Build Your Firewall
Having five years of living expenses in liquid assets means you can be totally zen-like about plummeting stock prices.
“Five years is roughly the length of an economic cycle,” says Harold Evensky, a Coral Gables, Florida, financial planner. A five-year reserve isn’t a guarantee, but it greatly increases the likelihood that you’re stocks will have fully recovered by the time you have to sell them. What's more, it gives you an ample cushion to sit out a bear market; the typical bear market bottoms out within 18 months. If indeed early March was the low in this horrific bear market, for example, it lasted almost exactly 19 months.
Take a look at your portfolio. Between the cash reserves you have in your bank or money fund and the safe investments in your 401(k), such as your stable value fund, you may already have much of your firewall in place. That should make you breathe a little easier. Then even if the market heads south, tell yourself: “I’m not going to worry about what’s happening now, because I won’t have to sell my stocks for a long, long time.”
Nitty Gritty
Keep an Emergency Reserve
Evensky recommends building that firewall in two parts, the extremely safe and the very safe.
The extremely safe part should hold two years’ worth of your expenses, divided between a money market fund and a ladder of CDs.
To build a ladder, divide your money equally among five CDs ranging in maturity from one to five years. As each CD matures, reinvest it in another five-year certificate. This ladder will give you a higher overall interest rate than a one-year CD and more flexibility than a five-year CD. If rates rise, well, at least you’ll be reinvesting each maturing CD for a higher return. If they fall, at least you’ve locked in a higher rate on your remaining CDs.
The very safe part should include three years’ worth of expenses in a high-quality short-term bond fund. Such funds have a bit more risk than CDs or money funds, but also a higher yield. Many financial advisers like Vanguard’s Short-Term Investment Grade Bond Fund.
Revisit Your Asset Allocation
Having a solid plan puts you back in control. You’ll feel calmer even when stock prices are sinking.
Whatever asset mix you had a couple of years ago has been totally thrown out of whack by the 2008 market implosion. And in retrospect, you may decide it was too aggressive. Perhaps you want to hold fewer stocks going forward, now that you’re closer to retirement, and you’ve seen what a bear market can do. “It’s never a bad time to do the right thing,” says Ron Rogé, a Bohemia, New York, financial planner.
Bear in mind that “no risk” isn’t a choice, however. Your portfolio must strike a balance between two risks: gut-wrenching bear markets and serious belt-tightening in retirement.
Evensky recommends a 50/50 mix of stocks and bonds for a 59-year-old. If you don’t have that mix today, then gradually and systematically make any changes necessary to get there. Build up the side that’s short with new contributions or monthly transfers over the next six months, not by making wholesales shifts all at once. Trying to do too much at once can be stressful — what if the market tanks the day after you make your move? — and it might trigger capital gains taxes.
And if that panicky feeling bubbles up again, step back from the ledge by reminding yourself: I am following a sensible plan. And I have a firewall to protect me.
Danger! Danger! Danger!
Don’t Get Too Conservative
It’s easy to confuse certainty with safety. When you invest in Treasury bills, for example, you’re certain to get your money back; but after inflation, it may be worth much less.
From 1926 through 2008, T-bills posted a nominal 3.7 percent average annual return. But after inflation, their real average annual return was just 0.68 percent ― and in 35 percent of those years their inflation-adjusted return was negative, according to Morningstar. T-bills’ worst year: a 15 percent real loss in 1946.
Imagine a Worst-Case Scenario
A hypothetical stress test gives you a fix on your real risk tolerance.
A 50/50 mix of stocks and bonds is a good basic allocation for someone in their mid-to-late 50s. But don’t get too hung up on a formula. The most important issue to consider in building a portfolio is how you’ll respond to market swings, says Ross Levin, a Minneapolis financial planner. In other words, how much pain can you take?
So make like a U.S. bank and give yourself a mental stress test. Assume that you get back into the market and have a 50/50 mix that’s $400,000 in stock funds and $400,000 in bond funds. And then assume the Standard & Poor’s 500 index falls another 40 percent. That would temporarily cut the value of your stock funds from $400,000 to $240,000.
Remember, however, that your bonds might hold their value or even rise in a market that was beating up on stocks (as they did while stocks were tanking in 2008). So your $800,000 total portfolio would be down to $640,000, a 20 percent loss. And you’d have your five-year cushion to see you through. If you still think you’d be so scared you’d bail out of stocks at that point, you need a smaller stock allocation.
Or you may find that simply imagining a worst-case scenario—and writing down in a moment of calm how you plan to respond — can help you hold steady if it happens.
What Not to Do
Don’t Try to Time the Market
OK ― so why can’t you just flee stocks when they fall and return after they recover?
It’s a nice fantasy. Unfortunately, it doesn’t work.
Market recoveries tend to be very fast. For example, the low point of the 2000–2002 bear market was immediately followed by one of the biggest four-day rallies in stock market history, recalls Weston Wellington, vice president of Dimensional Fund Advisors in Santa Monica, California. Investors who’d sold and returned only when it was clearly “safe” missed one-third of the gain of the following five-year bull market.
Besides, what could be more nerve-wracking than selling at a huge loss and then agonizing over when to buy again?
Consider Professional Help
As smart as you are, it can still be very helpful to get an expert second opinion.
Talking to a knowledgeable adviser is a good way to make sure your anxiety isn’t distorting your judgment. To be sure, hiring a financial adviser is not like having a personal Warren Buffett on call. Don’t hire one expecting a market genius.
But an experienced adviser does have perspective on the market history and can be a great antidote to the panic you feel when stocks are going down — and the hesitation you feel when they’re rising. A real financial planner’s business isn’t making clients rich, says Evensky. “It’s helping them sleep at night.” And talking them off the ledge.
Other Resources
Find a Qualified Adviser
Limit your search to certified financial planners. A CFP must pass a difficult 10-hour exam, maintain a minimum level of continuing education, and agree to a code of ethics.
While there are many conscientious CFPs who work for commissions, you should at least interview CFPs who make their money only from fees. This reduces the risk that an adviser will be tempted to recommend a product rewarding him more than it does you. Fee-only advisers charge hourly fees, flat fees, or an annual percentage of assets under management.
For lists of CFPs in your area, go to www.fpanet.org, www.napfa.org, and www.cfp.net/search.
To find CFPs who specialize in selling hourly advice on an as-needed basis, go to www.garrettplanningnetwork.com.
For a list of good questions to ask when you interview advisers, go to www.cambridgeadvisors.com.
