In Our Meeting with Two Financial Planners there was an epic comment that I just couldn’t let go to waste.
I know that many people don’t read the comments (I don’t know why as there’s often very valuable information in the comments but I know many don’t read them because I often get questions emailed to me that have been answered in the comments).
Off track a bit: if you have a question about a post, please put that question in the comments. If you email me 1) I might not see it as I get a ton of email and 2) no one else gets the benefit of the answer if I do respond.
Anyway, Apex left a comment which I’ll be sharing below.
The overall subject is how one should invest in retirement if they have $1 million or less. At least that’s how it’s phrased.
I think it’s just as good of an answer (or maybe even better) to “how should I set up my retirement investments to account for sequence of returns risk?”
We’ve talked about sequence of returns risk (also known as sequence risk) a few times lately, but here’s a short re-cap from Investopedia in case you missed those:
Sequence risk is the danger that the timing of withdrawals from a retirement account will have a negative impact on the overall rate of return available to the investor. This can have a significant impact on a retiree who depends on the income from a lifetime of investing and is no longer contributing new capital that could offset losses.
Sequence risk is the danger that the timing of withdrawals from a retirement account will damage the investor’s overall return. Account withdrawals during a bear market are more costly than the same withdrawals in a bull market.
Before we get to what he said, here are a few comments of my own:
- The response was made on January 31, 2020. A few things have changed with the market since then. 😉
- It begins with the commenter’s thoughts on the market. This was pre-meltdown, of course, and whether his thoughts would have held true or not under normal situations is anyone’s guess. It’s “funny” that he says at one point: “The Coronavirus could kill us all and crash the entire economy.”
- The “guys” he refers to in the beginning are the two financial planners my wife and I met with. They told me they thought the market was way over-valued and that long-term returns would be in the 0% to 3% range.
- The heart of the answer of how to invest with a lower level of assets is at the end. It contains what I feel is an awesome way to account for sequence risk. In fact, I don’t know why someone with even greater levels of assets couldn’t do this as well. Perhaps his answer for those people is in his first paragraph: “My preference for retirement is to have growth assets like real estate and dividend paying stocks which throw off enough income that I never have to touch any principal yet the underlying asset tends to increases in value with the market as a hedge against inflation so that future income streams also increase.”
After you read what’s below, let me know your take on it in the comments section.
Now let’s move on to the comment…
TL;DR – if you just want the investment advice and not the long prelude skip to the section below the ************
Before I give my opinion on this let me just address the scary 800lb gorilla these guys brought into the room. Namely that this market has been riding a cocaine high for the past 10 years and the future looks dim. This was a purposeful scare tactic.
The data makes it look plausible and of course anything is possible. After all the metaphorical doomsday clock has been at 2 minutes to midnight for the past 2 years and they just moved it closer last week to only 100 seconds to midnight. The world could end at any moment, so eat, drink, and be worried. That seems to be the general state the media is always telling us to live in.
I see it differently and thusly:
1. Yes we have had the longest expansion in post WWII history, but it came after the sharpest recession and pullback in post WWII history. That fact is rarely part of the narrative but it’s a critical omission. We didn’t shoot off on a rocket from the top of the empire state building. We have been floating up in an air balloon from deep within an abyss. Everything is relative and our relative altitude is not as high as some stats can be made to appear.
2. Yes our PE ratios are historically higher than average, but they are not at levels that the previous two crashes had and there other differences that decrease risk.
- PEs are above average, but not at crash levels. Historical PE chart.
- Interest rates are considerably lower than the 2000 and 2008 crashes. Interest rates are the competing market for stocks. When there are no alternatives for yield, the demand for stocks tends to stay strong.
- Both 2000 and 2008 had massive pressure building from excesses in the market. I am aware of no such pressure or excesses in the market today that are remotely on par with what was building in the market in those two crashes.
2000 was the dot com explosion where the Nasdaq went up over 100% in 1999. People took out loans on their houses to buy stocks. Which stock? Any stock, because stocks just go up.
There were jokes about brokers promoting certain stocks and the client asking what do they do? Answer? Go up! That is likely just a story but it is representative of how mom and pop investors had gotten sucked into the mania.
2008 was the housing bubble where people bought houses with no income, no documentation, and no plans to even use the house. They just sat on it for 6 months and sold it for a 15% profit. When those loans began to default it was so pervasive across the financial sector that it brought down huge institutions and nearly the entire financial sector all because of rampant speculation. That is a key ingredient to a bubble. Speculative mania which is not present in a meaningful form in the current market.
(i) Side note: Housing prices have fully recovered since the crash and become hot in some areas. Housing is no longer cheap, but it is not a bubble either. House price strength is currently driven by pent up demand, low supply, and low interest rates, not speculative demand. There is no current bubble in housing. NO CURRENT BUBBLE IN HOUSING. Could housing stagnate or go down. Yes it could. Could it crash like 2008. No way. The buyers and holders of houses today are 10 times stronger than the sub-prime mess, credit default swap, AAA rated mortgage backed security fraud that precipitated 2008.
(ii) side note 2. I am not saying this just with hindsight. You have no way of knowing what I really thought but in 1998 I already saw excess in the stock market. I had predicted to many people that the mania had to end. I didn’t actually pull out any money so I don’t know what that meant about my conviction but I did believe it would end.
I was two years early and more than doubled my money before it actually did end so it was still better to stay in. Plus I was young so I didn’t have much to gain or lose anyway.
Oddly enough in March of 2000 I finally lost heart and threw up my hands and said I guess I am wrong, to infinity and beyond is possible. It crashed about a week later. So my fortitude gave out just a little too early, but it is a perfect example of another phrase I have heard often about the market. “The market can stay irrational longer than you can stay solvent.”
Don’t try to bet against the market. In 2006 I told my brother that housing had peaked. I didn’t expect housing to go up anymore after that year. It had become too detached from reality. From a housing sales number stand point that appears to have been about the peak, but housing prices did still climb for another year and it was another 2 years again before the stock market crashed.
So in both those crashes I felt there were strong pressures from excessive mania in the markets. My assessments appeared to be a couple years early before any consequences hit the market. And of course anything can happen and we don’t have to follow old patterns. The Coronavirus could kill us all and crash the entire economy. But I don’t currently see the types of things that caused the last two crashes.
So that all being said, do I think we can keep getting these kinds of returns for the next 20 years? No. Returns have been too high. There will probably eventually be some reversion to the mean but with interest rates this low that mean might be higher than it historically has been. And of course the pull back could be after the market goes up considerably from here.
Who knows. Not me and not these advisers. However the idea of 0% over the next 20 years seems very implausible. Even 3% seems unlikely to me. So I think one needs exposure to equities to provide any meaningful growth in their retirement portfolio.
*********** INVESTMENT ADVICE STARTS HERE ************
My preference for retirement is to have growth assets like real estate and dividend paying stocks which throw off enough income that I never have to touch any principal yet the underlying asset tends to increases in value with the market as a hedge against inflation so that future income streams also increase.
That is why bonds are not listed as one of these assets because they only throw off income but have no growth potential.
I believe this to be the gold standard for retirement.
But other than the types of people who read sites like this, the number of people who are in a position to do this is negligible.
So what to do for the masses.
For those with less than $1 million of retirement assets, I would do the following:
- A few years before needing to draw on the assets, 3-5 years worth of income requirements (calculated needs after Social Security, pensions, and any other income sources) should be put in cash equivalents. Laddered CDs, medium term bonds, corporate bonds of very safe companies, etc.
- The rest should be invested in various index funds. Most in broad funds like an SP500 fund or even a balanced type fund such as Vanguard Wellington if portfolio variation is strong concern. (Side note: I am not personally a fan of target date funds, but for some people they might make things feel safer.)
- Needs for new funds should come from the stock portfolio when the market is doing well or is flat.
- When the market is down more than a small amount, lets say greater than 5% or 10%, then needs for funds should draw from the cash funds. Once the market recovers then stocks can be sold to replenish the cash funds for the next downturn.
- The 3-5 year cash supply is to withstand large draw-downs instead of short corrections. In that sense 5 years is best if one can afford to have that much of their portfolio in cash equivalents and still generate enough return to fund their retirement.
The goal of this plan is to remove sequence risk where withdrawals from stocks at the wrong time have a devastating affect on the size of a portfolio making it nearly impossible to maintain the life style that it was previously affording.
I too had shifted from bonds awhile back and instead invested more in reits (like vnq or O).
REITs are definitely volatile like stocks but if you are able to get enough of them to live off of distributions then you really do not worry as much about the asset price if you never need to sell and potentially lock in losses if it is down. It also has potential for growth which goes along with your philosophy
I share your thoughts on how to approach retirement income and cashflow in an ideal situation.
Prior to pulling the trigger last year, I began purchasing real estate to supplement our dividend income to generate enough cash to pay for our “normal” annual expenses. Conceptually, I see our real estate income as a synthetic COLA pension that is semi-passive.
To break it down, my overall portfolio “fortresses” are: 1) a year worth of cash, 2) real estate that pay for our living expenses, 3) a dividend stock portfolio that generates enough to travel, 4) bonus non-qualified deferred compensation that pays out over the next 10 years, 5) long term after tax brokerage account, 6) “official” pre and post tax retirement accounts, 7) SS + small pension at previous company, and 8) any supplemental inheritances.
If I relied any one or two of these, I would have been concerned about SORR during the recent market and economic downturn.
BTW, trying to explain this broader concept of portfolio and cash management to a financial advisor is like pushing a square peg into a round hole. I also completely agree with you that this isn’t for everybody and have a very strong E (within your ESI framework) helped immensely.
This post has been very helpful to me. Thank you very much for the information and advice, ESI!
I second that! This is the most helpful post I’ve read anywhere in a long time.
Andrew Herrig says
While a large part of my net worth is in physical real estate (rental properties), I couldn’t resist the opportunity to pick up some REITs in my stock portfolio when they crashed a few months ago. I just wish I had added more at the lows – solid dividend plus a good chance for appreciation.
Rental properties are great, but at least in my market, it’s more of an appreciation play than steady cash flow.
JeffB MI20 says
Commercial real estate is going to take a huge hit if many work remote and the business traveler doesn’t go back to high levels. Hotels and office buildings will be ghost towns.
This is valuable stuff. Generally speaking, it seems best practices for accumulating capital (e.g., ESI; don’t get into heavy consumer debt; etc.) are more worked out than how to optimize the drawdown/maintenance phase, especially in the middle-space of financial success.
As in other areas of life, so too in finance: timing matters a great deal; when we do something is often as important, and sometimes more so, as what we do (e.g., crossing the street). And structure matters a great deal, too (e.g., how forces are deployed in military engagements is often more determinative of outcome than the number of those forces, all else being equal).
Having a market-insulated pool of capital that can be called upon in times when the market is down, and which can be replenished by market-exposed capital when the market is neutral or up, makes a lot of sense for those who can’t live solely on the dividends/interest being thrown off of an enormous corpus. As does drawing on the market-exposed capital in those same market conditions.
It’s actually an optimized cost-of-capital approach to financing your lifestyle (given the funds available). Whatever the market conditions at any given time, the need for consistent capital is largely the same, especially for folks in retirement.
This is a great blog.
BC | FrugalWheels says
People’s perception of the market is always interesting to me. Any time it is over-valued people always talk about an inevitable crash and speak of it like it’s the end of the stock market. The market overall has recovered from every crash that has happened. That’s why it’s still here today. And, the market is always the first thing to recover. The S&P 500 recovered from 2008 by 2012, even though jobs were still scarce and there were plenty of doom and gloom stories from every day folks, and houses were still hard to buy. The most influential people in the world have a stake in the stock market’s success – so investing in the stock market is betting on those who frankly control the system. I see it as a “if you can’t beat ’em, join ’em” kind of a thing.
A note about the housing bubble – it wasn’t just speculation in individual houses, but deregulation on mortgage lending that led to houses being sold to people who couldn’t afford them on variable rate mortgages, along with deregulation on the banking side allowing the trading over over-rated junk bond packages that rating agencies refused to downgrade because they didn’t want to lose their big banking clients. It was a perfect house of cards that collapsed upon itself.
You are correct that situation does not exist today. While the lack of regulations that allowed for junk bonds to be traded by big banks still exists, the mortgage lending industry tightened up post-2018 and has loosened some since, but not much.
Anyway, I think we’re seeing from the Coronavirus meltdown how quickly the market is recovering. What will it do next? Who knows. All I know is eventually it will go up.
We retired at ages 57 and 59. Seven years before we retired we bought a second home and three investment properties. When we retired we sold one home that was mortgage free and my business. We’ve since sold two of the investment properties. I took all the proceeds and kept it in cash or cash equivalents. I have a five year cushion.
Yes, there is an opportunity cost of having the big cash cushion, but I’m glad I have it. Living on the cash has enabled my stock portfolio to continue to grow. I have more money today than when I retired three years ago.
It’s nice to see a contrarian approach to investing discussed here. Too much time is spent on maximizing portfolios. Our goal has always been to invest so we can live the lifestyle we want, not just to pile up big sums of money.
In general, I like the investment advice. A few things I do differently:
1) REITs are part of my portfolio. I keep them in tax advantaged accounts since I’m still working but at some point, I would own REITs in taxable accounts and less dividend paying stocks since I need the dividends to live on and on average, REIT yields are higher than dividend stocks. I also want them for diversification. I guess others gain real estate exposure through owning real estate outright and/or participate in real estate crowdfunding. I’m too lazy to find properties and a management company. I’m also a bit wary of crowdfunding as it’s still pretty nascent. Apex made a nice comment in a past article about individuals being at risk of being chumps to the big boys that hold most of the strings and have much higher expertise in these real estate deals.
2) My equity holdings will hold a reasonable share of international stocks (roughly 30%). Europe would have the heaviest weight but I also have exposure to emerging markets in Asia and Latin America. North America is dominant now but if you look at snapshots of returns over different decades, the regression to the mean by geography principle holds quite well.
3) Having more than $1M in investable assets, I plan to have a 5+ year cushion in cash and “safe” bonds. With more assets, you can sacrifice some return to get piece of mind and still capitalize on market gains.
Frank S says
The whole concept of ESI of Earn/Save/Invest is very sound; but there is an opportunity to assist my family members to start even earlier (and I have not asked). I actually bought my first mutual fund before age 18 (prob had a parent as co-owner for legality, can’t remember, current age 64) but I was only wanting to be like the guy I worked for who owned a drug store and he was 24. It was a bank draft of $30/month. Over the years I added more and more mutual funds and eventually got into individual stocks, mainly big tech very early, did very well. Not sure what the age mix of the followers of this site are, but I am planning on starting monthly investment accounts for our two grandkids now, they are less than age two; I can’t imagine the benefit of that time value of money starting this early for them. I will start with $1000/per grand, and then throw a few hundred in as the months go by and then see how it goes and setup a monthly contribution; I think it will be a great benefit even if I am no longer alive; I don’t anticipate it being needed for college expenses but hopefully more as a life kicker/booster once they started to gain true knowledge, post age 35 :-), IE after a few hard knocks in life.
There is a statement similar to “Time can cure a lot of Investment/money issues”; so this is a big block of time;
Articles and comments are always educational ESI, thank you for hosting.
Frank S says
I think at the 1 mil level of investments at retirement there is an bigger comfort need of keeping more in cash or cash like investments than say a 5 mil portfolio. Mainly because in a 5 mil portfolio, even in bad times with good dividend paying stocks, funds, REITs or whatever, there is more significant cash flowing; I would think that a one year amount of cash would be fine although friends in their late 60s and 70s feel like much more is needed, like 3-5 years. A lot has to do with personal feelings of comfort and risk with stocks and investment. I trade and invest personally 100% of my funds and have for 40+ years, but some friends have an advisor and make zero decisions on investments, just phone discussions with their advisor, so not near as comfortable with markets and investment instruments. And if you did that through life, I doubt there would be interest in self management as you got older. IE start early on education. Match your cash account to your “mental comfort”.
This is a very good review of the article and the comments are very helpful. I have maintained a 3 year cash reserve since retiring, which equates to about 8.5% of the portfolio. The rest in index equities (63.5%), rental properties (15%) and gov/muni bonds(13%). This seems to be a mix I can live with and endure a prolonged recession without digging into the equities at the wrong time.
For the definitive series of article on Sequence of Return Risk (and strategies to overcome it), the best source IMHO is Big ERN blog. He is a friend of ESI.
My suggestion above was based on what makes intuitive sense to me, but some times intuition can be misleading.
I reviewed Big ERN’s safe withdrawl series which analyzes dozens of strategies. I eventually found he did an analysis of a cash bucket and found that adding a little more than $100K of cash on the side to a $1M portfolio for a total of about $1.1M would have allowed the portfolio to use the 4% withdrawal rule (of the $1M in stocks) and survive for 50 years during the two worst sequence risk events in a 150 year history of the stock market one of which was the great depression of 1929. It looks like his analysis used a 20% draw down before dipping into the cash where as I had suggested closer to a 10% draw down.
So his analysis does seem to put the weight of some data behind the theory.
This was a great article. Lesson: Always read the comments!!
I never fail to learn something new reading ESI articles 🙂
And thank you Apex!!
Bernie Johnson says
The strategy listed in the commenters feedback is nearly identical to ours, but the only question I ask my self 5-10% relative to what time frame? Do you reference average over the past yr? Since last high? or some other reference?
“When the market is down more than a small amount, lets say greater than 5% or 10%, then needs for funds should draw from the cash funds. Once the market recovers then stocks can be sold to replenish the cash funds for the next downturn.”