No, I know. You’re right. We probably can’t time the market. And lots of people think the economic party is just getting started.
But let’s be honest, okay… Today’s lofty valuations do make you a little nervous, right? Me too.
Given that, rationally sizing up what actions we might prudently take now and then actions you and I should and shouldn’t take when the next bear market occurs, well, that makes good sense.
Usefully, David Swensen’s advice to endowment fund investment managers in “Pioneering Portfolio Management” provides dozens of practical insights for individual investors–including ideas for surviving a bad bear market.
In this post, therefore, I want to share a bit of this wisdom from Dr. Swensen. But if you’re interested in more detail? Go ahead and get and then carefully read “Pioneering Portfolio Management.” The book is excellent.
Bear Market Survival Tactic #1: Use Common Sense Asset Allocation
A first tip for avoiding a serious mauling: You and I want to use a common sense asset allocation. An allocation that dampens the volatility of our investment portfolio.
More specifically, we want to avoid allocating our savings so heavily to any particular asset class (like U.S. stocks) that a really bad bear market in that asset class destroys our portfolio returns. And ideally we want to spread our savings around into different asset classes (like maybe developed market foreign stocks or US Treasury bonds) so if one asset class’s value zigs, another asset class’s value zags.
Note: In his wonderful book for individual investors, “Unconventional Success,” Swensen suggests a 70% allocation to stocks with 30% directed to US stocks, 15% to developed foreign stocks, 15% to real estate investment trusts and 10% to emerging foreign stocks. The 30% bonds allocation gets split in half, with one part going into intermediate US Treasury bonds and the other part going into the US Treasury’s inflation protected securities.
Two really good things flow from this sort of common sense asset allocation. First, you and I don’t get as beat up in a bad market. During the great recession, for example, the 70% to stocks part of a Swensen portfolio would have gotten beat up like everything else. But the 30% to Treasuries part of the portfolio actually increased in value.
A second benefit relates to the first: Because with a common sense asset allocation you and I are less likely to get beat up by a bear market, we’re also less likely to do the one thing that really compounds the destruction: getting out of an asset class (like emerging market foreign stocks or REITs) after damage occurs.
Summing up, then, one of the key bear market survival tactics you and I can use is a common sense asset allocation.
Bear Market Survival Tactics #2: Rebalance to Avoid Drift
A quick second tip related to the first tip for dealing with bear market damage: We need to rebalance to maintain our asset allocation percentages.
If stocks go up as a percentage of our portfolio, we need to move money from stocks to bonds.
If stocks go down, we need to do the opposite and move money from bonds to stocks.
And just to make these two important and connected points: First, if we don’t rebalance, our asset allocation changes over time to something we don’t want. For example, if stocks perform well, we’ll end up bearing more and more risk over time because we’ll have a larger and larger chunk of our money in stocks.
A second related point: If we rebalance out of asset classes that have recently done well and into asset classes that have recently done poorly, we will tend to boost our portfolio returns by automatically “selling high” and then “buying low.”
Bear Market Survival Tactic #3: Simulate the Future to Test
A third, more complicated tip flows from Pioneering Portfolio Management. To the extent we can, you and I want to simulate how our portfolios perform once we’ve nailed down the asset allocation percentages. And we want to include in these simulations the impact of various spending plans.
Swensen describes the pragmatically ad hoc approach the Yale Investments Office uses to simulate how the endowment fund’s investments might perform. (The simulations rely on estimates of each asset class’s mean return and return variance.) And you might choose to use a similar approach for simulation.
To make this important point: You and I benefit from simulations because we test our asset allocation formula and our spending plan together. We not only want an asset allocation and spending plan that stands up reasonably well in a financial storm, we want an asset allocation and spending plan that helps us avoid freaking out at the worst possible moment.
Bear Market Survival Tactic #4: Avoid Panic Changes
A fourth quick tip: You and I may want to adjust our asset allocation formula in the future. Changes in our life situation or our understanding of investing may mean a new better asset allocation makes sense.
But the wrong time to change the asset allocation is when the stock market or some other capital market freaks out. We do not, for example, want to decide to dial down our stock market allocation right after some dramatic drop in stock market indices. We need to at least wait until the dust has settled and we’re sure we’re not simply emoting when we should be critically thinking.
In a bad bear market, we compound damage if we reduce our allocation to stocks once the market tanks. Ouch. (Swensen in his book points to endowment funds that have panicked… and then describes the predictably bad results such endowment funds suffer.)
Bear Market Survival Tactic #5: Vary Your Withdrawal Rate
A final, really important tip for minimizing bear market damage flows from Swensen’s discussions of how Yale spends the money from its endowment fund: The benefit of using a variable withdrawal rate once you or I start drawing on our investments during retirement.
The big sophisticated endowment funds have learned something over the decades and in some cases over the centuries in which they’ve operated: If the portfolio shrinks in value, spending may need to shrink to protect the long-term value of the portfolio and spending in future years.
Note: Yale’s withdrawal rate runs about 5%–a reflection of the market beating returns they’ve earned as an active investor. But the actual formula reflects a variable withdrawal rate because the planned draw for the coming year equals 80% of the current year’s draw plus 20% of the historical spending rate times applied to the endowment fund’s previous year’s ending balance.
To quickly explain how a variable withdrawal rate works, though, let me tell you what I plan to do. I plan to draw 4.5% of my retirement savings.
To make the numbers easy to understand, if I had exactly $1,000,000 at retirement, I would draw $45,000 that first year.
In the second year, if all goes according to plan, I plan to bump up my draw by the inflation rate. If inflation runs two percent, for example, I would like to bump my draw by two percent. That means an extra $900 in year two, so $45,900.
There’s a potential problem with this approach, however, which crops up if we experience a bad patch of returns around the time I retire and I remain inflexible.
If a $1,000,000 nest eggs shrink dramatically in value due to a bear market early in retirement, drawing $45,000 in year one and then inflated amounts in subsequent years may mean running out of money later on in retirement.
In fact, my own simulations based on the Swensen asset allocation suggest, gulp, that a 4.5% withdrawal rate would in the past have failed about 15% of the time if retirement lasts 30 years. Yikes.
But using a variable withdrawal amount–sort of like Yale does for its endowment fund–solves this problem.
If I’m willing to cut my spending from my retirement savings by about 10% if my portfolio craters–going from say $45,000 to $40,000–that flexibility lets me mostly dodge the worst-case scenarios where I run out of money before I run out of road. (More precisely, this flexibility suggests that in about 95% of cases in past, my savings would sustain retirement over three decades.)
Final Thoughts Related to Bear Market Survival Tactics
I’ve got to get back to working on tax returns, but let me leave you with three thoughts:
- First, you’ll probably want to experiment with more than one variable withdrawal rate tool. I like the cfiresim.com web calculator best. But other calculators exist too, including a simpler variable withdrawal option at firecalc.com and Bob Herlien’s variable withdrawal rate spreadsheet (available here). And we probably all get better insights into the flexibility we need to show if we run lots of simulations using different approaches.
- Second, if you do need to dial down your expenses during retirement, one of the easiest ways to do that is by taking a do-it-yourself approach to your investing. Just saving on mutual fund expense ratios and outside advisor fees–if you’re now paying those–will probably let you painlessly decrease your spending.
- Third, if you can delay your retirement draws by a year or two at the very start of your planned retirement because of a terrible stock market, that sort of flexibility should dramatically reduce your risk of running out of money.
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