Sequence of return risk is now considered one of the greatest risks to a successful retirement, especially those in the early stages of retirement.
Sequence of return is when money is withdrawn as asset values are falling in value. Think of 2000 and 2008 and how virtually all investors sold at losses in those markets. The market will sell off again – that’s what markets do – and this risk will take its toll again. It is devastating to a retirement portfolio that depends on long-term average returns.
If you think you can deal with this by not selling into a falling market, forget about it! The average person, retired or still working, always sells at a loss in sell-offs and corrections. It is one of the few guarantees in the markets.
The only way I have found to effectively deal with the knee-jerk reaction to cut and run is to plan for sell-offs and set up your portfolio to benefit from them.
Hedge your bets.
Considering the fact that we are at all-time highs on stocks, 30-year highs on bonds, and with the antics coming out of the EU and Cyprus adding to the mix, this is something you have to consider.
With stocks it’s a simple fix, a broad-market short ETF. There are many to choose from, just avoid the leveraged or two- and three-times return ETFs. Those are trouble.
Short-market ETFs go up as the market goes down, and can provide upside in a falling stock market to offset your losses just enough to prevent panic-selling.
You can use ETFs to protect your bonds, too, but a two-step process works better.
The first step is to hold only ultra-short maturities – less than seven years. An average maturity of five years or less is recommended. This will significantly limit any downside in a bond correction.
The next step is to stagger the maturities to have at least one bond a year maturing for the next six to eight years. This reduces panic-selling in two ways.
First, it is easier to hold a bond in a rising interest rate market if you only have to do so for two or three years. Holding it for 10, 20, or even 30 years is impossible for most folks, and they sell at a loss.
Second, having money coming out of maturing bonds every year gives you the opportunity to buy into rising rates and falling bond prices. That means buying at bargain prices and higher total returns.
It’s a win-win portfolio. Limit your downside and take advantage of the upside.
If you know you will benefit from falling stock and bond prices, it’s a lot easier to ride out a sell-off. And riding them out is how you make money.
Staggered short maturities and stock market short ETFs. You have to plan on sell-offs if you plan to survive in retirement.