Podcast Summary
Managing Sequence of Returns Risk in Retirement: Approaching retirement, managing sequence of returns risk is crucial. Balance avoiding potential drawdowns with maintaining adequate returns to support retirement lifestyle. Optimal time to derisk depends on personal circumstances and risk tolerance.
As you approach retirement, managing sequence of returns risk becomes crucial. A stock market crash in retirement can lead to a significant reduction in your portfolio value, potentially leaving you struggling to live off your investments. To mitigate this risk, some investors choose to derisk their portfolio before retirement by shifting some assets into safer investments, such as bonds. However, doing so comes with the trade-off of lower expected returns. The optimal time to derisk depends on your personal circumstances and risk tolerance. It's essential to strike a balance between avoiding potential drawdowns and maintaining adequate returns to support your retirement lifestyle. Planning and backtesting different scenarios can help determine the best approach for your unique situation.
Balancing risk and safety in retirement planning: Careful planning, flexibility, and understanding market conditions are essential for a successful retirement strategy
Retirement planning involves finding a balance between risk and safety, especially during the years leading up to retirement and the early retirement years. The speaker, who has a significant amount of equity in his portfolio, plans to derisk gradually over a 10-year span before retirement but acknowledges that some members believe this may not be enough of a buffer during market downturns. The length of these downturns depends on various factors, including the location of investments and the specific market conditions. The speaker also emphasizes that it's essential to maintain some level of risk in the portfolio to avoid hurting long-term standard of living. He suggests that the decision on how much to derisk and which assets to choose depends on the yield curve and the expected length of the stock market downturn. Overall, the key takeaway is that careful planning, flexibility, and an understanding of market conditions are crucial for a successful retirement strategy.
Managing market volatility in retirement: Prepare a financial plan with emergency funds and diverse income sources to manage market volatility during retirement.
Having a well-prepared financial plan during retirement is crucial for managing market volatility and ensuring sufficient income. This includes setting aside a safe amount of money for emergencies or market downturns, and being mindful of the size of your income sources, such as the state pension and other investments. The statistics suggest that a significant market drawdown, such as 20% or more, might prompt the use of these reserves. However, if one's financial situation is more secure, with ample other sources of income, then the issue may not be as pressing. Overall, maintaining a larger equity allocation in retirement, despite market risks, can lead to the best long-term outcomes due to stocks' higher returns. This concept, counterintuitive as it may seem, is a key lesson learned from working in pension planning.
Challenging the Traditional Retirement Investing Approach: Maintaining a high equity allocation throughout retirement could lead to greater wealth accumulation and more spending, despite increased risk.
The traditional approach to retirement investing, which involves starting with a high equity portfolio when young and gradually shifting to bonds as retirement approaches, may not be the most optimal strategy. A recent paper, "Beyond the Status Quo: A Critical Assessment of Life Cycle Investment Advice," challenges this assumption, suggesting that maintaining a high equity allocation throughout retirement may lead to greater wealth accumulation and the ability to spend more during retirement, despite the increased risk. This goes against the common belief that risk should be minimized during retirement. The paper also suggests that selling bonds and holding onto stocks as retirement progresses could be a more effective strategy. This is counterintuitive to the traditional glide path approach, but the research suggests that it could lead to a larger retirement pot and more spending throughout retirement, as well as a larger terminal wealth to leave to beneficiaries.
Challenging the Norms of Age-Based Investment Strategies: Evenly splitting a portfolio between domestic and international stocks may outperform age-based stock-bond strategies in building wealth, supporting retirement consumption, preserving capital, and generating bequests.
That an evenly split portfolio of 50% domestic and 50% international stocks throughout one's entire lifetime may outperform age-based stock-bond strategies in terms of building wealth, supporting retirement consumption, preserving capital, and generating bequests. This finding, which goes against the common belief of diversifying and taking more risk when young, was surprising and challenged the norms in the world of investing. The researchers arrived at this conclusion through a simulation approach, using empirical data to model various aspects of couples' lives, including their income, retirement income, and savings patterns. They also used a comprehensive database of historical returns from 38 countries spanning over 2,500 years. The study's findings were classified into three groups, with the 50/50 stock-international stock strategy falling under the category of "risk parity" strategies, which aim for equal risk exposure to stocks and bonds. Overall, the study challenges the traditional age-based investment strategies and offers a new perspective on portfolio management throughout one's lifetime.
Historically, a globally diversified equity portfolio outperforms other investment strategies for retirement income: A 50/50 split of US and non-US stocks in retirement portfolios can lead to better outcomes than bond-heavy or target date funds, even in the worst-performing cases. Stocks and bonds tend to move together over the long term, making bonds a short-term hedge rather than a long-term one.
A globally diversified equity portfolio, consisting of 50% US and 50% non-US stocks, has historically outperformed other investment strategies, including bond-heavy portfolios, in terms of providing greater consumption capacity during retirement. The study found that the 50th percentile, or typical case, of a global equity portfolio produced better retirement outcomes than other strategies, including target date funds. The surprise was that even the 10th percentile, or the worst-performing cases, fared better in the international stock case. Bonds, while providing some short-term diversification during market crashes, do not offer long-term protection and underperform stocks over extended periods. The author of the study speculated that this is because stocks and bonds tend to move together over the long term, making bonds a short-term hedge rather than a long-term one. The safest strategy, putting all investments into money market funds, drew down the least, but the international stock portfolio drew down significantly less than a domestic stock portfolio. Overall, the findings suggest that a globally diversified equity portfolio can provide greater financial security and retirement income compared to other investment strategies.
US Stocks vs. Diversified Portfolios: A Long-Term Perspective: Historically, US stocks have outperformed globally diversified portfolios, but their deeper and longer crashes may not justify investing all funds in them. Over 30-year periods, stocks and bonds tended to move together, reducing diversification benefits. Embrace stock volatility for potential better outcomes and consider a longer investment horizon.
That investing all your money in US stocks may not be the best strategy for long-term financial security, despite their historical performance. Crashes in US stocks tend to be deeper and longer than in globally diversified portfolios. Additionally, the diversification benefits from bonds during periods of equity market downturns may not be as significant as expected. The researchers found that over 30-year periods, stocks and bonds tended to fall and recover together, reducing the hedging effect of bonds. Therefore, it's crucial to consider a longer investment horizon and embrace the volatility of stocks to potentially achieve better outcomes. The paper also revealed that a 100% stocks portfolio has a lower probability of "risk of ruin" (running out of money) compared to diversified stock-bond portfolios, as long as the investor avoids selling during market crashes. This finding challenges the common belief that stocks offer higher long-term returns but come with a higher risk of running out of money.
Retirement with 100% stocks less risky than stock-bond portfolios?: Study finds 100% stock portfolios may have lower risk of ruin in retirement compared to stock-bond portfolios, but emotional impact of losses should be considered, and creating a single equity fund might help manage irrational decisions.
A 100% stock portfolio during retirement may have less risk of ruin compared to a stock-bond portfolio, even in the worst-case scenarios of market crashes. However, this finding might not fully account for the emotional impact of significant stock market losses, which could lead people to make irrational decisions and underperform their investments. The author's solution was to create a single fund with a 100% equity allocation to avoid selling during market downturns and instead add more capital to it. The study's findings challenge common beliefs about retirement investing and highlight the importance of understanding and managing emotional biases. The author suggests incorporating investor psychological biases into financial models to provide a more accurate representation of real-world investment experiences.
Reconsidering Traditional Retirement Portfolio Allocations: The Role of Bonds: Considering no bonds in retirement portfolios for potential higher long-term returns, despite the uncertainty and risks involved.
The discussion highlights the importance of reconsidering traditional retirement portfolio allocations, specifically the role of bonds. The speaker shares her experience of being shocked by a paper suggesting that having no bonds at all for a long period in a retirement portfolio might be the best approach. Although she remains open to refutations, she is leaning towards this strategy due to other supporting research. The paper argues that for long-term retirement portfolios, bonds may actually be more risky than stocks due to their lower returns. However, it's important to note that this doesn't mean stocks are risk-free, as there's still a chance of running out of money even with a 100% stock allocation. The challenge lies in making decisions under uncertainty and striking a balance between risk and potential returns. For more insights and to join the conversation, visit pensioncraft.com. Regarding the 'dumb question of the week,' the answer is that a stock market crash can be good for long-term returns, but it depends on how it affects your ability to invest. If it prevents you from investing, then it's not beneficial. Otherwise, the market eventually recovers, and the potential for higher returns down the line can outweigh the initial loss.
Impact of market crashes on investor psychology: Market crashes can cause fear and caution, but also present opportunities for higher long-term returns. Diversified index investing can provide comfort during market downturns.
The psychological effects of living through a market crash can significantly impact an investor's attitude towards risk and potential returns. Those who have been traumatized by past crises may become too cautious, leading to underperformance. Conversely, younger investors may view market crashes as opportunities. The key idea is that during market crashes, stock valuations decrease, leading to higher expected long-term returns. However, for retirees heavily invested in stocks, the trade-off is that every pound withdrawn during a crash won't be compounding for a long time. The authors of the paper argue that diversified index investing can provide comfort during market crashes, as a recovery is inevitable. It's important to note that not all markets bounce back, and some may not exist anymore due to historical events. The authors factor these scenarios into their calculations. Ultimately, the assumption that the world will always need capitalism and investments to meet our needs is a crucial factor in the expected returns of various investment strategies.
The fear of market crashes is natural, but it's important to remember they're usually short-lived: Stay invested during market downturns for potential good returns, but derisk as you age and approach retirement
The fear of a market crash is natural, but it's important to remember that market crashes are usually short-lived and markets typically recover. However, a long period of stagnation with high inflation and low growth can be more problematic, especially for those nearing retirement. It's impossible to know which statistical distribution we'll follow in real life, so the best we can do is plan for the path we're on. The speaker suggests that if you're young and adding money to your portfolio, a market crash can be a good thing. But as we age and approach retirement, the fear of a crash becomes more pronounced. It's a question of derisking, but the answer may depend on the length and severity of the market downturn. The speaker also emphasizes the importance of managing through rough periods and staying invested, as good returns often follow. Ultimately, the best we can do is make informed decisions based on available information and seek professional advice when necessary.
