I start this article with no idea as to its conclusion. I want to revisit the question: “Am I taking the appropriate amount of investing risk in early retirement?”
The chart above shows my portfolio returns since I retired in 2018. For comparison, I also show the performance of three other portfolios: all US stocks; all US bonds; and a 50/50 mixture. My portfolio for the period shown is around 30% stocks. Much less than almost every financial podcast I listen to recommends. Based on the end of 2022 results shown, perhaps I should have followed their advice?
Of course, there is more to the story. For example, annual returns miss the initial effects of COVID19 on the market. This shows up in March 2020 when the data is plotted monthly.
Even this monthly view is incomplete. The low-point for stocks occurred on March 15th.
On that particular day, the all-US stock portfolio was down 33% from the previous high. My portfolio was down 7%. The market had several large down days prior to the 15th. I was busy trying to stay safe from the virus and paid little attention to stocks at the time. But many investors were paying attention and many of them were selling (trading volume was at its highest since the 2008 financial crisis). What happened to their portfolios?
The chart above shows the 5-year period of returns we started with, but this time the 100% and 50% stock portfolios switched to all bond (or cash) portfolios near the COVID pandemic low-point. These portfolios move back to their target stock allocations at the end of 2020. Compared to people reacting this way, I fared quite well. My guess is there were lots of these people.
This illustrates the core of risk tolerance in investing. If you ever sell (or feel an urge to sell) to “cut your losses” during a market downturn, you took too much risk.
At the start of my retirement (a couple of years before COVID), I decided my risk tolerance was no more than a -10% portfolio loss after 1 or more years. There was no real science behind this figure, I just felt uncomfortable with the idea of losing more. However, I did use some science to help me figure out how to achieve my target. Based on historical annual returns of the S&P 500 and US Bonds, I determined a 30% stocks portfolio should come close.
The last 5 years saw several large market drops including the COVID selloff. For me, the worst period was from December, 2021 to September, 2022. My portfolio allocation lost around -15%. More than the -10% predicted by my spreadsheets (bonds behaved atypically), but not enough to make me feel nervous or uneasy about my retirement finances. I was actually eager to buy stocks “on sale”, re-balancing often during that period.
So why revisit my risk tolerance?
- I clearly would have more money now (mid-2023) if I selected (and maintained) a higher stock allocation.
- I did not give market downturns a second thought with 30% equities (-10% worst downturn predicted, -15% experienced). Can I stretch this and still keep my emotions in check?
There are many ways to think about retirement financial risk. We, of course, have the luxury of turning to some previous spreadsheets!
A good resource is the Safe Withdrawal Rate (SWR) chart from the 4% Rule article/spreadsheet.
This chart helps answer perhaps the most important risk tolerance question: “How much risk do I NEED to take in retirement?”
For example, if you require 4% of your portfolio per year for essential expenses at the start of a 30-year retirement, history says you need between 50% and 75% stocks in your portfolio. This range succeeds for any 30-year period starting in 1871, though sometimes just barely. The 4% rule article/spreadsheet also shows us how the two points just off the 50%-75% plateau differ.
Both points have a single failure year, but the lower stock allocation has many more nervous cycles (failures after 30 but before 45 years) towards the end of retirement.
The choice for a 4% rule retiree seems easy. Pick the right side of the plateau and the higher stock percentage.
However, that choice, once made, requires a full commitment for several years into a retirement. If the portfolio grows significantly over time, revisiting your required risk (less) and stock allocation (lower) is appropriate. If not, the initial target stock allocation must be maintained by re-balancing no matter what. Otherwise, the historical SWR simulation no longer applies. The retired investor falls off the plateau and into the abyss…
Here are three retirement starting years that were tough at first, but ultimately successful* using the 4% rule (*although the 2000 retirement is short of its 30-year period, it’s on track for success).
A 75% stock allocation is quite scary during the early years of these retirements. The worst is a -65% portfolio loss before recovering. This is a little atypical, but downturns near -40% are not.
No matter how frightening, a retired investor’s reaction to large market drops must be: BUY MORE STOCKs. The 4% rule and other SWR strategies depend on regular re-balancing (at least annually) back to the initial target stock allocation.
Put yourself in this scenario. You recently retired with a $1M portfolio consisting of $750,000 in stocks and $250,000 in bonds. After 2 years of ~$40K withdrawals for living expenses and a poor market, your portfolio drops to $800K. You re-balance each month, which gives you $600K in stocks and $200K in bonds.
A banking crisis occurs and the market suffers a -50% dip over a 3-day period with no end in sight. You are very close to a monthly re-balance date and your portfolio now sits at $300K in stocks and $200K in bonds.
- Will you feel OK about a portfolio that suffers large losses like this in early retirement?
- Will you re-balance as usual to $375K stocks and $125K bonds? Into a market that is still falling?
You must know the answers these questions to use a strategy like the 4% rule. You must also commit to the answers before retirement. Finally, your answers must be YES.
My situation is different.
I am in the fortunate position of not needing very much from my portfolio. I have a spreadsheet (of course!) that looks at my expenses, pension income, projected social security, inflation estimates and many other factors. Currently, my estimate of average annual portfolio withdrawals required for essential expenses (adjusted each year for projected inflation) throughout retirement is under 2%.
SWR curves are still very useful to my situation, but provide different insights.
For a 30-year retirement, I don’t NEED ANY stocks, but I CAN HAVE 100% stocks. This is true up to a 2.4% withdrawal rate.
Because I retired early, I like to think the 45-year SWR curve applies to me. In this case, I need at least a 10% stock allocation, but any amount higher is OK.
As mentioned before, I actually started retirement with 30% stocks per my risk tolerance assessment at the time.
At that equity percentage, the first thing the SWR curves tell me is I am not spending enough!
For a 45-year retirement and 30% stock allocation, the SWR is 3%. 50% more than my current 2% spending rate! For a 30-year retirement, my SWR is 3.7%.
What about nervous cycles? For a 45-year retirement, let’s define nervous cycles as failures between 45 and 60 years. The distance between these two curves at a given stock allocation is an indicator of nervous cycles. Wider equals more.
At 30% stocks and a 3% SWR, I’m at the worst possible spot as far as nervous cycles. From here, I have two paths to get to the 60-year curve, where nervous cycles go away. The first is to increase stocks from 30% to 40%, keeping SWR at 3%. The second is reduce SWR to 2.6% leaving stocks at 30%.
Both of these choices essentially turn my 45-year retirement into a 60-year retirement, which I think is too conservative. What I really want is a point on the 45-year line that minimizes nervous cycles without excessive downside risk.
The right-most point on the first plateau is an intriguing choice (60% stocks, 3.5% SWR). Other than the spot where the 45 and 60-year curves touch, this point is one with the shortest gap. However, I don’t think I’m quite ready for the downside risk of a 60% stock allocation.
A much better point for me, I feel, is 45% stocks and a SWR of 3.4%. This has the shortest gap in the range of 30% to 55% stocks. Here is what it looks like on our simulations of early and late retirement nervous periods:
I’m still not thrilled with the possibility of a -40% portfolio downturn, so I added worst case downturn figures to some points on the SWR chart to explore that concern.
What I find really interesting is that increasing my current spending rate by 50% only increases my downturn risk by 4%. Now I am convinced I need to move up to the 45-year curve spending line. Once there, it becomes a trade-off between increasing downturn risk versus reducing nervous cycles (by lowering the gap size to the 60-year line). Taking one step up on the 45-year curve to 35% stocks lowers the gap. Taking another step does not lower the gap and going farther, I feel, is not worth the increased downside risk for now. This will likely change over time because my risk tolerance should increase. I will explain why in a future article (relating to social security and/or annuities).
Now I have the answer to my earlier question: “Am I taking the appropriate amount of investing risk in early retirement?”
The answer is no. I need to increase my stock allocation from 30% to around 35%. I also need to increase my current portfolio spending rate by about 50%. This does little to investing risk but should greatly reduce “not having enough fun” risk.
Emotionally, I need to accept a downside risk of -30%. It turns out my original estimate of -10% (for a 30% stock allocation) is really -20% given my 2% spending rate. Since I made it through the pandemic market dip without worry, I feel fairly confident I can take on -10% more risk.
April 2023
Jan 2024 Update: I went ahead with this risk reassessment and my current stock allocation is 37%