This leads to the obvious follow up question: How do I properly allocate my portfolio to limit this risk?
In a Fidelity study of each bear market since 1926, the average decline, from peak to trough, lasted 22 months.[i] In major downturns (like 2000-2002 and 2008-2009), the market took ~5 years to go from peak to trough and finally back to the prior peak (a “full recovery”).[ii] Generally, the best equity returns come in the period immediately following the trough.[iii]
We incorporate this data in our clients’ asset allocation strategies, with the objectives to (1) limit selling equities during a downturn (i.e., peak to trough), and (2) limit selling equities during the subsequent recovery period (i.e., trough to (hopeful) peak).
Researcher Michael Kitces examined this issue in a recent study.[iv] Kitces found that equity exposure should be reduced, and exposure to fixed income increased, in the years immediately before and after projected retirement. As a retiree ages, the equity allocation can be increased by spending down the fixed income portion of the portfolio (if risk tolerance allows). This research goes against the traditional asset allocation rules in which a portfolio’s allocation should become more conservative with age. Our portfolio construction philosophy parallels Kitces’ research.
Consider a client nearing retirement with a portfolio value of $5,000,000 and an annual portfolio distribution requirement of $250,000, adjusted for inflation.
We can account for future spending by allocating 6-8 years of distribution requirements, or ~30% - 40% of the portfolio value, in fixed income ($1.50 - $2.0 million). In many historical bear market periods, this timeframe would have allowed for full recovery without the need to liquidate equity positions. The future is unknown, but we view this reallocation process as prudent for those clients around retirement age.
Circling back to Kitces’ research. He terms this reallocation a “bond tent” – increasing bond exposure for the years immediately before and after retirement, then reducing bond exposure with time.
While there is no way to eliminate the effects of market volatility in retirement, stress testing the portfolio to limit sequence of return risk in retirement is an exercise we review with all clients.
If you have any further questions or would like to schedule a time to review your portfolio, please contact our office.
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