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By Jason Stipp and Christine Benz | 08-28-2013 03:00 PM

Lessons From Our Bucket Portfolio Stress Tests

Christine Benz's 2000-2012 simulations for bucketed retiree portfolios produced some interesting takeaways on rebalancing, the 4% rule, and more.

Jason Stipp: I'm Jason Stipp for Morningstar. Christine Benz, Morningstar.com's director of personal finance, recently ran a series of enlightening stress tests on so-called retirement bucket portfolios to see how the bucket approach would have fared in a tough early-2000s market environment. She's here to talk about some of the key lessons she learned in running those scenarios.

Thanks for joining me, Christine.

Christine Benz: Jason, it's great to be here.

Stipp: Before we get to some of the takeaways, let's just remind folks and maybe viewers who don't know what is the bucket approach?

Benz: The basic idea, Jason, is that as you are retired you want to carve out a certain amount of liquid dollars that you are going to use to fund near-term living expenses. The idea is that, if stocks and bonds gyrate around, you won't have to tap them maybe when they're at a low ebb, instead you can go to your cash to fund the living expenses. We wanted to see how a bucketed portfolio would have performed over a period of years to see if actually it was a workable strategy over the past, say, five or even 10 years.

Stipp: And certainly that time period gives us plenty of market environments to test for this bucket approach. One of the first takeaways you have is one that was really very severely questioned after the financial crisis, and that was, does buy-and-hold, does diversification really work because it seemed like everything suffered in 2008. And you found diversification does work.

Benz: It did work, as did buy-and-hold. But you needed to add an important component to that approach, and that is rebalancing. Periodically, every year we would look at what had performed best in the portfolio and scale back on the holdings that had performed best and steered at least some of that money to some of the underperforming positions. What we found was that that was a really profitable approach as academics have long suggested.

Almost on a year-by-year basis, when you looked at the things we were scaling back on, they went on to have not such a great year the following year. We saw in action that rebalancing and scaling back on the laggards and steering that money to the winning positions generally worked pretty well for us.

Stipp: It is important to note, though, that this would require you to do some rebalancing in some tough years where you would have to take money from bonds that performed actually pretty well in 2008 and put them back into stocks, which everyone was really freaked out about at the time.

Benz: That's right. This is very hard to do in practice. Our exercise had the benefit of hindsight, and we did stick with the rebalancing regimen regardless of what the market environment was. But I'm sure in practice, someone trying to employ a similar approach probably did have a few moments of anxiety along the way.

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