This happened in the 1990s, as the tech-stock bubble produced paper millionaires that melted away. In the 2000s, Americans grew comfortable with stock-heavy portfolios and with using home equity as an ATM. This scenario was savaged by the worst financial crisis since the Depression.
It will happen again. In March, the current bull market will be six years old. It might run an additional six years—or end in April. The lesson from financial history is, when you’ve won the game, stop playing.
So, retirement nest-egg-wise, what constitutes “winning”? You’ve won when you’ve acquired enough assets to provide your basic living expenses for the rest of your life.
Add up your basic annual expenses. Include taxes on required and voluntary withdrawals from your retirement accounts. And on the income and capital gains in your taxable assets. Then subtract your Social Security and pension checks. This leaves you with your residual living expenses or RLE.
Your retirement is reasonably assured only if the bulk of those assets is in relatively safe holdings. On three different occasions in the past eight decades, the S&P 500 has experienced five-year drawdowns up to 60%. If you enter retirement at the start of such a bad stretch and stack 5% annual withdrawals on top of those equity losses, your nest egg will evaporate so fast that you’ll have little left by the time the markets finally recover.
If you’re of a certain age and have saved and invested well, it’s possible you’ve just now won the race. This may be a good time to start reducing the risk in your portfolio.
You say you can’t abide the crummy yields in your now larger bond portfolio? Cheer up. Those coupons are the result of accommodative Federal Reserve policy, which inflated stock portfolios. If you have substantial equity exposure, you have more assets than you would without Fed intervention. The pile of fixed-income securities you can buy with those equities will make up for their low yields.
So just how do I know that stocks will decline in the coming years? I don’t. Rather, I bear in mind Blaise Pascal.
The probability of error matters less than its consequences. The wisest course is the one with the most acceptable worst-case scenario. Warren Buffett expressed the same idea in describing the collapse of Long Term Capital Management. “To make money they didn’t need, they risked what they did have and did need.” Retirement investing fits this. Let’s say you’ve acquired an adequate retirement nest egg, as defined above. You decide to increase your bond exposure in the belief that stock prices will fall. But the stock market proves you wrong by powering ahead. Sure, you’ll be sorry you just blew your chance to buy a BMW.
But if you bet on rising prices and hold a too-high equity exposure the outcome will be far worse. This is what happened to many new retirees in 2000 and in 2008. It will certainly happen again to retirees who should have known better.
Just Do It
Take a hypothetical investor named George who retired in 2000. At 65, he has a $1 million all-stock portfolio, and spent $50,000 a year on his RLE, adjusted for inflation. Considering the S&P 500 lost 41.2% in nominal dollars between the day he retired and Feb. 28, 2009, George would have barely $100,000 left of his nest egg by 2014. Had he held a 70/30 stock/bond portfolio, using intermediate Treasuries as his bond component, he would have $428,000 left. Had he held a 40/60 portfolio, he’d have $703,000.
George got into trouble with an overly aggressive portfolio because his nest egg could not support his retirement—that is, the recommended 20 years of RLE.
In contrast, Greg also had a nest egg of $1 million, but only $25,000 of RLE, or 40 years of expenses. At 100/0, 70/30, and 40/60, he had $939,000, $1.2 million, and $1.4 million left as of the end of 2014.
Historical back testing suggests that a 65-year-old with 20 years of RLE in his nest egg should hold no more than 50% of his portfolio in equities. If you have 35 years of RLE, then up to 70% is probably safe. If you have 50 years of RLE, then even an all-stock portfolio is reasonable.
If you decide to reduce your equity exposure, how quickly should you do it? Since no one knows if stock valuations will decline, the “correct” answer will only be clear in hindsight. You could do it all at once, or you could do it gradually over the next few years. The key thing, though, is to do it.
Somewhere, Blaise Pascal will smile on you.
Is your retirement nest egg is big enough? Mr. Bernstein is an investment adviser. He is the author of “If You Can: How Millennials Can Get Rich Slowly.” He lives in Portland, Ore.