Protecting retirement equity savings through market crashes
One of my friends asked me this question:
If I invest in equities all my working life, and just when the retire, the markets crash eroding 30%, then wouldn’t that leave me poorer off? Shouldn’t I invest in a mixture of bonds, or real estate for that scenario?
So, here is someone who understands the value of investing in equities and believes that the returns are good enough in the long run, but is afraid of erosion of wealth in case of an untimely crash, specially one that occurs after he has accumulated enough wealth for retirement.
This is indeed quite a common concern. Most planners/advisors suggest moving a part of your money to bonds to avoid this situation, or to diversify your portfolio into other assets.
However, I have a couple of issues with this approach. One is, with increasing life expectancy, and changing industry trends (becoming obsolete early & earlier retirement), there is a good chance your post retirement life might be longer than your working years. Your working life might be from 25–55 and you might live from 55–80, for instance. In that case, your choices at retirement to choose a less risky, but lower return instrument will have an adverse impact over your retirement funds.
Secondly, getting the timing right is very difficult. What if you plan to do it on retirement day and the crash happens the day before? Or if you plan it 10 years earlier and there is a nice bull run you fully miss out on for 10 good years?
From historical data of returns S&P 500 vs US treasury 10 year T-Bills, which I have reproduced in a google spreadsheet:
it seems that there is at least a 3.61% difference between equities and bond returns in the long run, if not higher. Over a 10 year period, that’s about 42% more money if you invested in equities. If you are planning to move your investments to bonds 10 years earlier, the 40% *sure* drop in return in exchange for a possible crash eroding 30% on retirement date doesn’t make sense.
Let’s understand this better.
Firstly, why should we choose 30% as our potential indicator of value drop in case of crash? It seems like a good estimate of the worst case — it has happened 3 times in 88 years of data (1931, 1937 & 2008). A higher quantum, say 40% drop, happens even more infrequently (1/88 years) and 50% hasn’t happened at all. So, 30% seems representative of a worst case scenario. It happens often enough and is big enough to be the scary situation . you want to plan for.
Then, let’s consider the period between 2007 & 2016, the period that actually contained one of those really bad years (2008) which in turned also translated to one of the best bond return decades. Stocks returned 1.88x and bonds returned 1.42x. So even when we saw one of those really bad years, stocks seem to hold up well.
But let’s imagine that even in that scenario, the following year 2017, were to see another 30% drop, (like it happened between 1931 & 1937), you would be about 1.29x (0.7 * 1.88x) better off, compared to the bond return of 1.42x. But remember, the probability of that happening is 3/88.
But I digress. The question to answer is, wouldn’t you feel psychologically poor off because of such a crash? The answer is probably yes. So how do you prepare to deal with a situation like that?
Firstly, you should perhaps plan your retirement around dividends — if the dividends are enough to satisfy your annual requirement, the price of the stock in the market should be of lot less consequence. Between 2007 & 2008, the S&P dropped by 40%, but dividend between 2008 & 2009 was only 20% (There is a trailing relationship between price & dividend, which makes sense, since you price an asset based on it’s future dividends). The 20% drop itself is the second worst, with 1931 posing a bigger drop if 31%. Outside of these two years, never has the dividend drop been 20% or more.
So, as long as you leave a 20% buffer — either because your dividends are 25% ((1/1–0.2) –1) more than your need every year or you can reduce your expenses by 20% in a bad year, you are fine. You can just ignore the market prices and continue living your retirement.
Secondly, use a policy of selling only as much shares as is immediately needed. i.e. Withdraw money through dollar cost averaging, as you would accumulate using dollar cost averaging. This way, in a good year, you sell less and save up for a bad year where you sell a little more. Overall, you are better off with this strategy.
Thirdly, if you feel that prices are irrationally high & you still want to hold on to your dividends, you can always buy a PUT option on a small portion of your holdings as an insurance against a market crash. 2 year PUTs on current strike price is typically 8% or so, but if you only buy it for 1/10th of your holding (assuming, you don’t need more than 1/10th of your retirement savings over a 2 year period), then the overall cost of the PUTs are < 1% of your total holdings and would prove to be handy in case of a crash. If not, you can repeat it 2 years later and so on.
So, it seems that so long as the equity returns are generally well above bonds, you are perhaps better off holding equities even after retirement, while employing one of above strategies to mitigate risks of a crash.
Thoughts?
Notes:
- There is still a pending homework on how this pans out in other markets.
- If dividend returns are the basis for your retirement, REITs could be a possible diversification strategy. I would love to analyze that.
