Looking at the current economic conditions, for a while it’s been our opinion that we are in a late-cycle economy. Economic reports are generally good, but growth is slowing. For those whose retirement is 15, 20 or 25 years away, this generally doesn’t pose a problem. However, for those whose retirement is five years away, it can be rather intimidating.
Commonly, you don’t want to be in a position where you are selling stocks to cover liquidity needs when the market is falling. This is why we advocate using the Ten Year Rule. Any money needed to cover spending needs in the next 10 years is invested in fixed-income instruments and money with a longer time horizon is invested in stocks for growth. While it sounds simple, the reality is that the plan is highly customizable to your specific financial situation.
Let’s look at the couple who will be retiring in five years. First, we consider all of their retirement income sources like Social Security, annuities, pensions, rental income, etc. Then we look at their desired after-tax spending. Any shortfall is their liquidity need. If this couple is retiring in 2024, this liquidity need was determined and planned for in 2014. Fixed-income securities were purchased with a maturity date that matched 2024. So regardless of what the market does in 2024, this couple has their spending needs covered.
This year, 2019, we would be helping this couple plan for their 2029 spending. If the market were to tumble, we would have the option to postpone selling because the actual need is 10 years out. Recessions average about 22 months in duration. So, if 2019-2020 were down years, we could wait until 2022-2023 before selling stock investments for 2029, hopefully selling at recovered prices.
For money not needed in the next 10 years, we recommend keeping it invested in the stock market. Wait—if we’re headed into a bear market, which is a loss of 20%, why would you want to stay in the stock market? The answer is because timing the market can be very difficult. If you sold and went to cash, you would lose purchasing power to inflation. You’d also need to know the precise moment to get back into the market to capture the gains from the very bottom. That “bottom” isn’t often known until several months later when the economic outlook changes, and by then, you’ve likely missed out on a good bit of growth.
You can, however, position your investment portfolio more defensively to reduce the effect of volatility. During down markets, you may consider increasing your exposure or even overweighting in Utilities as people will generally pay to keep the lights on and the heat and air conditioning running; Consumer Staples, because families will continue to buy toilet paper, soap, and food, and Healthcare, because people will continue to see the doctor when they are sick. These are sectors that are less discretionary when it comes to consumer spending. Likewise, you may consider cutting back on Industrials since building and manufacturing may slow down, and Financials since lower interest rates make it hard for banks to be profitable. Finally, you may also consider more high-quality dividend-paying stocks.
While you may likely still lose money in your investments in a downturn, the allocation toward defensive stocks may help you lose less. While no one likes a bear market, a downturn shouldn’t be something to fear. If you “can’t afford” a downturn, you may need to re-evaluate your risk tolerances and asset allocation.
If you have questions regarding your investment allocation, the experts at Henssler Financial will be glad to help: