Retirements were put on hold back in 2007 when the markets tanked as the housing bubble burst. Worse off were those retirees in the first years of post-employment; their investments were in use but they had little time to continue maturing. What could these investors have done to avoid what had happened to them?

This hazard is called the “sequence of returns risk,” where the order in which investments record annual gains and losses can have a massive effect on accumulated wealth. There exist a couple of practices we can take that can mitigate this risk. Those near-retirees who made the news back then were all but certainly not exercising either of them.

Our choices help shape our financial future. Deciding them can feel like looking into the void for some. For many workers, it’s a source of anxiety, even fear. They often delay making decisions or acting upon them, which are costly mistakes. If thinking through the particulars of asset allocation or if retirement investing as a whole are off-putting, the best move is to make an appointment with a professional investment advisor.

Now for those two practices.

First, adjusting risk asset allocation (stocks) according to age. Younger investors, particularly professionals with a strong likelihood of decades of increasing income ahead of them, can shoulder much financial risk. That means an all-stock allocation at least until the mid-forties because there’s likely more income ahead of them. Older investors have fewer years to recover from market tumbles, so they should be more conservative in their approach.

Some investors accomplish this progression from higher to lower risk by rebalancing their portfolio annually using the one-hundred-minus-my-age rule of thumb, or 110-age, or for the more aggressive, 130-age. That means a 60% stock allocation at age 40 for a cautious investor or a 90% allocation for the more aggressive.

Alternatively, target-date retirement funds are tailor-made for this practice. By picking a fund targeted for a date closest to a prospective retirement date and depositing to it regularly and automatically, an investor can be assured of proper risk allocation according to age. By the time a worker is approaching her prospective retirement date, most of the assets will be bonds and cash-like. These funds are a terrific choice for workers who don’t want to dive into the details of investing.

The particular rule or fund in use is less important than the application itself—the stock allocation shrinks as the investor approaches retirement. Sudden declines in the stock market become less consequential, even as an age when the consequences would be more dire approaches.

Those investors who had to postpone retirement back in 2007 were too deeply into stocks with just a year or two of employment left, often with little or no bond or cash cushion. A bond cushion buffers a loss in stocks because bonds rarely decline much when stocks are falling. They usually appreciate as stock investors bail out and head for safety.

A cash cushion allows a retired investor to ignore stock losses nearly altogether since she can always draw on that cushion for income rather than stock holdings.

Therein lies the second and, perhaps, more critical practice of having a cash-like holding in the portfolio once I’m within five years of leaving full-time employment.

Investment advice is replete with examples of big-name investors who maintain substantial cash reserves. Warren Buffet is one; I’ve read accounts of his holding cash above 30% of Berkshire Hathaway’s assets. Berkshire’s assets aren’t a retirement portfolio, but the principle is the same. Whether the money is in reserve for investment opportunities after a market tumble or is held for income, having it on-hand means never being caught short.

As an example, I rebalanced my retirement portfolio to a much lower stock allocation when market indices, such as the S&P 500, recently came back to near-even for 2020. In the process, I moved a minor portion of the assets into a short-term US Treasury bond fund, which, due to its duration, acts much like a money market fund. By my post-retirement calculations, it now holds about two years-worth of needed investment income. I’ll carry that allocation into retirement in a few years.

Should the market stall and decline in my last year of work, I can keep my exit date. Should the market decline in the following few years, it’s safe to continue drawing from my portfolio. I have only to switch the source from stocks to cash-like funds in either case.

There are significant inherent risks to relying on the public markets rather than a pension for retirement income. Those risks can be effectively managed with a bit of reading and careful thought, or a relationship with an investment advisor. The resulting peace of mind is also a valuable asset.

I’ve made a few investment mistakes in my life that were only revealed when the market took a tumble. It’s arguably time to look back and assess what effect past lessons learned had this time around—arguable because I don’t believe we’re near the end of the current market turmoil.

Our portfolio has always been centered on index funds. Still, I began investing outside my original strategy during the dot-com boom. The old saying about everyone being a genius in a bull market is correct. It was hard not to do well in the nineties, but the real test of investment wisdom came when the bottom fell out.

All at once, institutional investors figured out that companies with no bottom line didn’t make for suitable long-term investments. They bailed out of these stocks, and amateur stock-pickers got slaughtered. I learned then about the value of broad diversification; some equity sectors did better than others, and bonds held value or appreciated as investors fled to safety and stability.

These individual stocks were a minority of our portfolio, but the losses were painful. We moved what remained of our tech stock holdings into a couple of managed equity funds and left stock-picking behind.

Eight years later, the realization of what was about to happen led me to mild panic and a rebalancing out of the bulk of our equity holdings, just before the housing bust occurred. The conventional wisdom holds that timing the market is a losing proposition. I was lucky to get out when I did, but even more lucky getting back in at nearly the right time. Even so, I missed the first 30% of the recovery.

I easily could have waited out the recovery on the sideline, though, unwilling to re-take the risk that I’d successfully unloaded. How much wealth gain would I have missed then? That’s the trouble with timing—it’s a two-step process, and you have to get them both right. Luck shouldn’t be a deciding factor in successful investing.

I learned that jumping out too early or getting back in too late could have undone the good work of a well-diversified portfolio. I realized that I’m in the market for a reason and that I set an allocation for a reason. Either those reasons are valid, and I should stick with my strategy, or they’re invalid, and I should try something else. Jumping back and forth only adds risk.

I incorporated what I learned each time, so when the recent sharp decline hit, I remained convinced we’d keep the portfolio intact, come what may. I kept a fairly aggressive 75%-stock allocation in place until just this past week.

We suffered a decline over the last quarter, but nowhere near the drop in the broader market. Our diversified bond buffer worked as intended.

I’ve been in the habit of periodically rebalancing our portfolio to the allocations I’d set for it as it drifts out-of-balance over time. I stepped up that practice to once per month as market values eroded, essentially buying into now-cheaper equity shares with bond shares that were holding their value. Doing so helped, but not to a great extent. This was a very short period to test rebalancing theory, so I’ll continue the practice regardless.

So what did I learn throughout this turmoil? Nothing is exciting about holding investments that don’t move much when the stock market is on an upward tear. Still, they pay their way by reducing portfolio volatility and providing resources to purchase beaten-down shares when the market comes tumbling down. There’s always a tumble looming. The jury is still out on increased rebalancing.

In short, staying the course has profited me. The V-shaped bounce back up in equity prices helped exemplify all of this quicker than I expected—most recessions take longer for the markets to clear. This one is unusual in our lifetimes. Lately, most significant declines are so.

The Future

If I knew what the next year or so holds for the pandemic, or the stock market, or life in general, I wouldn’t be writing about it. It’s the uncertainty that’s intriguing. A few things seem clear, and I’ll prognosticate beyond.

Some US states are showing a sharp uptick in COVID-19 cases since the grand re-opening. It’s almost as if the virus is making us all suckers. This raises the specter of a re-closing before the fall flu season.

The travel, hospitality, and restaurant industries are all going to suffer significant job losses soon, regardless. Many re-opened businesses will not survive. Restaurants only succeed with packed houses. Ditto bars. Airlines make money only when their seats are near-full. Hotels are much the same. Many of these businesses report low demand. How many will remain past the fall of 2021? Fewer, I think.

I believe we’ll see a significant re-testing of the lows in the US stock market as a result, so I’ve recently re-allocated our portfolio to 50%-stock. That’s relatively conservative for me, but I feel a more defensive posture is the right way to face what comes next.

I’ll continue rebalancing monthly, regardless. That practice has proven its worth. Some caveats to that are the cost of rebalancing—trading commissions and fees, and mutual fund restrictions on frequent trading.

When the day comes that we have a COVID-19 vaccine, I’ll go back to a higher stock allocation. Recall that the past decade’s run-up was predicated on Fed intervention in the markets after the housing bust. The same type of response, only much higher in degree, is going on right now. Imagine how that will spur the market down the road.

In Parting

Nothing I write should drive your investment decisions. This is an effort to organize my thoughts and consider next steps. Do your own homework. Investing can be a rewarding duty, but only through education and discipline. If that’s not your cup of tea, finding a professional investment advisor is a smart move.

Markets declined at a historic pace last month. Did you look at the rapid decline in your investments—your means of retirement subsistence—and feel a flutter of panic? Confidence and contentment are natural when markets are advancing; not so much as paper losses mount.

Financial experts tell us to remain calm and stay the course when that happens. The arrangements we’ve made, they say, are as prudent and useful in bad times as good. Splitting up investments across multiple asset classes, company sizes, and tax efficiencies is a smart practice. As has been noted elsewhere, a broad allocation can feel like running uphill with a weighted vest on, but it sure feels good in a downhill slide.

Still, we are, in the quiet of our thoughts, alone and prone to second-guessing the choices we’ve made, or might fail to make. What if the markets, having surged back this far, are about to take another significant fall? Should I step off the roller coaster here, closer to the peak?

At the same time, doing nothing feels like a choice, too, and not a particularly good one. I’m a smart investor—or a lucky one, at least—I should be doing something now.

Such thoughts have been the downfall of many investors. Those exiting their investments after declines and remaining out for fear of losing more lock in their losses as markets move higher.

I could rest easy if I invested in a target-date fund whose primary feature is set-it-and-forget-it. Professional management keeps the fund’s internal allocation appropriately balanced for the target retirement date regardless of market conditions. I have only to restrain myself from bolting the market altogether.

I have more on my mind if, on the other hand, I’ve decided to self-allocate my investments across asset classes.

Here’s a handy bit of make-work to occupy myself with something beneficial while markets remain in turmoil: Rebalancing my allocation back to what I’d previously set. If I’m not in the habit of periodically doing this, now’s a great time to begin.

If I had set, say, a 75-percent stock, 25-percent bond allocation, and further, split the stock assets evenly between large-cap and mid/small-cap, and split my bonds between the Aggregate index and a junk bond fund, that allocation is all over the place today. Stocks are down but large-caps not so much. Bonds fell at the outset of the plunge, but investment-grade issues have rebounded. The various valuations probably don’t reflect the care I once took.

Here’s where a spreadsheet or an investment company’s allocation tool comes in handy. My 25-percent bond allocation could amount to well over 30% of my portfolio today. I’ll take a look at my allocation values using current balances and shuffle money back and forth to bring each back in line. And I’ll have purchased additional stock fund shares at discount prices that’ll appreciate well as markets recover.

This activity isn’t only make-work, however. As has been noted elsewhere, periodic rebalancing leads to better overall investment performance. My frequency of rebalancing is mostly a function of how much attention I’m willing to give it and how much it’ll cost to execute the trades. Sales within a tax-advantaged retirement account are, of course, without capital gains taxation, so causing taxable events isn’t a consideration. Investment companies generally don’t charge for transfers among funds, though they may restrict re-investment after transferring out of some of them. Many brokers are charging nothing for trading now, so even rebalancing among individual stock shares might be without cost.

Take a quiet afternoon to look through the links above and research how your investment company handles asset transfers. You might be surprised at how easy and cost-free the practice of rebalancing is, and how satisfied having done something beneficial for your financial prospects leaves you.

#retirementInvesting #rebalancing #markets #stocks #bonds

A friend who stood to collect a windfall of money asked me what I thought of using it to pay off his mortgage. His other option, investing the proceeds for growth or income, were on the table, as well. What to do?

Equity markets are in a turmoil these days as they lose both supply and consumer demand to the COVID-19 outbreak, but for this question I want to consider more normal times. We’ll get back to there, someday.

I’ll use my own circumstance to run the numbers, so assume a $216,000 remaining balance on a mortgage financed at 4% fixed, with twenty-eight years remaining on a 30-year note. The monthly payment amortizes to about $1122 net of tax and insurance expenses.

Assume, too, that our retirement investing is already taken care of. If it weren’t, the right move would be to put the windfall to work there.

In exchange for paying off the mortgage, we can keep the $1122 I’d otherwise hand to my lender every month, or $13,464 annually. That’s 6.23% of the outstanding balance. The money has already been taxed when I earned it, and I’m assured of keeping that payment in-hand as long as I own this house. That makes the virtual dividend both tax-free and guaranteed.

This option carries significant intangible benefits, as well. There’s the peace of mind that comes from knowing that we have a place to live for not much outlay—taxes, insurance, utilities, and upkeep—no matter what.

We could invest the money in the financial markets, instead. Since the money isn’t destined for our retirement accounts, growth isn’t absolutely necessary. Increased current income would also be a welcome outcome. Stocks and bonds, respectively, fit the bill. I’m partial to mutual funds and ETFs rather than direct stock and bond purchase, so I’ll draw my comparisons from them.

We’ll have a more significant opportunity for gain if we decide to invest in equity funds. The US stock market returns roughly 8% annually over the long term. More narrowly focused funds and ETFs perform better than that, so let’s be generous and assume an overall annual gain of 10%. Over the course of a reasonably smooth decade such as the one just finished, we could see our principle rise by $344,000 to over $560,000.

But that gain is taxable. Our current long-term capital gain tax is 15%, or about $52,000 of that gain, yielding a net gain of around $292,000. And although there are no historical ten-year spans when equities returned negative results, this return is by no means guaranteed. Throughout the decade this money is invested, it’s out of reach and there’s still a monthly mortgage payment to be made. Still, a potential six-figure gain is enticing.

Finally, we could invest the money for current income. Recall that the mortgage payoff yields a virtual income gain of roughly 6.25% on $216,000, tax-free. The equivalent taxable yield for taxpayers in the 22% tax bracket is an astounding 7.99%! Any income-producing investment would have to beat that.

The closest we can come is with high-yield bonds, bond funds, and ETFs. For example, the Vanguard HY fund’s (VWEAX) dividends are paying about 5.25% annualized right now, taxable. Bond fund dividends are generally reliable, but not guaranteed.

So: pay off the mortgage and reap a 6.25% guaranteed, tax-free virtual dividend plus peace of mind; shepherd an investment in equities for a decade—on top of any retirement investments I’m already holding for long-term gains—and hope the market adds to my wealth; or sink the money into, say, high-yield bonds for an income of around 5.25% taxable.

It it were my money, I’d pay off the mortgage.

#mortgage #payoff #choices

Ben Carlson–A Wealth of Common Sense:

I get the idea behind being against inflation. Why would people want to see prices rise over time? Wouldn’t people benefit from lower or stable prices? 

In theory, this seems rational but theory rarely works in the real world. In the real world, the economy operates based on expectations. And, right or wrong, inflation and deflation bring about a very different set of expectations about the future, which can subsequently impact the present.

Carlson’s lucid answer to an elemental question in personal finance and investing; better a little of the bad than a lot of the worse. Think of the Fed’s 2% core inflation target as a buffer between affordability and disaster.

#investing #personalFinance #inflation