Clarifying Sequence of Returns Risk (Part 1)

If you read much about retirement finance, then you've probably seen a piece or two on sequence of return (SOR) risk. They don't provide much clarity, IMHO.

Different writers define SOR risk differently (part of the problem), but I use the term to describe the observation that two investors who withdraw or invest periodically from their retirement portfolio can experience the same average stock market returns and have very different outcomes when the order of those returns differs.

Those investors subject to SOR risk would include most who save in a 401(k) savings plan, investors who dollar cost average, retirees who implement a safe withdrawal rates strategy and investors who save or spend random amounts from their retirement portfolio.

In fact, as I will show, there is only one way to avoid it.

The risk is best described with an example.

I read a nice post by Dana Anspach entitled, "Sequence of Returns Risk Misunderstood by Many Retirees." It explains the effects well, except that the assertion that sequence of returns risk does not apply in the accumulation phase of retirement funding is incorrect, as I will demonstrate¹.

The article shows that a series of 10 market returns:

·       1996 23.10%
·       1997 33.40%
·       1998 28.60%
·       1999 21.0%
·       2000 -9.10%
·       2001 -11.90%
·       2002 -22.10%
·       2003 28.70%
·       2004 10.90%
·       2005 4.90%

would result in a terminal portfolio value of $164,513² for an investor who started out with $100,000 and spent $6,000 per year. An investor who did exactly the same but experienced those returns in reverse order (4.9% in year one, 10.9% in year two, etc.) would end up with only $125,691.

One thing that bothers me about this analysis, which is quite common in the literature, is that the reader may come to think that he or she is endowed with a pre-ordained set of future market returns and need only worry about their sequence.

The article compares two of these series, forward and backward, but there are actually 10!, or 3,628,800 different permutations of these ten returns (a rare opportunity to use the factorial key on my decades-old HP 12C calculator. It’s right there under the “3”.)

Retirement plans typically cover 30 years or more. How many different sequences can you create from 30 numbers? There are approximately 2.65 x 10³² permutations of 30 years of returns, or 265 followed by 30 zeroes, which rounds off to a gazillion bazillion.

These two aren’t even the best and worst series orders for the ten years of returns. The largest portfolio value will result when the returns arrive in descending order ($181,026) and the smallest will occur when they arrive in ascending order ($80,994).

Of course, we’re not limited to permutations of 30 or so market returns in retirement, the possibilities are limitless. So there is no “sequence” of future returns, as if when you don’t get one then you'll get the other. We have no idea what those 30 annual returns will be, so it seems pointless to hope that, whatever they might be, they arrive in decreasing order.

Sequence of returns risk isn’t a phenomenon, at all. It’s algebra.

Let’s say a retiree has a portfolio worth $100,000 and experiences annual returns of 20% followed by a loss of 7% followed by a gain of 3%. His terminal portfolio value (TPV) can be calculated as:

We can factor out the $100,000 initial portfolio value and get

The terminal portfolio value after three years is $114,998. The commutative property of multiplication tells us that we will get the same result no matter what order we multiply these four factors. So, the portfolio represented by this equation will always accumulate the same total value regardless of the sequence of the returns.

If we don’t add new funds or subtract spending from our portfolio each year, there is no SOR risk.

What happens to the algebra if we do withdraw, say $4,000 at the end of each year? The portfolio value is then calculated as follows:

There are three things to observe about equation [2]. First, the equation no longer contains only multiplication, so the commutative property does not apply and the order in which the market returns appear affects the solution. Swap the 1.2 and the 0.93 in equation [2], for example, and you change the result to $101,884.

Because we are subtracting amounts each year, we now see sequence of returns risk that wasn’t present in equation [1].

The second thing to observe is that this would be the case if we added $4,000 each year instead of subtracting it, so SOR risk is present in both accumulation and spending phases (just change the minus signs to plusses in equation [2]).

The third observation is that sequence of returns would also matter if we subtracted or added random amounts each year. SOR risk is present when we withdraw or save fixed dollar amounts periodically, as the safe withdrawal strategy requires, or if we spend or save a different dollar amount every year.

There was no SOR risk before we introduced periodic buying and/or selling from the portfolio. That tells us that SOR risk is simply the uncertainty of the stock prices at those periodic buy and sell points in our future.

Now, what happens to equation [1] if our investor decides to withdraw say, 4% each year of his portfolio’s current value instead of some dollar amount? Portfolio value is now calculated as:

or

 

which simplifies to:

Equation [3] now looks like equation [1]. The percentages are each smaller by 0.04, but once again, the expression is the product of four factors, so the commutative property of multiplication applies and the sequence doesn’t matter. There is no sequence of returns risk.

Also note that if the percentage isn’t the same every year (e.g., we spend 4% of remaining portfolio value the first 5 years and 5% the second 5 years), we re-introduce sequence of returns risk.

What does this high school algebra exercise tell us about sequence of returns risk in investing for retirement?

• SOR risk is present when you invest your retirement portfolio in volatile assets like stocks. It is not present in fixed annuities and is negligible in low-volatility portfolios like short and intermediate Treasury bond ladders.

• SOR risk can be present in both accumulation and spending phases of retirement funding.

• The only way to avoid SOR risk with a risky portfolio is to withdraw the same percentage of your portfolio’s remaining balance every year.

I was exposed to SOR risk while I saved for retirement, but saving a set percentage of my increasing portfolio balance wasn’t feasible. There was no practical way to avoid SOR risk in the accumulation phase.

I withdraw about 4% of my current portfolio value every year, so I’m not exposed to SOR risk in retirement.

Lack of exposure to SOR risk did not, however, protect me from the 2007-2009 market crash (my portfolio allocation did). So, it didn't protect me from the risk that a large portfolio loss early in retirement would threaten my portfolio’s survival if I live a long life.

That’s another way financial writer’s define sequence of returns risk, but I believe that is a different risk.

I’ll tackle that in Part Two.


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¹The reader can work through the same three-year example I provide but adding a fixed dollar amount each year instead of subtracting and observe that sequence of risk does, in fact, exist in the accumulation phase.

²The referenced article states the total of $162,548 but I believe this is in error. That number appears to be the portfolio value after 9 years, not 10. The mistake is inconsequential. I note it only to avoid confusion.

A Little Reality

I received a comment on my recent post, A $2.5 Million Rant, from a gentleman named “Anonymous” that I find quite intriguing. Anon doesn’t seem to realize that, for the most part, he and I are in agreement, but I’ll argue with him, nonetheless, because, well. . . I just like to argue.

My friend, Anon, either doesn’t read many of my posts or he’s missing the points. Maybe he isn’t the only one. Maybe I haven’t explained them well enough for some, so I’m using this week’s post to clarify. (Anon’s comments below are in italics.) 

I agree with a lot of what you say, but not necessarily the spin you put on it. Many of the problems you identify are simple economics. You cannot expect a guaranteed good return in the stock market.

True, but you miss my point. My complaint isn’t with stock market risk and return. Without stock market risk there would be no reward and the stock market rewarded me well over my career.

My complaint is that our politicians set up a retirement system based on the belief that individual families could harness that risk to fund their own retirement. And they created a windfall for the financial services industry. And now, our political leaders are doing nothing to fix it.

No, you can’t expect a good, risk-free return in the stock market. You also can’t expect the stock market to fund retirement for the vast majority of individual families.

My problem is your constant tone of outrage.

“Constant” is hyperbole, but someone needs to be outraged at our retirement system. William Bernstein is outraged. (“I've flown airplanes, and as a doctor, I've taken care of kids who can't walk. Investing for retirement is probably harder than either of those first two activities, yet we expect people to be able to do it on their own.”)

Helaine Olen is outraged. (“The truth is this: the concept of a do-it-yourself retirement was a fraud. It was a fraud because to expect people to save up enough money to see themselves through a 20- or 30-year retirement was a dubious proposition in the best of circumstances.”)

Teresa Ghilarducci was outraged, before Congress. (“It is now more than 30 years since the 401(k)/Individual Retirement Account model appeared on the scene. This do-it-yourself pension system has failed. It has failed because it expects individuals without investment expertise to reap the same results as professional investors and money managers. What results would you expect if you were asked to pull your own teeth or do your own electrical wiring?”)

John Bogel is outraged. (“Where are we in terms of our retirement health? We’re facing a train wreck.” and “We have a 401(k) system that is profoundly flawed even as it has moved to the position of pre-eminence in our retirement system. There are elements of the 401(k) system that are just unacceptable if you’re trying to build a system that accumulates for retirement.”)

If you’re not outraged, you don’t understand the situation.

You were duped.

(Besides, it’s my blog. I can be outraged if I choose.)

At whom, exactly, should these folks be "outraged"? At "the retirement system" or the government for not forcing them to save perhaps 25-30% of their income throughout their working lives?

They should be outraged at political leaders who sold them a bill of goods back around 1980. In the words of Helaine Olen, you might be tempted to ask, “what went wrong,” but a better question might be “why did we ever expect this to work at all?”

And they should be outraged that most American workers will drop out of the middle class after they retire and today’s political leaders are doing nothing about it.

 [Should they be outraged] at the economy for not guaranteeing future returns?

Now you’re just being silly.

Look, we can certainly improve the "system"; fine.

Ya’ think? It is failing about 95% of American workers so, yeah, maybe a little room for improvement there.

But to accumulate a lot of money for retirement now that quite a few people live into their 90s requires real sacrifices and not many people are signing up for that. Look at all the complaints about increasing taxes this year and realize that it will take MUCH more than that to fund retirement. Try telling folks you're going to require them to save at least another 20% of their income.

My point, exactly.

Our current retirement system requires a level of savings (sometimes 20% isn’t enough, Anon) that is ludicrous for the American middle class. Then it requires investment skills that even few professionals have. And on top of that, it requires that you be born in a fortunate year. (I’m still working on that one. A tardis, maybe?)

Do-it-yourself retirement funding doesn’t work for the vast majority. I don’t have the answer, but my gut tells me it must involve risk pooling to protect against longevity risk.

So, here’s what you missed, Anon. Our current retirement system doesn’t work. It doesn’t come close. This blog is an effort to help the 95% or more of Americans who haven’t saved enough for retirement. As I have posted often, there isn’t a tremendous amount I can do to solve a problem that began over 30 years ago, but I may be able to help you make the most of a bad situation.

Unfortunately for my generation (Boomers) and the next, it’s too late. But you can begin to be outraged enough to demand that someone fix it for your grandchildren.

We need a little realism here.

True that.

Retired Guy's Recovery from the 2007 Market Crash

In my last post, I used the following chart to demonstrate how much longer it took a Retired Guy's portfolio to recover from the 2007 market crash than it took a Working Guy's.

Throughout this period, Working Guy was saving an additional $6,000 per year in a portfolio that held 80% in stocks and 20% in bonds, while Retired Guy was spending $4,500 per year from a portfolio that held a 30% stocks.

This example begs the question, “Would Retired Guy's portfolio have recovered sooner with a larger allocation of stocks in his portfolio?”

In the case of the 2007 market crash, the simple answer is no. A more aggressive portfolio would have recovered even more slowly because it would have fallen much further by the March 2009 market bottom.

The S&P 500 index, as represented by the index fund SPY, recovered from the bottom much more quickly than Vanguard Total Bond Market index fund (VBMFX), as you would expect. The following chart from Yahoo! Finance compares the two investments from the bottom of the crash until today.

However, if you compare the two funds from the pre-crash peak, you will see that the stock fund only recently caught up with the bond fund.

The following graph shows Retired Guy portfolios with various allocations of stock over the period from the 2007 peak until recently. More aggressive allocations climbed back at a faster growth rate but had dropped further on March 2009.

Any stock allocation greater than 30% has not yet recovered by then end of July 2013. When will they recover?

If the current bull market continues, some Working Guy portfolios will probably recover in the next year or so. But, this bull is getting long in the tooth. We may also encounter another bear market before these portfolios return to their 2007 peak value and it could be years more before they recover.

Of course, Working Guy's portfolio recovered a long time ago, early in 2010 and more quickly than the S&P 500, because Working Guy continued to pour new savings into his portfolio without spending any of it. You can't do that after you retire.

It is entirely possible that many retirees will sell at the bottom and never regain their October 2007 portfolio peak balance.

But that has been the point of my last two blog posts.

Managing your portfolio after you retire is an entirely new ball game.

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.

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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.

Event	Date	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	16
Working Guy’s portfolio recovers	January 14, 2010	27
S&P 500, adjusted for splits and dividends, recovers to October 2007 level	August 16, 2012	58
Retired Guy’s 30% Stock Portfolio recovers	May 21, 2013	67

Retirement Changes the Game

The challenges of financing retirement change dramatically on the day you retire.

You may imagine that retiring with adequate savings one day will feel like winning. But you’re really just taking a lead into the locker room at halftime. In reality, the game will have changed and the challenges will be even greater in many ways when you return to the court for the second half. The goal shifts from accumulating a pile of money to making a pile of money last.

It’s a different game.

We refer to the period before retirement as the accumulation phase because our goal is to accumulate enough wealth to maintain our pre-retirement standard of living after we retire and the paychecks end. We call the period after retiring the decumulation, or spending phase because our objective then becomes stretching out our wealth to pay our bills for the rest of our lives.

The accumulation environment is very different than the spending environment. Here are some of the important characteristics of accumulation:

·       We have jobs and paychecks that cover our living expenses. The paychecks arrive, for the most part, during both bull and bear markets. A temporary loss in the stock market may not affect our spending at all.

·       We hopefully have some money left over to save in a retirement account and to increase its value.

·       We can take some risk with our investments, because we don’t need that money to live on (yet) and that generally means we can earn a higher return.

·       Our investment returns apply to a growing base of capital as our wealth grows. When we are 30, we might earn 8% a year on a $20,000 portfolio, or $1,600. When we are 60, we might earn that same 8% on a portfolio of $500,000, yielding $40,000.

·       Dollar Cost Averaging (investing the same amount of money every year) allows us to buy stocks at lower prices over time.

·       We could lose our entire retirement savings portfolio and possibly have time to rebuild it before we retire.

·       We may have health insurance paid for by our employer.

Here are some important characteristics of the spending phase:

·       No more paychecks. Expenses are paid from our savings.

·       No more savings contributions. Our portfolio increases only when our investments do well.

·       We need to reduce investment risk, because we no longer have paychecks to bail us out during bear markets. That generally means a lower return on our investments. We might expect a 6% portfolio return instead of 8%, for example.

·       Our investment returns apply to a shrinking base of capital as our portfolio is being depleted. Even if we earned 8% every year, it would return 8% of a (probably) smaller number every year.

·       Dollar Cost Averaging works in reverse. We spend roughly the same amount every year so we sell more stocks at lower prices and fewer stocks at higher prices.

·       We pay for health insurance out of our own pockets. It is very expensive.

·       Since we are no longer working, when the retirement savings is gone, it’s gone.

·       On the positive side, we no longer pay FICA taxes and no longer need to save for retirement.

If accumulation is like sailing a boat with fair winds and a following sea, as they say, with plenty of fuel for the engine if the winds die down, then investing in the spending phase is like pounding into the current with strong headwinds in a boat that’s growing heavier as it takes on water and has spent its fuel reserves.

During the accumulation phase, you’re contributing to savings and not spending from savings. In the spending phase, you’re doing the reverse. And probably earning a lower return to boot.

A retiree spending 4% of her savings each year adjusted for inflation has to earn 4% plus the rate of inflation plus the cost of taxes and commissions on her investments just for her portfolio to break even that year.

Let’s say John has a portfolio worth $100,000. His investments return 8% one year and inflation runs 3% for an inflation-adjusted rate of return of 4.85%. (This example is in constant dollars.)

This younger John contributes $4,000 at the first of the year to his 401(k) account. Before retirement, his portfolio increases to $104,854 plus $4,000 of new savings for a new value of $108,854.

Because John’s portfolio is growing, a 4.85% inflation-adjusted return next year will provide an additional $5,284 of real value (4.85% of $108,854).

If this scenario occurs after retirement, the older John still earns $4,850 in the market, but his portfolio shrinks a bit from spending $4,000. He is no longer contributing to his 401(k), so his portfolio value ends the year at $100,854.

Because older John’s portfolio is shrinking in the spending phase, an 8% return next year with 3% annual inflation will provide only $4,896 of real value, 7.4% less than younger John’s portfolio would earn.

And so it goes, on and on.

There is a larger message here than “investing is really tough after you retire” that I will address in my next post. It’s about the amount of risk you can actually handle after you retire, because it will be much harder to recover from large portfolio losses.

I used a sailboat analogy to describe the difference between accumulation and spending phase economics, but having just finished my eighth year of retirement and surviving the 2008 market crash, the real estate crash, seventeen grand a year for family health insurance, two kids still in college and a third in med school, I can think of a more visceral analogy for how investment feels after you retire.

Remember when you were a kid sledding on a hilly street of packed snow and near the bottom, at top speed, your runners ran into a patch of dry pavement?

Yeah, sort of like that.

Cashing Out

I recently received an interesting e-mail from a friend nearing retirement. He told me that he believed his portfolio had recently reached seven figures and wondered if I thought he should “cash out” soon.

I wasn’t sure precisely what he meant by “cash out”, though I assumed he meant sell his stocks and probably his bonds, so I asked, “What would you do with the money if you cashed out?”

“Retire,” he replied. “Maybe buy a bigger sailboat.”

Good answers, as the game show hosts like to say, but not what we were looking for.

“I meant to ask where you would hold your money until you need to spend it,” I responded. “In a savings account? Under your mattress? Mattresses are actually paying competitive returns on cash lately.”

If you believe “Safe Withdrawal Rate” (SWR) advocates, then you probably assume you might be able to spend about 4-½% of your retirement nest egg each year and have a 94% probability of your savings lasting 30 years or more¹. 

I don’t believe this for an instant, mind you. The so-called SWR analysis is fatally flawed, but I think it can serve as a comparison of the alternatives.

Using the same data, the analysis shows that if you hold your retirement savings in money market accounts, you have only a 31% chance of your money lasting 30 years or more with a 4-½% annual spending rate.

I have no confidence that a retiree today could invest in a 60/40 stock portfolio, spend 4-½% annually and remain solvent for thirty years, but I might be convinced that socking savings away in a money market account would be roughly three times worse.

SWR believers would say my friend could lower his spending rate to about 2.8% a year and get close to that 94% survivability rate. With a million dollar portfolio then, my friend could spend $45,000 a year if he stays in stocks, but only $28,000 a year if he “cashes out”. Of course, this is in addition to the income he and his wife will receive from Social Security benefits, so either way they’re better off than 95% of the retiring U.S. workforce in 2013.

Another alternative would be for my friend to sell his portfolio and buy a lifetime fixed annuity from an insurance company, but the last time I looked they were only paying around 3.5% annually for an inflation-protected annuity. If he were worried about market risk, that might be a reasonable thing to do, but he’d still have to worry about the financial health of the insurer.

Furthermore, the sweet spot for annuities is around age 70, so he might be better off staying in stocks for a few more years until he can get a better deal. Maybe interest rates will rise by then, helping even more.

So, you can’t just “cash out” your stock portfolio and declare victory on the day you retire. You may have made it through the accumulation phase with enough savings to maintain your standard of living in retirement, but in many ways the spending phase is tougher. You have to make that portfolio last for the rest of your life.

You might be able to do that with a portfolio of stocks and bonds, or by purchasing a lifetime annuity, but it will be nearly impossible to achieve with cash alone.

While “cashing out” your portfolio when you retire is probably a poor strategy, reducing your risk is not. A bear market just before or just after retirement can destroy your retirement plans, as many retirees learned in the 2007-2008 stock market and real estate crash. That means lowering your stock allocation to somewhere around 40% to 50%, in my opinion, and that’s probably what my friend should do, if he hasn't already.

According to William Bernstein's The Intelligent Asset Allocator, an 80% stock portfolio would probably suffer a decline of no more than 35% in a bad bear market, while a 40% stock portfolio should lose no more than 15%.

I typically cover topics that might help retirees who haven’t saved enough and this one obviously applies to people with significant retirement savings. The transition period just before and after retirement is very interesting for those with large portfolios, though, so I will digress a bit over my next few blogs to discuss that topic.

My point today, however, is that your investment challenges don’t end the day you retire. In fact, they become more difficult. Not only do you no longer have income from work, you're spending down your portfolio and you may need to take less risk with your investments, which more often than not means lower returns.

You'll need more help solving that problem than you're going to get from cash.

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¹Safe Withdrawal Rate calculations are based on the spreadsheet provided by The Retire Early Homepage.