Stress Testing Your Portfolio
Once a year most folks schedule an annual check-in with their general practitioner or cardiologist to ensure everything is up-to-par. Weight, height, diet, vitamin deficiencies, blood work, blood flow, etc. Recently, while I was at the cardiologist performing a “stress test”, I couldn’t help but think of the recent market volatility and an article I wrote addressing Risk Tolerance vs. Risk Capacity. Ideally, not the best time to think or see the consistent negative news headlines “S&P 500 looking bleak – poised to drop another 30%, “Doomsday Coming, Brace Yourself, etc.”. The time on the treadmill allowed me to review the big picture on market pullbacks and raised the question – how can one prepare for or understand market pullbacks to ensure success for their individual goals/plan so they don’t derail their financial future?
After completing an initial baseline cash flow and/or running various what-if scenarios within ACM’s planning software, we may determine that your lifetime withdrawal rate (or financial need) is roughly 3%/year from the portfolio. Investing in individual stocks and bonds, we’re able to obtain the 3% need with solely dividends and interest acting as an additional income source to an existing pension, social security, etc. We’re able to pluck the apples from the tree and not forced to sell off pieces of the orchard to meet the income need.
Taking it a step further, assuming a 6% lifetime rate of return while only needing 3% from the portfolio each year it seems smooth sailing. Yet, as we all know, life is not intended to be linear and neither are the markets. What if lightning hits the orchard and 25% of it is burned in a fire? What happens when a drought strikes and 40% of the crops vanish? Here comes the “stress test” to confirm if we’re prepared for a lightning strike, drought and/or a market pullback…
The first thing folks need to understand that while pullbacks can be emotionally disconcerting, they are extremely common. Since 1980, the average intra-year drop (peak to trough) is 14% and since WWII ended in 1945 the majority (roughly 90%) of market pullbacks have registered declines under 20%. Roughly 98% of market pullbacks have registered declines under 40% and the remaining 2% have registered declines above 40%. Recovery time has varied from 2 months to 60 months for the worst downturns with the average Bear Market taking roughly 14 months to recover. What does all of this translate to for my own portfolio, income need/withdrawal rate, personal goals and future?
The S&P 500 is down roughly -20% year-to-date. What if it drops another -20% within the next 12 months to experience a -40% total drop? What if it drops another -30% over the next 12 months to experience a -50% drop? Financial planning software will allow us to run linear returns and also incorporate a fancy Monte Carlo simulator running 1,000’s of random trials of market variations including below or above average market returns. This is where your ACM advisor can take it a step further and customize a specific market decline for a certain period of time keeping the above statistics in mind.
Not comfortable with where the market is today after reading news headlines? Great, let’s run an updated plan based on your income need from the portfolio and see where you stand. Spooked that the market will experience a doomsday and drop another -30% after reading another negative news headline? Ok, let’s model this potential scenario and provide you a sense of security. Remember, a -50% downturn has only been experienced 3 times since WWII (1945) which represents roughly 2% of the declines. Better to be safe than sorry as retirement only happens once and there are no do-overs.
Most folks nearing or in retirement desire a portfolio that will allow them to sleep at night, knowing if the market tanks -40%or -50%, they will be able to live through the downturn, continue to maintain their lifestyle and only have to make minor adjustments until markets recover. This reinforces the importance of owning a combination of cash and individual bonds, acting as a “War Chest” to tap into as equity markets recover. While there is no magic number or one size fits all mentality, your war chest should be appropriate for the amount you spend and the number of years you’d like to tap into if the market were to take a turn for the worse. Remember, cash and fixed income isn’t intended to appreciate like stocks or the equity market. It is intended to act as an anchor or safe haven as equity markets turn back around.
It is easy to get wrapped up in the intraday, weekly, or monthly news headlines when everything is looking bleak. It is the “confirmation bias” thought process of seeking out news that will only reassure your opinion without understanding the historical statistics. Looking at market crashes since 1870 (below chart), any 30 to 40-year time period will always be higher. Most folks tend to forget that retirement may be 30, 40 or even 50 years and while it is extremely important to understand where you are today, please do not forget to keep a long-term perspective in mind. Easier said than done and that is why it is extremely important to work with an ACM advisor. If you have any questions, please don’t hesitate to reach out to your ACM Wealth Advisor.
Sources:
https://www.morningstar.com/features/what-prior-market-crashes-can-teach-us-in-2020 (Chart)
https://www.guggenheiminvestments.com/mutual-funds/resources/crucial-conversations/putting-pullbacks-in-perspective (Statistics)
The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.
