On January 1st we conducted our Annual Financial Review for our retirement portfolio.
I’m smiling.
Since I retired in June 2018, the S&P 500 has had a nominal annualized return (including dividends) of 14.62%! On an inflation-adjusted basis, it’s 10.73%. Our retirement appears to be solid, and our net worth is ahead of our projections.
Even with the smile, however, there’s always fear lurking around the corner:
Market revert to the mean over time.
After years of above-average returns, the future will involve some corrections.
Bear markets are unavoidable, and we’ll likely face one in the next few years.
What if inflation continues to be a problem, increasing our spending?
As if reading my mind, Goldman Sachs recently made a bearish forecast that raised many eyebrows. As quoted in this article on Investopedia, GS is projecting:
“The S&P 500 will return just 3% a year for the next decade and 1% after adjusting for inflation.”
Scary stuff, indeed. Sure, it’s just another bank’s useless forecast, but what if they’re right? What if stocks only return 3% over the next decade? To further strengthen the point, it’s worth mentioning that Vanguard came out in December with a similar forecast, projecting a growth of 3-5% for US Equities over the next decade.
As early retirees, what should we do about it? Are there steps we should be taking, regardless of market conditions, which improve the odds of our money lasting longer than we do?
Today, I share my thoughts on “What if stocks only rise 3%?”…
What if stocks only return 3% over the next decade? As retirees, what should we do to prepare? Share on X
For the record, I suspect Goldman Sachs and Vanguard are probably right. The surprising thing is, I’m not too worried about it.
They may be off by a percentage or two, but after the run we’ve had it’s realistic to expect future returns will be low. Reversion to the mean is legitimate, and we’d be naive to think the market will continue to return 15% for the next 6 years of our retirement.
A long stretch of low returns certainly wouldn’t be unprecedented.
The S&P 500 had a negative return of -0.72% during “The Lost Decade” of 2000 – 2009.
I got that number from this handy calculator. I suspect many of you have already forgotten that decade, right? Looking at my favorite chart during the same timeframe (thanks, Ben Carlson), you won’t find “Large Cap” in any of the top 3 spots over the entire decade (in fact, you’ll only find it above the #6 spot once in the entire decade):
We’re all susceptible to “Recency Bias”, a risk distortion due to a focus on recent performance. Using that same calculator, we can see that the S&P 500 has returned 13.56% from 2015 – 2024, and Large Cap dominates the top segments of the related asset return table (thanks again, Ben Carlson, for updating your great charts!):
What a difference a decade makes, right?
So, let’s assume GS is right. Let’s ask ourselves, “What if stocks only rise 3%?” In effect, we’re saying that the 2000 – 2009 chart is more reflective of our future than the 2015 – 2024 chart.
Seems reasonable to me. I’m not all doom and gloom, I’m just a realist.
Nothing goes up forever. (Likewise, nothing stays down forever – remember that in the next bear market)
If you think a bit longer about reversion to the mean, it’s not all bad. Sure, it means the S&P 500 likely has some downside as it resets after a decade of outperformance. It also means that those asset classes with sub-par performance are due for their time in the sun.
If only we could see the future, this portfolio management stuff would be a lot easier.
So….what to do?
Here are 5 things I’d encourage you to think about:
5 Things To Always Remember (Especially Now)
None of us know the future, and we never will. Regardless, we should always keep 5 principles of personal finance in mind. These are sound principles, regardless of what’s happening in the market. They’re particularly relevant now, with several years of above-average returns in the market.
1. The Power of Asset Diversification
As we prepare our portfolios for retirement, we must diversify our assets to mitigate our risk. If you’re depending on your portfolio to fund your spending, what are you going to do when the next bear market hits? If you’re too heavily invested in stocks, you could be forced to sell stocks after a downturn, which exposes you to a sequence of return risk.
It’s critical to diversify your assets among a broader class of assets, including cash, bonds, and alternative assets (REITS, commodities, etc). A common asset allocation for retirees is 60% stocks / 40% Bonds & Cash, though your asset allocation should be determined based on your specific needs and risk tolerance. For further detail, read 10 Steps To Prepare Your Finances For Retirement. As part of our annual financial review, we update our Asset Allocation, and you should, too. It’s an important element in managing your portfolio and a critical waypoint on your retirement map.
One way to think about your asset allocation is to consider the “Time Segmentation” approach, where you place assets in various classes based on when you’ll need to withdraw the funds. I discuss this in detail in my Bucket Strategy Series. For example:
Cash: To cover the next 1-3 years of spending
Bonds: To cover years 4-7
Stocks: To cover spending beyond 7 years
This oversimplified example can be complemented with smaller holdings in “Alternative” assets, such as Real Estate (REITS) and commodities. If stocks decline, you can draw down your cash or other asset classes (based on relative performance), mitigating your sequence of return risk.
Looking back at that table of returns from 2000 – 2009, a diversified approach would have given you some exposure in the asset classes that performed well during that timeframe (REITS, International Stocks, and Bonds), which could have been sold to fund your retirement expenses.
A final point about the bonds used in Bucket 2. As I wrote in How To Build A Bond Ladder, I’ve been restructuring some of my bond holdings into a bond ladder, eliminating the interest rate risk that bond mutual funds are exposed to. We currently hold ~50% of our annual income needs in bonds with known maturities through 2030 (with one rung as far out as 2033), which reduces my anxiety about a below-average stock market over the next 8 years. Some of the “rungs” in the ladder are held in TIPS, (2028 iShares IBIE fund) which also reduces our inflation risk. This will allow us to draw down the cash in Bucket 1 as we approach bond maturities, knowing exactly how much (and when) our “replenishment” cash will be available from the bonds. If stocks continue to do well, we can easily “roll” the bond rungs out to future years and use stock sales for our cash replenishment.
Options are good, and diversification is how you create them.
2. Beware Home Market Bias
We are all at risk of having a home bias, which works against our goals of maintaining a diversified portfolio. As this article states “U.S. equities represent about 60% of the global market…but Americans invest 85% of their portfolios in domestic equities.” Not only should you be diversified among asset classes, but you should be diversified geographically. Many argue that many stocks in the S&P500 are globally diversified, and they’re protected as a result.
I prefer a more intentional approach and maintain specific holdings to meet my diversification goals. For example, I hold ~30% of my stock position in VFSAX (Global Small Value) and VTIAX (Global Large Cap). Holding my international exposure in standalone funds allows me to sell whichever fund outperforms as part of my rebalancing process, which would be difficult if my international exposure was only through an S&P 500 fund.
Yes, international stocks have lagged domestic funds for years, but I’m ok with that. I’ve replenished my cash bucket through sales of the domestic funds (sell the winners) while maintaining my position (and targeted asset allocation percentage) in the international funds. That’s the whole point of a diversified portfolio. If “reversion to the mean” is a valid theory, one could expect international stocks may outperform domestic stocks at some point in the future, at which point I could sell the international funds for cash and maintain my domestic holdings.
As mentioned, Vanguard came out with a forecast consistent with GS, with a 3-5% range for US Equities. What I liked about their article was the inclusion of the following table, which includes their forecast for other asset classes (click on the link to see the entire table, including forecasts for bonds, commodities, and inflation – it was too large to include the entire table below).
Their forecast suggests global returns could outperform domestic equities in the next decade:
Forecasts are worthless, but it is reasonable to assume that international stocks could outperform domestic stocks at some point in the future, and having a fully diversified portfolio provides the opportunity to reap the rewards when and if that happens.
3. The Value of Rebalancing
Having a diversified portfolio is the first step, but you must structure a regular rebalancing routine into your portfolio management process to reap the full benefits of a diversified portfolio. As you’re withdrawing funds from your portfolio to fund retirement spending, it’s essential to “Sell The Winners” to restock your cash needs. Have you sold any of your stocks after the last two years of above-average returns? If not, you’re doing it wrong. Rebalancing sells the winners automatically, as it “forces” you to sell assets when they exceed your targeted allocation %’s, and buy those that are below target.
In How To Manage The Bucket Strategy, I shared the following chart from Michael Kitces which shows the value of regular rebalancing:
As part of our Annual Financial Review, I update our Asset Allocation and compare it to our target allocation. Since we’ve spent down cash over the year, our cash allocation will be below target. To refill it, I look for whatever asset class exceeds its target, and liquidate sufficient funds to refill the cash bucket. This year, for example, I sold some of our S&P 500 holdings and redirected the proceeds to our CapitalOne360 Money Market account. At the same time, I’ll analyze the number of years I have in each “Bucket” and rebalance accordingly.
I’ve noticed an interesting phenomenon since retiring that’s worth noting. This one takes some explaining, so stick with me. Remember my goal is to hold 3 years of cash in Bucket 1 and 4-7 years of bonds in Bucket 2. Everything else is Bucket 3, which we’ll call equities for simplicity. When the market returns more than your SWR, and you maintain a constant value in Buckets 1 and 2, the growth (by default) occurs in Bucket 3 (stocks). If your goal is to maintain 3 years of cash and 5 years of bonds, your asset allocation of stocks gradually increases as your overall portfolio grows. Kitces refers to increased exposure to equities throughout retirement as a rising glide path and states that a “rising equity glide path actually does improve retirement outcomes!” Without being aware of it, my bucket strategy has resulted in exactly this outcome, and I consider it an unexpected bonus of the bucket strategy. My focus is on maintaining (and rebalancing to) the “years of spending” targets in Bucket 1 and 2, and I expect our stock allocation will continue to increase whenever the market exceeds our 3.25% SWR. From a risk perspective, I’m comfortable with the higher asset allocation to stocks since I know I have 8 years of spending covered in the “safer assets” in Buckets 1 and 2.
Interesting, and worth a mention. I welcome your thoughts on the phenomenon in the comments.
4. The Need For A Flexible Spending Plan
What if stocks only rise 3% and we’re withdrawing 4%?
Two points to make:
1) Even if stocks only rise 3%, there’s a chance our other asset classes will deliver more than our Safe Withdrawal Rate, so we may not lose much ground.
2) We’ve built a flexible spending plan into our retirement strategy to mitigate the risk of lower-than-expected returns.
Every year during our annual review, I update our Net Worth and calculate our new Safe Withdrawal Rate boundaries (3%, 3.25%, 3.5%, and 4% of our 12/31 spendable assets). If the entire market tanks, we can increase our SWR from its current level of 3.25% to 4% to offset some of the impact. If the market has declined to the point that it requires a smaller “paycheck” the following year, we’re fine with that.
As we were planning for retirement, we made sure that our spending estimates included some “wants” in addition to “needs.” Worse case, we can forgo some of the “wants” for a few years.
As I mentioned in How Much Can You Safely Spend in Retirement, having a flexible spending plan based on the prior year’s market performance greatly increases the odds that your money will last throughout your retirement. Considering that it’s human nature to cut back when the markets are performing poorly, it seems reasonable that we can reduce spending as a last resort if Goldman Sachs ends up being correct with their forecast.
5. Don’t Panic
I sincerely doubt a forecast from Goldman Sachs will make any of you panic. I can’t say the same about your reaction to a bear market. As the following chart shows, we’ve had two downturns since I retired in 2018:
Both times, the tone of the comments I received on this blog changed dramatically.
Interest in The Bucket Strategy always skyrockets after a downturn. Folks get nervous and worry that the bear market will impact their retirement. It shouldn’t be that way.
As you’re preparing for retirement, you MUST build a plan that will endure market downturns. There WILL be bear markets during your retirement, and we shouldn’t be surprised when they occur. My strategy is to hold 3 years of cash and 4+ years of bonds and includes an allowance to draw those balances down if the market underperforms (to avoid selling stocks after a downturn). I’ve taken it a step further and built a bond ladder to reduce my risk over the next 7 years. I didn’t even blink during the two downturns of my retirement, and I won’t blink at the next one. That’s exactly why I stated earlier:
I suspect Goldman Sachs and Vanguard are probably right. The surprising thing is, I’m not too worried about it.
Here are a few warning signs for you to consider. :
Have you held onto all of your stocks (no rebalancing) over the past 12 months?
Did you get nervous during the market downturns of 2020 and 2022?
Did you question the way you’re funding your spending during those downturns?
If you answer “yes” to any of the questions above, it’s time to revisit your plan. Take action now, while the market is still strong and you have an opportunity to prepare for the next storm. Remember, you should be happy right now – the market has just experienced two of the strongest years in our lifetime. Lock in some of the gains, and prepare for the likely reversion to the mean. It’s all part of the game.
What if stocks only rise 3% over the next decade? Even if GS is wrong, the markets will experience a downturn at some point in the next 10 years. Since 1929, bear markets have occurred on average every 4.8 to 5.7 years and last about 9.6 months. It’s the nature of the beast, and we have to learn to live with it.
The sun has been shining, but there’s rain in the forecast.
Do you have your umbrella ready?
Conclusion
Markets go up, and markets go down.
It’s our job to prepare a strategy that allows us to enjoy our retirement regardless of what the market is doing. While I don’t pay any attention to forecasts, it is a valid question to ask what you’ll do if GS and Vanguard are right.
What if stocks only rise 3%?
For fun, I put the question on my X account and promised to post my favorite response in this article. Congratulations lifeaftersales, you win with the following response. The final two points of your Tweet are great reminders of what matters, though I’d also add Spirituality to the list (I also loved that you touched on knowing how much you spend, being conservative, building a bond ladder, and rebalancing – all topics I touched on in this post. You’re a mind-reader!):
If you’ve done your homework and have a plan in place, your response should be the same as lifeaftersales, which was consistent with what I wrote earlier in this post…
“I’m not too worried about it.”
What about you?
Your Turn: Ok, no bashing forecasts. I consider them useless, but thought the GS forecast was a good jumping-off point to discuss the realities of market volatility, and how we should build our plans accordingly. What are you doing to protect against the next downturn? Let’s chat…
