Scare-Testing Your Risk Tolerance on Halloween

jackoIt’s Halloween as I finishing writing this, and soon little ghosts and ghouls will be lining up to score treats from my great-aunt. She’s lived through some amazing times. It’s really hard to predict how you will handle a scary situation until you are actually faced with it. The fear, the uncertainly, the doubt. Sometimes the best you can do is try to scare yourself and imagine your response.

Scary stories. Instead of a horror flick, I read all 240+ posts from an October 2008 Bogleheads thread where a 75-year-old retiree discussed whether or not to cash out some of his portfolio. What happened October 1st to October 8, 2008? The S&P 500 went down 25%. In a week.

sp500_0810

Even if you managed to keep it together then, March 2009 rolled around and you found yourself down over 55% from a little more than a year ago.

sp500_0903b

Scary news articles. On Google Finance, if you look back at historical quotes, they will adjust the “News” box to include articles from that time period. Here’s a few I picked out:

Scary numbers. Here are historical S&P 500 drawdowns from user BlueEars.

1973 down 38% in 21 months (understated because of inflation)
1980 down 27% in 13 months
1990 down 19% in 3 months
2000 down 49% in 31 months (growth bubble, SP500 loaded with it)
2007 down 42% in 12 months to date

Lessons?

  • Know your own tendencies. We did live through 2008/2009, but it felt like a different time. We were barely 30 years old and both employed. We “lost” a six-figure balance but we didn’t need it immediately. We did not sell any stocks and kept up all our automated 401k and IRA contributions. The hardest part was rebalancing, because that required action. Lesson: I tend to freeze and do nothing.
  • Everyone is different. One poster had 33% cash, 33% bonds, 33% stocks and was still in a panic. Others wanted to increase their stock holdings to 90% or higher. Some bought in after the first major drop but then got nervous when it kept dropping.
  • Stocks can drop 50% very quickly. Whatever you have in stocks, imagine it cut in half. Are you okay with that? Are you sure? I think I would be more nervous today given our much larger portfolio size. Therefore, our current asset allocation is more conservative (66% stocks/34% bonds).
  • Cash helps keep you calm. If you don’t need the money for a long time, it’s easier to be detached. However, retirees tend to view investment loses in terms of “years of expenses”. If you usually take out $50,000 a year to cover spending, and then your portfolio drops by $500,000, that’s an entire decade of spending “lost”. Knowing that you already have at least 3-5 years of withdrawals in a safe money bucket can help.

If you are willing to read something longer, I recommend The Great Depression: A Diary. 2008/2009 was bad, but things could have been much worse. It’s easy to not appreciate safe assets when things are going well.

Comments

  1. Thanks Jonathan for giving all of us a reality check. Just curious how far you are from retirement? I am in retirement and still at 70% equities and 30% bonds.

    • That’s a good question. Our portfolio is big enough that we can cover all expected household expenses at 3% withdrawal rate. However, we are currently still working half-time. I think I will still be earning some sort of income over the next 5 years, but definitely less than annual expenses, so we will be living partially off portfolio within 5 years. I consider 2/3rd stocks and 1/3rd bonds as my long-term portfolio.

      • Hi Jonathan, regarding the benefit of cash reserves, at a 3-4% withdrawal rate, 3-5 years of cash would be 9-20% of a portfolio—nothing to sneeze at! Do you take this into account with your “2/3 – 1/3” portfolio? Also, what would be the strategy of when to actually use the cash reserves and then replenish? From the research I’ve done, years in cash might be a good psychological comfort trick but the constant drag on the portfolio returns and then the timing games to actually use it make you fall behind compared to having much less cash. How would you approach that issue? Cheers!

        • That’s a good question. I was more thinking of a CD ladder and not “cash”. So right now you could be opening a FDIC-insured 5-year CD at 2.80% APY if at top bank. Your blended rate should be 2% or so right now. Alternatively, I would say a short-term Treasury bond fund would be effectively similar. Or short-term TIPS. That should keep up with inflation (barely) and I’d be okay putting 10% of total portfolio into that.

  2. note: I am an amateur and just deciding between 100% equity ETF or 70% equity ETF and 30% bond ETF.

    Are bonds still a counter point to stock? These days they seem to move in the same direction (positive beta), but bonds with less volatility. So is a 70/30 mix intended to reduce volatility? Wouldn’t an whole market ETF reduce volatility on its own?

    I have yet to see an asset class that moves counter to stocks (up when stocks are down and vice-versa; beta= -1).

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