The stock market’s bull run, which began in 2009, is now 8 years old. That’s the equivalent of about 80 dog years. And many talking heads are convinced that Wall Street is ripe for a nasty correction.
Were I in my 20s or 30s, I would welcome such a correction. I love buying stuff on the cheap, stocks included. But come next month, I’ll be retired. My nest egg will no longer have an income to help prop it up. I need stock prices to keep getting higher. The last thing I need is a 2008-like correction—especially in my first year of retirement.
Financial planners refer to stock market losses early in one’s retirement as sequence-of-returns risk. Investopedia defines the sequence-of-returns risk as follows:
Sequence risk, also called sequence-of-returns risk, is the risk of receiving lower or negative returns early in a period when withdrawals are made from an individual’s underlying investments. The order or the sequence of investment returns is a primary concern for retirees who are living off the income and capital of their investments.
So how do Mrs. Groovy and I protect ourselves from the dreaded sequence-of-returns risk?
Two financial cats that I really dig are Wade Pfau and Michael Kitces. They believe the best protection against sequence-of-returns risk is to begin your retirement with a low equity allocation (20-40% of your portfolio), and then gradually increase your equity allocation to 60 or 70% of your portfolio over a couple of decades. They call this strategy the glidepath strategy.
Intuitively, the glidepath strategy makes sense. But how does it stack up against the classic balanced-portfolio strategy? To find out, I put both strategies to the test, beginning in 2008. Here are the testing parameters.
- Begin 2008 with a million dollar portfolio.
- Take $40,000 out of the portfolio at the beginning of each year for living expenses (four percent rule).
- Factor in a three percent inflation rate for withdrawals after the first year. So in 2009, we will withdraw $41,200 for living expenses. In 2010, $42,436. In 2011, $43,709. And so on.
- Re-balance every year after living expenses are withdrawn.
- For the balanced-portfolio strategy, we will begin 2008 with a 60/40 split between equities and bonds. Every year after that we will re-balance to maintain that 60/40 split.
- For our glidepath strategy, we will begin 2008 with a 40/60 split between equities and bonds. Every year after that we will re-balance to achieve a 2 percentage point increase in the equity allocation. In 2009, then, we will re-balance to a 42/58 split between equities and bonds. In 2010, we will re-balance to a 44/56 split. In 2011, we’ll move to a 46/54 split. And so on.
- Our equity benchmark is the S&P 500 Index.
- Our bond benchmark is the Barclays US Aggregate Bond Index.
Okay, here are the results of our balanced-portfolio strategy.
Not bad. The balanced-portfolio strategy handled the sequence-of-returns risk better than I expected. Sure, this portfolio lost nearly a quarter of its value in 2008. But by the end of 2015, the portfolio was worth $1,104,895. And it provided an average of $44K in income per year.
Now let’s take a look at the results of the glidepath strategy.
Not bad as well. The glidepath strategy shoulders the crash of 2008 better (a 15% loss vs. a 23% loss), provides the same amount of income, and produces a portfolio that is roughly $65K larger at the end of 2015. It’s not a blowout victory. The glidepath strategy didn’t demolish the balanced-portfolio strategy. But it did win. And that’s good enough for Mrs. Groovy and me. The last thing we want in retirement is drama, especially during the first five years. A less volatile portfolio will allow us to sleep at night.
Right now, the Groovy portfolio is split evenly between equities and bonds. By the end of the year, we’ll move to a 40/60 split.
But what asset classes will we use in our equity and bond holdings? Right now, our equity holdings consist of 7 asset classes—large cap, mid cap, small cap, energy, real estate, and international. Our bond holdings consist of 3 asset classes—intermediate US, high-yield corporate, and emerging markets. Are these 10 asset classes really necessary?
One cat who doubts the necessity of so many asset classes is Jim Collins. Jim blogs over at jlcollinsnh.com, and his site’s tagline says it all: The Simple Path to Wealth.
Jim is a big proponent of just two funds: a total US stock market index fund and a total US bond market index fund. And his reasons for advocating a two-fund portfolio are pretty convincing.
- The average investor sucks at picking stocks.
- Professionals suck at picking stocks.
- Since the average investor can’t beat the market, and since the average investor can’t rely on a fund manager to do it for him or her (once fees are accounted for), the average investor’s best strategy is to shoot for market returns. Nothing more, nothing less.
- You get market returns by buying low-cost, broad-based US stock and bond index funds.
- Forget international funds. S&P 500 companies do business all over the world. That’s enough international exposure.
- Forget real estate (i.e., REITs). The inflation protection it offers is no better than that offered by US stocks.
- Buy the Vanguard total stock market index fund (VTSAX) and the Vanguard total bond market index fund (VBTLX).
Mrs. Groovy and I know our limitations. We are very, very, very average investors. In other words, we have no delusions that we can beat the market. We will be more than happy with market returns over the next thirty or forty years. And if we can do that with two asset classes rather than ten, sign us up. The less complexity in our retirement the better.
Okay, groovy freedomists, that’s the game plan. To deal with the sequence-of-returns risk, we’re going with the Phau-Kitces glidepath strategy. And to make portfolio management as easy as possible, and still get whatever the market is kind enough to give, we’re going with the Collins two-fund portfolio approach. What say you? Does our game plan make sense? Do these cats know what they’re talking about? Let me know what you think when you get a chance. Peace.