Stock prices have been making new highs on a regular basis lately. Does that make you nervous? Should you be worried about the next correction, or worse yet – another bear market?
If your goal is to accumulate wealth over the long run, market pullbacks can be your best friend by allowing you to buy more shares at discount prices. Dollar-cost averaging is a great way to build wealth, as long as you stay committed to it through good times and bad.
For example, if you’re investing $1,000 each month, falling prices allow you to buy more shares than you did the month before for the same amount of money. Lower prices, more shares; higher prices, fewer shares. That’s why this simple strategy works.
It’s different once you retire, though. Dollar-cost averaging doesn’t work so well in reverse, as many retirees (and sometimes their financial advisors) are dismayed to discover. When you’re withdrawing money regularly from your portfolio, falling stock prices mean you have to sell more shares at lower prices to come up with the same amount of money.
Overly simple withdrawal guidelines such as the “four-percent rule” require retirees to do just that. By blindly selling shares every month whether prices are high or low, the advantages of this wealth-building strategy turn into disadvantages. Dollar-cost averaging becomes dollar-cost ravaging.
And when you couple that with the unique risk that newer retirees face – sequence-of-returns risk – it gets even uglier. While you’re accumulating wealth, the timing of corrections and bear markets don’t matter much, especially if you’re systematically adding the same amount to your nest egg each month.
Once you retire, however, it matters a great deal when those bad markets appear. A market crash in the early years of retirement can easily knock the value of your equity holdings down significantly. And while bear markets are temporary, when you have to sell stocks every month to pay your bills you turn short-term volatility into permanent losses. Even with decades of retirement still ahead of you, you might not have time to make those losses up.
The trouble with bear markets is that they are beyond our control and can’t be reliably predicted. That takes market timing off the list of viable options, thankfully.
Here’s a better solution: don’t buy stocks with funds you plan to withdraw in the next few years. Or as I tell our clients: Keep your rent money out of the market.
From 1950 through 2020, it’s taken less than two years on average for stock prices to fully recover from bear markets. Even in the most prolonged downturn (1973-74), equity investors broke even within eight years, assuming they didn’t have to sell shares along the way.
If you can structure your portfolio so that it’s unlikely you’ll need to sell stocks until they have a chance to fully recover, you will be largely immune from sequence-of-return risk. That means figuring out how much you plan to withdraw from your portfolio over the next 5-10 years and investing those funds in something with less short-term downside than stocks, such as bonds or other fixed-income investments.
What you’ll likely wind up with is a balanced portfolio with enough in fixed-income to cover up to a decade of planned withdrawals, and enough in equities to provide potentially higher returns and a source of rising dividend income.
Let other people bet their life’s savings on a rule of thumb or trying to predict the unpredictable. You’re smarter than that.
Any opinions are those of Mike Brown and not necessarily those of Raymond James. This information is intended to be educational and is not tailored to the investment needs of any specific investor. The information contained in this report does not purport to be a complete description of securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected, including asset allocation and diversification. Past performance is not indicative of future results.
