If you’re a retired investor who lives off your portfolio, you’re probably concerned about the AI-driven stock market boom that some observers are calling a bubble.
By some measures, valuations for the benchmark S&P 500 stock index are higher than at any time since the late 1990s tech boom.
While no one can reliably predict what’s going to happen and when, that market frothiness raises the odds of a sharp stock market reversal at some point.
If a severe correction or bear market happens and you can wait it out without selling stocks, you may avoid lasting damage.
But there is potential for serious harm if you find yourself needing to sell stocks at distressed prices to cover your cost of living for an extended period.
If you get caught early in retirement by a severe and long-lasting bear market, your continuing stock sales could deplete your portfolio to such extent that it doesn’t benefit much when stock prices eventually recover. That phenomenon is known as sequence of returns risk and in extreme cases can devastate a retiree portfolio.
How to create a resilient portfolio that safeguards cash flows
Fortunately, there are several things you can do to create a resilient portfolio that safeguards your needed cash flows. A key goal is to ensure ready sources of cash that avoid the need to ever sell stocks at depressed prices. That gives stocks a chance to recover undisturbed from down markets.
Here are three key portfolio actions that can help: start with finding the right balance between stocks and investment grade bonds; then structure your portfolio so you always have sufficient assets that hold their value to use for paying out needed withdrawals; and invest (to a degree) in assets that generate sizable amounts of reliable interest and dividends.
We discuss each of these actions in turn.
Start with the right mix of stocks and bonds
Building a resilient retirement portfolio starts with getting the right mix of two core assets, stocks and relatively safe forms of fixed income like investment grade bonds.
Many retirees suit a classic mix of 50 to 60 per cent stocks and 40 to 50 per cent bonds for long-term investing, but it can be more or less depending on individual objectives, risk tolerance and other factors.
Be cautious about trying to make “tactical” adjustments to the long-term mix based on your take on current market conditions. Trying to time the market is difficult or impossible for average investors and it is easy to get off track in relation to your long-term objectives.
Stocks earn you relatively high expected returns over long periods, but prices are relatively volatile and suffer periodic losses. Bonds provide modest expected returns with more stability, while generally cushioning your portfolio when stock prices are hard hit.
Keep most or all of your fixed income in relatively safe forms like investment grade bonds (or government-insured GICs). Invest sparingly in high-yield bonds and other riskier fixed income, since they don’t provide as much stability and tend to sell-off similar to stocks in plunging markets.
Identify withdrawal sources that hold their value
Having appropriate amounts of both stocks and bonds sets the stage for smart sourcing of your withdrawals under what’s sometimes called a “bucket” strategy.
In its simplest form, it works like this: when stock prices are distressed, source withdrawals from bonds or other relatively safe assets that hold their value. This provides your stocks a chance to recover without being sold off at a bad time.
When stock prices are flying relatively high (like now), it makes sense generally to source withdrawals from stocks. That way you realize a good price on stock sales while conserving bonds for drawdowns at other times. If stock prices are at moderate levels, draw from both stocks and bonds in combination.
It’s called a bucket strategy because it involves notionally separating your portfolio into two or more risk-based segments or buckets. More elaborate versions can have three or more buckets and complex rules for moving funds between them.
A sophisticated version might be useful in protecting your portfolio against stagflation, which typically involves a weak economy, strong inflation, and (after inflation gets going) rising interest rates. In that scenario, conventional bonds and most stocks tend to get hit hard at the same time. In that case, additional buckets that have a better chance of retaining value might include: real assets, assets that pay variable interest or have very short-term maturities, and perhaps U.S. Treasury Inflation-Protected Securities (TIPS).
A bucket strategy essentially involves a gradual form of rebalancing. Sourcing withdrawals from assets that have done relatively well helps to gradually adjust the asset mix back toward its target.
Be cautious about more aggressive forms of rebalancing, such as actively buying stocks at depressed prices and selling additional bonds beyond what’s necessary to fund withdrawals. Restraint in rebalancing helps conserve bonds so they can last longer in funding withdrawals in the event a bearish stock market lasts for a few years.
Income investing can help cover withdrawal needs
Income investing uses reliable forms of interest and dividends to cover much of your withdrawal needs, thus reducing the need to sell assets.
Sticking with relatively safe forms of fixed income ensures the interest you earn from it is fairly reliable.
When it comes to stocks, income investors typically skew their stock choices toward stable blue-chip companies that generate reasonably high and reliable dividends that grow steadily. These dividends can generally be counted on even during tough economic times.
While dividend stocks have attractive features, having your entire equity exposure devoted to them results in less diversification and minimal exposure to growth stocks. For many retired investors, it makes sense to have a sizable position in dividend stocks but have other stocks as well.
One pitfall to avoid is the temptation to “chase yield” by buying stocks paying exceptionally high dividends. That typically means the stocks are relatively risky and the dividend is likely to be cut.
Plan reliable cash flows for at least five years
Plan so that you can cover your needed portfolio withdrawals from bonds and other relatively safe sources if necessary for at least five years (and ideally a few additional years). That helps you to wait out down markets without being forced to sell stocks or other riskier assets at adverse prices.
The overall result is to help ensure that funds necessary to support your retirement lifestyle will keep flowing for as long as needed even if you encounter a particularly nasty bear market.
