Although much has been written about saving and investing for retirement (i.e., accumulation), there is comparatively little written about portfolio management in retirement (i.e., decumulation mode, aka after becoming financially independent). Different considerations, however, come into play when you start to live off of your FIDough. In particular, when you are saving and investing (i.e., accumulating assets), you should view market downturns as opportunity. When stocks tanked in 2008, for example, you could suddenly buy significantly more shares of your favorite index funds for the same dollar invested. A great opportunity to buy stocks on “sale” and put your bones to work during the ruff spots.
But when you stop saving and start living off of your nest egg, the math is reversed and even a dog can do that math. Ideally you only want to spend from the equity portion of your portfolio during market highs, not lows. Indeed, if the market declines 50%, you must withdraw twice as many shares to obtain the same amount of money. Over time, withdrawing from the volatile portions of your portfolio during downturns could spell trouble for your FIDough.
Fortunately, there are some strategies that you can implement to help minimize the probability that you will need to sell your volatile assets during lows. In what follows, I provide a high-level overview of four such strategies.
Perhaps the most popular method for avoiding depleting equities or other volatile assets during market downturns involves using a so-called “bucket strategy.” Highly regarded financial planner Harold Evansky initially developed the strategy, which essentially uses a mental model by which to conceptualize one’s portfolio in a manner that makes market volatility more palatable. In a nutshell, the strategy typically involves three “buckets” for your portfolio. Bucket 1 consists of a cash component with one to two years’ worth of living expenses. Bucket 2 consists of intermediate-term component (typically intermediate term bonds and sometimes balanced funds) designed to cover five or more years’ worth of living expenses. Bucket 3 consists of long-term, more volatile growth products (typically equities, REITs, and higher-risk bond types). This third bucket provides the growth engine necessary to sustain those planning for a long retirement. When Bucket 3 does well (and market are up), you use it to replenish buckets 1 and 2. But when the market tanks (as in 2008), you have bucket 1 to keep you going, and bucket 2 as a backup. (You could also rebalance from Bucket 2 into Bucket 3 after a downturn.) The important thing about the strategy, however, is it provides a means to avoid spending equities and other volatile assets during market downturns. In other words, you can take a breather from drawing down on asset classes that have lost their value until after they recover. There are, of course, many variations on how to manage bucket maintenance, but the key is to have different buckets mapped to different time frames so that income needs are met over time and the portfolio is managed so as not to be depleted during market downturns. Interestingly, financial guru Michael Kitces has noted that a bucket strategy portfolio does not substantively differ from a more traditional retirement portfolio using a systematic withdrawal approach. However, because of the conceptual model that accompanies the bucket strategy—using different “buckets” for different time frames—the bucket strategy has a behavioral finance advantage over traditional strategies. In other words, it actually works better in the real world. FIDough Favorite Morningstar has some great free resources on the bucket strategy, including an article that provides an overview of the strategy, and an article with links to model portfolios for the strategy. Jane Bryant Quinn’s excellent book How to Make Your Money Last also has an excellent explanation of the strategy and details how to put it into action.
Another strategy to help avoid portfolio drawdowns during retirement involves using a zero-cost options collar or a “retirement collar.” This strategy requires owning, as part of the equity portion of your portfolio, one or more equity assets with a robust options market (such as a popular ETF). An options collar is then put around the equity by selling a covered call on the ETF with a strike price that is slightly higher than the current market price of the equity (e.g., 6.6%), and then using the proceeds from the covered call sell to buy a put with a strike price that is lower than the equity’s current price (e.g., 5%). If the equity then exceeds the strike price during the option period (typically three months), the strategy means enjoying the gain up to the call strike price (e.g., a 6.6% gain). It also, however, means missing out on any additional gains. So if the market has a terrific run up while the collar is in place, one may be disappointed. If, however, the equity tanks with the collar in place, the strategy limits losses to the put strike price during the option period (e.g., 5%). Some research suggests that this strategy reduces the likelihood of “retirement ruin,” i.e., running out of money during retirement, particularly if used during the early years of retirement when retirees face greater sequence of return risk (i.e., having to spend from a portfolio after a market downturn that occurs immediately after a person retires). The strategy is obviously not for beginners, and having a professional assist with it may be well worth it. There are many things to know about trading options that are beyond the scope of this overview. The strategy is described in more detail in Chapter 10 of Retirement Income Redesigned.
Mechanical Trend-Following Systems
A third risk-management strategy – mechanical trend following – involves using momentum indicators (typically moving averages) to systematically move into and out of the markets based on signals generated by the indicators. These strategies get called different things, including tactical asset allocation (which also has other meanings), optimal momentum, dual momentum, and more. I know what many of you are now thinking. “Interesting, but this sounds like market timing. I thought Mr. FIDough seemed reasonable, but everyone knows market timing doesn’t work, and is at best a form of voodoo.” I too have always been skeptical of market timing systems (particularly charts), so bear with me as I provide an overview of this risk-management strategy. You can then decide for yourself if you want to learn more about it. Mechanical trend following systems use moving averages to generate buy and sell signals for asset classes, including stocks, bonds, gold, and REITs. To avoid too much trading, some systems only check the signal periodically (once a month for example). So, for example, if on the last trading day of the month the large-cap US stock ETF portion of your portfolio is below its 200 day moving average, you would sell that asset class. When, on the last trading day of the month. the price moves above the 200 day moving average, you would once again buy that asset class. Because this system involves more trading than a buy and hold strategy, it is better suited for tax favored accounts. There has been much written about these systems, and it turns out some very good investors use them (for at least a portion of their portfolios). FIDough Favorite Paul Merriman, for example, uses such a system for roughly half of his portfolio (the other half largely being a traditional buy and hold strategy). As Merriman has explained, these systems do in fact reduce risk. They also can do as well as a buy and hold strategies, but with less draw downs. They thus provide those in retirement a solid strategy to avoid selling equities during periods of downturns. Many people, however, have difficulty following them. That’s because in the real world whipsaws occur, i.e., sometimes you must sell an asset class to only have to buy it back later at a higher price, or buy it to only then promptly sell it at a lower price. Many times, one would be better off not trading. People do not like this. Thus unlike the bucket strategy, the behavioral finance aspect of the strategy is not very good and is one reason why combining this strategy with others may make sense. So, if you have already proven to yourself that you do not buy and sell based on emotion and are confident you have the psychological make up to use such a strategy, it may be worth learning more about. As noted above, these systems reduce risk and minimize draw downs, which for retirees is a real plus. A very good book on mechanical trend following, which also uses trend for asset selection, is Gary Antonacci’s Dual Momentum. There are also several websites devoted to mechanical trend following systems, including Optimal Momentum, Meb Faber Research, Advisor Perspectives, and Asset Class Trading. Paul Merriman also has a podcast on the topic “The Best Market Strategy I Know,” and several articles, including one called “Why Market Timing Doesn’t Work” (where he explained that it does, but not for most people). Lastly, a very good blog that goes into these strategies in detail is Paul Novell’s Investing for a Living. You will have to go back through his TAA Investing category, but he has done some very interesting analysis on these strategies (and others). He also published a monthly spreadsheet showing the momentum rankings of a variety of ETFs for different asset classes, and showing whether the buy or sell signal has been triggered.
Varying Risk Based on Investment Conditions
A fourth risk-management strategy involves using a combination of market and other conditions as signals to increase or reduce the portfolio percentage invested in higher volatility assets (such as equities and REITs). The basic idea is to reduce risk when factors such as the purchaser manager’s index (PMI index) – a good predictor of recessions – start to turn south. FIDough Favorite J.D. Stein (see my review of his podcast here) follows this strategy, and publishes a monthly investment conditions report on his premium service Money For the Rest of Us Hub. His report looks at three factors (1) market valuations, (2) economic and central bank trends (including the historically reliable purchasing managers’ indices), and (3) what he calls market internals (e.g., momentum like that used in trend following systems and sentiment). Treating each factor as a “stoplight” that is signaling stop, caution, or go, he then gives a score to each factor which translates into red, yellow, and green. He also provides a similar combined overall score and red, yellow, or green signal. His goal is to objectively use these factors to assess the risk of pending bad times in terms of market losses and higher volatility. Although I have not seen how his system has performed over long periods of time, his site explains that all three factors went red in early 2008 – a signal to exercise extreme caution and a more conservative investment approach. All three factors then went green in late 2009 – a signal to increase portfolio risk.
Summing it up
While you are still working, saving, and Raising FIDough, investing is comparatively straightforward. A simple buy and hold approach works great because you are buying more equities and other riskier assets when markets tank and stocks go on sale. When you start drawing from your portfolio to cover some or all of your income needs, the math changes and managing risk become more important. The above four strategies provide a means of helping to ensure that your FIDough lasts. Moreover, these strategies are not mutually exclusive. One could, for example, could use a mechanical trend following system for a portion of the assets in the third longer-term bucket. One could also generally follow a bucket approach, but weigh the buckets differently depending on investing conditions. There are myriad combinations suitable for investors with different levels of psychological fortitude, time, and interest. So if one or more of these strategies looks appealing to you, learn more about it through the above resources and others. As always, do your own homework before investing. Have fun managing FIDough!
As always, nothing in this post should be considered investment advice. For real advice, consult a professional not a dog.