Purse Strings Approved Professional Blog Series
How to Protect a Portfolio
I had a meeting this week with one of my clients and the portfolio manager for their accounts. The clients are worried about what might happen with their portfolio if some of the proposals promised by the President Elect were to be put in place. The portfolio manager made the following statement. “The best way to protect a portfolio is to be able to withstand the downturns.” I thought that was brilliant and want to add my own thoughts and some examples where I can demonstrate what I’m talking about.
When Do You Need the Money?
One of my connections on LinkedIn is named Cullen Roche. He talks about an idea that he calls Defined Duration Investing. I am going to explain this concept very simply. Basically, he says you use the right type of investment for the correct time period when you will need the money. For example, if you need money in the next few years then we should use an investment with very little volatility such as a savings account or a money market fund or perhaps a very short duration bond fund.
Most bonds and bond funds have a little longer duration such as 5-10 years and should be used for needs in that time period. Finally, stocks have a longer duration. Cullen says stocks are 15–20-year duration investments. I have probably butchered his theory but hopefully you get the point. The idea is to match your financial needs in various time frames to the correct investments. Now let’s talk about a couple of examples.
Accumulation Phase
Let’s say you’re 25 years old and just starting to invest in your company’s retirement plan. The first question I often ask people is, what is the money for? They always say, I want it to grow. But that’s not the correct answer. I should probably ask, when will you need the money? What is the time period you will want to touch that money. In this case, the earliest my client can touch the money without incurring a penalty is age 59 ½. So, if we’re matching our asset’s duration to the time period, we should invest in an asset class with a longer duration such as stocks. Historically, stocks have outperformed other asset classes such as bonds and cash over longer periods of time. I wrote a blog post titled, The Greatest Chart of All Time. You can read it here.
What the chart shows is, over thirty-year rolling averages of the S&P 500, which is an index of large cap stocks in the United States, the worst 30-year rate of return was from 1929-1958. During that period which included the Great Depression and World War II, the 30-year rate of return was 7.8%. If someone had put $10,000 into the stock market at the beginning of 1929 and left it until the end of 1958, their account would have been worth $95,183.75. That means their portfolio would have grown more than nine times during one of the worst economic times in our country’s history.
Of course, the problem with this is you must be able to handle the downs along with the ups. There have been years when the stock market was down 50% in one year. They call the first decade of the 2000s the Lost Decade because the stock market had a negative return over those 10 years. If you are in the accumulation phase and you are making regular contributions to your 401k plan, for instance, it doesn’t really matter that much from a financial perspective. But you still have to withstand the constant noise you hear on TV and the media and social media telling you everything is terrible and it’s different this time.
If you don’t have the stomach for 50% declines in your portfolio, one way to lessen the blow is to add bonds into your portfolio. Generally, while bonds have a lower rate of return over long periods of time, they also tend to have less volatility than stocks. That’s one of the reasons you see balanced funds or 60/40 portfolios. These portfolios combine stocks and bonds and offer a little less upside growth but also, a little more downside protection. There have been two years in the past where both stocks and bonds had a negative return. Unfortunately, one of those years was 2022. Here is a chart that shows the returns of stocks, bonds and a balanced portfolio from January of 1980 through December of 2022.
1/1980 – 12/2022 U.S. Equities U.S. Bonds Balanced Portfolio
Annualized Return 11.5% 6.8% 9.6%
Annualized Volatility 15.3% 5.4% 11.3%
As you can see, whiles U.S. Equities provided a greater return than U.S. Bonds, they also had a higher volatility. By combining these asset classes, you were able to receive a reasonable return with less volatility. For some people this is a good tradeoff. For others, the greater return is worth the additional volatility. The point of this is, everyone is different, and you need to have a portfolio that works best for you.
Distribution Phase
This is where it gets interesting! It’s one thing to talk about protecting your portfolio when you’re 30 years old and have $25,000 in your 401k plan and you have 35 years until you have to touch the money. It’s a completely different ballgame when you’re 65 years old, have $2,000,000 and you need to live off the money for the rest of your life. What do you do now? Put it all in CDs? Buy an annuity? Follow the 4% withdrawal rule? Keep it all in the stock market and hope there’s not a big decline the year after you retire?
As you probably know, everything has advantages and disadvantages. Plus, there’s no right answer. But let’s talk about the options above then share one solution that ties into Cullen’s idea of asset duration versus asset allocation. If you are in the situation above, it’s pretty easy to say I’m going to buy a CD. It’s paying 5% and it’s guaranteed for 5 years. You’ll get $100,000 per year of income with zero volatility. There are a couple of issues here. One is inflation. Even though you are getting the same $100,000 per year, your purchasing power is being slowly eroded because of inflation. Plus, what happens when the CD renews? What if interest rates have dropped and now you can reinvest your CD at 3% instead of the 5% you’ve been getting for the past 5 years. Are you going to be happy making $60,000 per year instead of $100,000? Doubtful.
What about an income annuity. You give your money to an insurance company, and they say we’ll pay you $140,000 per year, guaranteed for the rest of your life. Can’t beat that, right? Again, inflation and purchasing power come into play. Also, what happens if your daughter has an emergency and needs some help. It can be difficult to access the money, although I know annuities allow for early withdrawal, it still can have implications for your future income.
The 4% withdrawal rule can work but it too has limitations. Instead of getting $100,000 per year we’re only going to take $80,000. Then, if we have a down year, we need the discipline to lower the amount we are withdrawing. So, we have a bad year in the markets and our $2,000,000 portfolio has dropped to $1,800,000. You’re supposed to only withdraw $72,000 instead of $80,000. That doesn’t sound that bad, but inflation makes things more expensive every year and it can be very tempting to still take out $80,000 instead of the lower amount. Over time, this can cause some problems.
And finally, you decide, screw it. The stock market has averaged 10% since Abraham Lincoln went to high school. I’m just going to put all my money in the S&P 500 index and do the 4% rule or set up a systematic withdrawal. 10% is more than 4%. I’ll be fine. What if you had retired in the year 2000 with this strategy? I’ll give you a quick answer. You would have run out of money. Too much life at the end of the money is not where you want to wind up.
One Solution
Again, there’s not one right answer. There’s not a best way to fix this, but here is a solution that I have used for several of my clients, and it solves some of the problems we have discussed above. It’s called a Bucket Strategy. I have written several blog posts about this strategy. Here is one of them if you want a more detailed discussion.
With the bucket strategy you are creating different “buckets” of money that correspond to the time you will need the money. Let’s take our example above. Our client has $2,000,000 and would like to receive an income of $100,000 that will keep up with inflation. With the bucket strategy, we can put 3 years of income in a safe bucket where the client can take out $100,000 per year plus inflation and know he’s not exposed to volatility. Then we create another bucket that has a little more upside while still being aware of volatility. And finally, we create a long-term bucket that can grow but we don’t need to worry about volatility because we know our immediate income needs are being taken from our safe bucket.
This strategy has several advantages. We reduce the sequence of returns risk by having our income needs met with very conservative investments. This also helps with the emotional aspects of investing as well. People don’t seem to get so worried about their long-term investments that are in stocks because they know they won’t have to touch them for another 20 years. As their conservative bucket gets depleted, we fill it back up from the balanced bucket. What ends up happening is you don’t feel like you must “do something” when the inevitable downturns occur. You know you have your short-term needs covered so you don’t get freaked out when your long-term portfolio goes down because you know you don’t have to touch it.
In Conclusion
You want to protect your hard-earned money. Intellectually you know there will be a time when your portfolio will go down, you just don’t know when. It’s also very, very difficult to time the market. It might not be that hard to get out, but when do you get back in? Having a strategy to withstand the downturns is key. When you’re in the accumulation phase it might be more of a behavior management strategy or even choosing and asset allocation that you can live with. When you’re in the distribution phase you have to choose a strategy, you can trust where you won’t end up broke. That’s a terrible way to put it, but I have a saying. Getting old sucks. Being old and broke really sucks!
If you want to talk about your own situation feel free to reach out to me here. As always, thanks for reading.
Kevin A. Brown CLU, ChFC
Financial Advisor at Charles Stephen & Co.
Kevin started in the financial services right after graduating from the University of New Mexico with a degree in finance. Over the years he gravitated toward working with people in the Y.O.Y.O. Economy. They include owners of private practices such as attorneys and dentists. This group also includes people who have changed jobs and find they are on their own when it comes to making decisions regarding their retirement plans and other benefits. Other members of the Y.O.Y.O. Economy are people who are about to retire or have already retired and people who have received an inheritance.
After decades of running a successful independent advising practice, he joined the respected team at Charles Stephen, where his own expertise is enhanced by a team of advisors who have their own areas of specialization.
