If you have listened to us for any length of time, you should be familiar with our Ten Year Rule, in which we believe any money you will need within the next 10 years should be invested in fixed-income investments held to maturity, while money not needed within 10 years should be invested in growth investments such as individual stocks or mutual funds that invest in stocks. The basis for this rule is to eliminate the need to sell stocks during a depressed market to cover spending needs.
We work with clients to develop detailed cash flow projections to determine when those needs will occur and how much money they should need from their portfolio to cover any gap between money coming in from wages, Social Security benefits, pensions, or other sources and their desired spending level. We then buy fixed-income investments with a maturity date that corresponds to the date we can best determine that our clients will need their money. In a perfect world, we would buy 10-year bonds and hold them to maturity. With our current interest rate environment, we have been keeping maturities short and reinvesting the assets when the bonds come due, hopefully at a higher interest rate. Money that will not be needed within the 10 years should be invested for the long-term, and ideally, have a growth rate that offsets your spending.
Many clients have a valid concern that investing in fixed-income investments would be a guaranteed way to lose principal in terms of purchasing power because of inflation. We don’t disagree; however, we believe that it is better than the potential to lose considerably more because of a market correction in the year you need to withdraw money.
Let’s look at a simplified example: Our investor has a $1,000,000 portfolio divided into two buckets of money: his fixed-income investments set aside for his living expenses for the next 10 years and his money that will not be needed for 10 years, invested in the stock market. We determined he needs $30,000 a year from his investments, so he has $300,000 invested in fixed income. The remainder of his portfolio, $700,000 was invested in stocks. In 2007 when the market was at all-time highs, he was filling his bucket for his spending needs in 2017.
Then the Great Recession of 2008-2009 happened and stocks were down nearly 50%. Because he had 10 years’ worth of liquidity, did not need to sell his stocks to cover spending needs and could have waited until 2018 before needing to sell. His fixed-income investments were invested in high-quality U.S. Treasury bonds and FDIC-insured CDs, which we believe are the least likely to default. Because he followed the Ten Year Rule, we were able to wait until 2013 before selling stocks to refill his fixed-income bucket. The market had recovered, and this investor was able to sell his stocks for a gain.
Over rolling 10-year periods, stocks tend to be higher. At the end of 2016, the Dow Jones Industrial Average was up about 60% from 2006. On our investor’s $700,000 stock portfolio, that equaled about a gain of $420,000. Over that 10 years, inflation was 19.7%, bringing his actual gain to the neighborhood of $270,000—just shy of what he spent from his fixed-income portfolio. Furthermore, this ignores the fact his fixed-income investments were earning interest the entire time. We were able to offset his spending with his growth investments.
Yes, you can lose some purchasing power, but you should see a higher portfolio at end of 10 years—even after living off it. If we can set aside spending needs in fixed-income and use growth to offset spending, that means you can live off your portfolio, nearly without eating into principal. If that is as good as we ever do, we still have successfully navigated our clients through their lifetime.
If you have questions on how to implement the Ten Year Rule in your portfolio, the experts at Henssler Financial will be glad to help: