000 per month, your bear bucket target amount should be a minimum of $24,000 (6 months of income). Having a $48,000 bear bucket (12 months) may be a bit overkill, but for the ultra worried investor it’s appropriate. The key to remember is having a bear bucket lowers your overall allocation to stocks. Take this into consideration because your long term returns will be lower.

 

What’s a bear slider?

Another strategy to help float a sinking lifeboat is the bear slider. A bear slider requires an adjustment to your asset allocation in bear markets.

Again the problem with bear markets is you’re selling more shares of your investments at lower prices. Since your stock market investments are more volatile they’ll drop further than your bond investments. A 60% stock and 40% bond portfolio in 2008 changed to roughly a 45% stock 55% bond allocation.

The bear slider strategy means you ONLY  sell your bond investments during a stock bear market. This changes your asset allocation more aggressively as you can imagine. A 60/40 portfolio may ratchet up each month that goes by 1% or 2% in stock allocation.

The nice thing about a bear slider is you don’t have quite so much money earning very low rates (bear bucket). The bad thing about a bear slider is you’ll be increasing your stock allocation when the stock market is nasty. But that’s not such a bad thing now is it?

 

Stock market investing isn’t easy

It’s not easy and it’s not supposed to be. If it was easy and safe the returns would be about the rate of bonds or inflation. Investing in the stock market has a risk premium because it’s volatile, not in spite of it!

Since it’s not easy it’s critical you have a quality financial plan created. Only with a solid plan can you truly feel good about your retirement. Part of that plan means running periodic lifeboat drills.

If your lifeboat drills fail, you need to consider a few things:

  • Should you spend less now?
  • Should you be prepared to spend less during bear markets?
  • Should you consider a bear bucket strategy?
  • Should you consider a bear slider strategy?

What I’ve laid out is a simple way to gauge how well your retirement plan may hold up in a bear market. It’s just a rule of thumb and very simplistic. Consider hiring a quality fee-only financial planner to run a more thorough retirement plan and lifeboat drill for you.