Sunday, July 28, 2013

Even Your Portfolio Heals More Slowly as You Get Older

I mentioned in my last post that there is a larger message than “investing is really tough after you retire”. It’s about the amount of risk you can handle after retiring. It will be much harder to recover from steep portfolio losses after you simultaneously begin spending your savings and foregoing new savings contribution — and your employer’s match, if you get one.

The mantra of the financial services industry is “just hang in there through bear markets and you’ll eventually earn it all back.”

But it’s a different game after you retire. Your portfolio will recover much more slowly.

Your retirement savings account is like a rain barrel. Rains (stock market gains) fill the barrel. While you’re working, you dump in a little more water from the faucet (savings contributions) on a regular basis. You never take any out. The barrel fills relatively quickly.

After retiring, you not only stop dumping in regular additional water, you begin drinking the water daily (spending your savings). It’s a different equation.

The financial services industry will tell you that stocks get safer the longer you hold them. They don’t. To quote Zvi Bodie, stocks are risky no matter how long you hold them. And the longer you invest, the larger your portfolio becomes and the more money you lose when the market drops say, 15%.

They say that if you simply stay in the market long enough, your portfolio will eventually recover its losses. That part is probably true, so long as the U.S. economy continues to grow and you gloss over “long enough”.

The 2007 crash took about 5 years for the S&P 500 to correct, but that probably isn’t the same as your own portfolio. Most investors don’t see anywhere near market index returns or invest solely in an S&P 500 index fund, so your individual recovery time may be much longer. Also, working investors are probably adding new savings while retired investors are probably spending some of their savings.

Let’s look at Working Guy and Retired Guy and how each might have fared after 2007.

When the S&P 500 peaked in October 2007, Working Guy and Retired Guy both had retirement savings portfolios worth $100,000.

Working Guy saved $4,000 a year in a 401(k) plan and never had to spend any savings before retirement. His paycheck covered the bills. His employer contributed a matching $2,000 each year. He held 80% of his portfolio in an S&P 500 index fund (SPY) and 20% in Vanguard Total Bond Market fund (VBMFX).

Retired Guy no longer contributed to retirement savings and he had decided to spend 4.5% of his initial portfolio value each year, or $4,500. Retired Guy knew he should take less market risk after he retired, so he held only 20% of his portfolio in the same stock index fund as Working Guy and the remainder in the same Vanguard Total Bond Market fund.

In a year when the market breaks even, Working Guy’s portfolio increases $6,000 and Retired Guy’s portfolio shrinks $4,500. That $10,500 difference every year is a lot — 10.5% of a $100,000 portfolio.

The following chart from Yahoo! Finance data shows what happened to the S&P 500 index fund SPY. After peaking in October 2007, the index fell 54% by March 2009. It recovered its October 2007 peak value in August 2012, 4 years and 10 months after it peaked.

An investor who stayed fully invested in an S&P 500 index fund would have recovered his portfolio value in that 58 months if he neither continued to save nor spend from his savings.

But Working Guy saves $6,000 a year while Retired Guy spends $4,500.

As you can see in the next chart, Retired Guy’s 30% stock portfolio fell 17% and Working Guy’s portfolio fell 37% before heading back upward. Working Guy’s losses would have been even greater because of his larger stock allocation, but Working Guy and his employer shoveled $9,000 of new cash into the teeth of a gut-wrenching, money-shredding, 17-month decline while Retired Guy did not. Not only did Retired Guy not put more money into his portfolio, he spent $6,750.

Working Guy’s portfolio then moved upward and recovered in January 2010, 27 months after the market’s peak and 31 months sooner than the S&P 500 index.

In August 2012, media pundits were saying, “If you had only stayed in the market, you’d have recovered your losses by now.” But that wasn’t true for either Guy, was it?

Working Guy’s portfolio had actually recovered 31 months earlier and Retired Guy’s 20% stock portfolio wouldn’t recover for 9 more months. In fact, had Retired Guy held more than 30% of his portfolio in stocks, his portfolio still hasn’t recovered after nearly 6 years.

If the bull market continues, a “Retired Guy” 40% portfolio will probably recover in a year or so, taking twice as long as Working Guy’s. If the bull market continues.

On the other hand, the nature of retirement portfolios is that they will be spent down over the retiree’s remaining life and it’s quite likely that many retirees and near-retirees who endured the 2007-2009 crash will never recover their October 2007 portfolio value.

If they had it to do over, they would have held less stock.

My point in all this is that it is much harder to recover from a severe market decline after you retire than it is before. See that blue line on the chart? That ain’t you, anymore. That line is headed upward, probably, until retirement. Yours is probably headed the other way.

When you get older, everything heals more slowly. Even your portfolio. You have to think hard about not getting hurt badly in the first place.

In the decade before retirement, when we can make “catch-up contributions” to retirement savings, we become really spoiled by fast recoveries from crashes. We become confused about how much of our “investment skill” is actually just saving more.

When the super-saving stops and the drawing down of savings begins, our sleds hit that patch of dry pavement at the bottom of the hill. Our momentum dies quickly and then we have to carry the sled back up that hill.

The sled ride downhill is a lot more fun.


Note: I must apologize for a spreadsheet error in the initial draft of this post that over-valued bond portfolios for Retired Guy.  The result was that the 63-month recovery period reported for Retired Guy's 40% portfolio should have been a 67-month recovery for a 30% portfolio. Correcting this mistake actually strengthens the arguments. Only a 30% Retired Guy portfolio has recovered its October 2007 value as of this writing, so the 40% portfolio used was replaced with the 30% portfolio.


Months after October 2007 Peak
S&P 500 peaks at 14,164
October 9, 2007

S&P 500 reaches a bottom at 6,6594, down 53%
March 5, 2009
Working Guy’s portfolio recovers
January 14, 2010
S&P 500, adjusted for splits and dividends, recovers to October 2007 level
August 16, 2012
Retired Guy’s 30% Stock Portfolio recovers
May 21, 2013


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    2. Savings for a typical U.S. family approaching retirement is around $120,000, if you include both retirement accounts and other savings. About 95% of households have saved less than $200,000 in retirement accounts, so million-dollar retirement savings accounts are atypical, in fact, relatively rare. That’s why I chose $100,000 for my example.

      Saving 6% is not the only reason the non-retired person can make a big difference. Spending 4.5% after retirement is the other reason. Both of these percentages are fairly representative.

      In the atypical scenario you propose, saving just $6,000 a year before retirement and spending $45,000 a year after retirement, Working Guy would still recover 26 months sooner than Retired Guy (rather than 39).

      In your scenario, Working Guy would have nearly 30% more in his portfolio today than Retired Guy, while in my scenario he would have 75% more, but that misses the point of the post: it takes much longer to recover from losses after you retire.

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