The Best Way To Prepare For The Inevitable Market Meltdown
Ask Real Deal Retirement
I hear a lot of talk about a possible major market correction. I’m nearing the end of my career and don’t want to jeopardize my retirement. What should I do to protect myself?
—Dennis M., Philadelphia
If all you want to do is protect yourself from a market downturn, the answer is simple: Put your dough in FDIC-insured accounts. Even if stock prices go into a free fall, your principal and investment earnings will be safe.
But that’s not a real solution for most people. We know that severe market setbacks are inevitable—and we get particularly concerned when stock prices are at or near a peak—but we’re not able to predict their timing. For example, when the Dow dropped 15% in the summer of 2011 amid concerns about S&P’s downgrade of U.S. Treasury debt, many investors feared the slide would continue. In fact, the Dow subsequently rose nearly 70%. So hunkering down in bank savings accounts, CDs and the like could relegate you to subpar inflation-lagging returns for a long time.
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Which means that you can’t invest just to avoid a loss. You’ve got to develop a strategy that gives you reasonable protection from short-term setbacks in the financial markets but also offers a shot at investment gains generous enough to grow your nest egg if retirement is still a ways off, or assure your savings will be able to support you the rest of your life, if you’ve already called it a career.
So, how can you manage this balancing act between security and growth potential? I recommend this three-step process:
1. Start with a portfolio review. Before you consider making any changes, you first need to make sure you know exactly what you own now. So you want to tally the value of all your investments and then break down the amount devoted to each of three broad categories: stocks, bonds and cash. You can do a finer breakdown if you wish: small stocks, value shares, short- vs intermediate-term bonds, etc. But to get an overall sense of where you stand, divvying up your portfolio into stocks, bonds and cash is fine.
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If you own funds or ETFs that invest in both stocks and bonds—asset allocation funds, target-date portfolios, balanced funds, etc.—you can get a stocks-bonds-cash breakdown by plugging the fund’s name or ticker symbol into Morningstar’s Instant X-Ray tool. Once you’ve gone through this exercise, you can calculate the percentage of your holdings in each category. Many investors may be surprised to find that they’re holding a more aggressive portfolio than they think? Why? Well, unless you’ve been rebalancing periodically (or pulling money from your stock holdings), the fact that stocks have returned roughly four times as much as bonds over the past five years would have significantly titled your portfolio mix much more toward equities, making it more vulnerable to a setback than it was five years ago.
2. Assess your risk tolerance. Once you know your portfolio’s stocks-bonds-cash mix, you want to determine whether that blend is consistent with your appetite for risk. This is important because investing more aggressively than you handle emotionally may lead to you selling stocks in a panic during market downturns, which could turn temporary losses into real ones. Invest too cautiously, on the other hand, and you may not get the returns you need to grow your nest egg or make it last throughout retirement.
The easiest way to get a fix on how much risk is right for you is to complete a risk tolerance questionnaire like the one Vanguard provides free online. You answer 11 questions designed to gauge, among other things, how long you plan to keep your money invested and how large a loss you feel you could take without jettisoning stocks. The tool will then recommend a blend of stocks and bonds (and, in some cases, cash) based on your answers of stocks and bonds. Many financial planners use a more comprehensive 25-question risk profile sold by FinaMetrica, an Australian risk-assessment firm. For $45, you can fill out that questionnaire online and receive a detailed report that shows how to translate your score into an asset allocation.
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If the recommended portfolio you get after going through the risk assessment differs significantly with the way your assets are actually allocated—say, you’ve got 80% in stocks vs. a suggested 60%—then you’ll probably want to seriously consider bringing your allocation closer in line with the recommendation. But before you do anything, go on to step 3.
3. Gauge a crash’s potential effect. Ultimately, what matters most is how well your portfolio (and you personally) can handle a major correction both in the short- and long-run. There are two ways to estimate that.
First, you want to get an idea of how your current portfolio (and your recommended allocation, if that differs materially) might fare in a severe downturn. From the market’s peak in late 2007 to its trough in early 2009, for example, the Standard & Poor’s 500 index lost roughly 55%, while the broad investment-grade bond market gained about 8%. There’s no guarantee future downturns will duplicate the past. But if you’ve got 70% of your nest egg in stocks and 30% in bonds, it’s reasonable to assume your retirement portfolio might lose in the neighborhood of 36% of its value (assuming no rebalancing). If, on the other hand, the risk assessment tool recommended a 50% stocks-50% bonds mix, that portfolio would have lost more like 24%. If a 36% loss would have you dumping stocks and fleeing to cash and bonds, then emotionally at least you may be more suited to the more conservative 50-50 mix.
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Remember, though, your goal isn’t just to minimize damage during a crash. For all you know, a big setback may not materialize for yours. So you want a portfolio that will perform well if the market continues to cruise a long time despite your concerns about a major correction. And even if a crash does occur soon, you’ll still have earn a decent return in the years afterwards if you want to enjoy a secure retirement.
To be sure that you’re well-positioned for the long-term, go to a retirement income calculator that uses Monte Carlo simulations and enter your nest egg’s current value as well as such information as your age, income, how much you’re saving (or spending, if you’re retired) and how your savings are divvied up between stocks, bonds and cash. The calculator will then estimate the likelihood that you’ll be able to generate the income you’ll need during retirement based where you stand now—that is, how much you’re saving for (or spending in) retirement, how your assets are allocated and the current market value of your portfolio. This is your “pre-crash” estimate.
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To see how your chances of achieving a secure retirement might change after a crash, plug in the projected value of your portfolio assuming the potential loss you estimated at the beginning of step 3. If the portfolio mix recommended by the risk assessment tool was appreciably different from your current allocation then plug the estimated loss for that portfolio into the retirement calculator too.
By going through this exercise, you’ll be able to see not only how different mixes of stocks and bonds might fare during a severe market downturn, but how they might affect your chances of achieving a secure retirement in the long run. By comparing the results—and also trying out other scenarios where you also see how saving more, spending less, retiring later, etc.—can affect your retirement prospects, you can come to a much more informed and nuanced decision about investing your retirement assets than you would by simply trying to minimize a short-term loss.
Just make sure you go through this exercise before the market goes haywire. Because if you wait until things are falling apart, you’ll have fewer effective options for improving your retirement prospects, and they’ll be much less appealing. (5/18/19)
Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at firstname.lastname@example.org.