Jason Stipp: I am Jason Stipp for Morningstar. The market has taken a small hit over the last few weeks with plenty of uncertainty on the horizon. There is likely to be more volatility in the days ahead. Here to talk about keeping things in perspective and also how to manage through volatility in retirement is Morningstar's director of personal finance Christine Benz.
Christine, thanks for joining me.
Christine Benz: Jason, great to be here.
Stipp: So, over the last four weeks we've seen about a 6% loss in the major stock market indexes, but you have to really put that number into perspective. And you might feel a little bit better once you do so, right?
Benz: I think so. So, if you focus on your portfolio's total return and if you are nearing or in retirement, you should have a pretty balanced portfolio at that point with some cash and some bonds, as well as some equities. And what you'll see if you look at your total portfolio's return, it's probably something that's still in the black year-to-date because not only have bonds and particularly long-duration bonds performed well through this period of volatility, but also stocks have not done that poorly for the year to date. In fact, every domestic stock fund category in our database is in the black for the year to date. And even foreign-stock funds which have had bigger losses than U.S. still have not suffered double-digit losses.
So, overall, I think if you've got a diversified portfolio, chances are if you step back and look at it through that lens, you probably will be pretty pleased and not likely to be so worried about what's been going on in the near term.
Stipp: So, a couple of things the headlines always tend to do is they always focus on a narrow niche of the market that's done really well or really poorly, and they always look just over usually the recent past few weeks. So, you're never going to see a headline about how your balanced portfolio did year to date; you always are going to hear about how poorly this section of Europe did because of all the crisis over there. So, keep in mind that your portfolio is not what's in the headlines; it's these areas that are in crisis. typically.
Benz: Exactly. And this is how it nets out over time. When we hold our portfolios you do have very good periods like the first quarter and sometimes they are book-ended by lousy periods like the past month.
Stipp: So, given that you need to keep that perspective in mind, we also know that there is plenty of uncertainty out there. The Europe crisis continues to boil on. So, we know that it will probably face some volatility in the coming months. Maybe we won't, but there is always a possibility that we will see some of that market action up and down. You have a few tips for how to manage through this, especially for retirees, and this is important for retirees who obviously are much more engaged in using their portfolios.
Your first tip has to do with the bucket strategy that you've talked about so much, and specifically that liquidity bucket. What should you do in analyzing that bucket given that we could be in for a rough ride in the market?
Benz: One of the reasons I am so attracted to this bucket strategy, Jason, is because of times like this. So, the idea is that you have your near-term cash needs, your income needs, carved out in your portfolio. Those are sitting in true cash or maybe in cash plus short-term bonds, if you have a larger liquidity component. But the beauty of making sure that you have, say, one to two years worth of cash sitting in your portfolio, is that it makes you able to ride out these volatile periods in the market because you know that your near-term income needs are covered.
Not only do you have that liquidity component, but you've also got sort of your next-stage reserves in bucket number two where you've got maybe intermediate-term bonds, where the fluctuations will not be nearly so great as what you might be experiencing with that long-term equity component of your portfolio.
I do think that making sure that you do have that liquidity component there, whether you're using a total-return approach or whether you're using some sort of an income approach, in which you are periodically spilling your income and dividend distributions into that liquidity portfolio, however you're arriving at it, make sure that you have that near-term liquidity reserve set aside.
Stipp: Once you check that, once you see how much money you actually do have in those buckets number one and number two, it will probably relieve some of that anxiety that you see that might be affecting that longer-term bucket three or bucket four in your portfolio, which is going to move around a lot in the short term because of volatility.
Benz: Right. So, if you've set up this thing correctly, you've got one to two years covered in cash and another seven years or even 10 years in fixed income, and of course it depends on your time horizon how you have this thing set up. But you might have fully 10 years to ride through volatility in the equity markets before you're even tapping that piece. So, it can give you some peace of mind.
Stipp: [It will] give you a lot of peace of mind there. Another thing, Christine, that we've written about and you've spoken to some experts about is withdrawal rate and how you can be sensitive and move that withdrawal rate around depending on the trends you're seeing in the market. What might you think about regarding the withdrawal rate in a volatile market or in a down market?
Benz: I think we could talk about this topic full time, Jason, because there is so much meat on it. So, the standard rule of thumb is that that 4% withdrawal rate is a sustainable withdrawal rate for a balanced portfolio over a period of 25 to 30 years, but more recently, some experts have been kind of poking at that and saying, "well, can we do even better by maybe pulling in our belts a little bit in those down periods, so maybe reducing those withdrawal rates?"
There are a few different ways to do this. I've written an article about it asking, should your portfolio withdrawals fluctuate with the market? One of the very commonsensical ways laid out by T. Rowe Price is simply forgoing that inflation adjustment that a lot of retirees take. So the traditional rule of thumb is, 4% plus an annual inflation adjustment.
Well, in weak market periods, a lot of times inflation is pretty well under control as it is right now in many respects. So in those down periods or after those down periods say, you simply say "Well, I'm going to forgo that inflation adjustment this year; I'll take what I took last year." So, that's a very commonsensical way to go about it.
Another strategy is what's sometimes called the 4% rule with guardrails where maybe you take more after very good market periods and relatively less during weak market environments. That's another strategy that a few different researchers have looked at.
Then another strategy that I know some of our readers say that they employ, is that they simply take a fixed percentage of their portfolio per year, and that may result in more fluctuations in withdrawals than some retirees are comfortable with, But that's another strategy that is very intuitive and it's easy to see how that reacts with market volatility that you do take relatively more when your portfolio is up and you're taking way less when your portfolio is down.
Stipp: So, one of the overarching themes here is that you want to buy low and sell high, and so if the market's really down, taking withdrawals is, in effect, selling out of your portfolio for that withdrawal. So, if you need to do that when the market's down, you want to try to limit it as much as possible, and then if the market's had a great run, maybe you can take a little bit more money off the table then?
Benz: Right. So the reason you don't want to maybe stick with that static withdrawal rate through very volatile periods, down periods in particular, is that it has the effect of locking in losses. So, less of your portfolio is there to rebound when the markets inevitably rebound. That's sort of the logic behind reducing those withdrawal rates during and after down markets.
Stipp: Last question for you Christine it's hard not to pay attention to that stock portion of your portfolio when the markets are moving up and down a lot. If you do want to kind of get a sense of what your stock portfolio might do during a time of acute market crisis, where can you get a handle on that? How can you know this fund might suffer a loss potentially of X percent and prepare yourself for what could be a worst-case scenario?
Benz: Well, probably the simplest way is just to go and anchor on that 2008 return because that shows you pretty starkly what to expect in a worst-case scenario, and I don't think anyone's suggesting that we are in a position to retrace what we went through in 2008. But use that as a starting point, I think we also have some very useful charts and graphs on the Chart tab for individual mutual funds on Morningstar.com. So you can look at rolling period returns. You can actually enter a particular period if you are choosing to see what the worst-case loss looks like from peak to trough and [whether you're] in a position to endure that.
We certainly have a lot of different statistics on the [Ratings & Risk] tab, as well. So for people who want to use either Morningstar risk statistics or statistics like standard deviation or our bear market percentile rank, we've got a lot of different ways to look at volatility.
One comment I would make though, Jason, is that I do think retirees need a good balance of different investment styles. So I'm not saying that you need to forgo more volatile investment types. Certainly, if you balance them with less volatile investment types, you should be OK because you are holding a well-diversified portfolio that will perform well in varying market conditions. But I do think on balance for most retirees, emphasizing those wide-moat dividend payers, high-quality companies, with the equity portion of your portfolio is a sensible strategy because you will tend to see less volatility with such names.
Stipp: All right, Christine, well some great tips for riding through some volatile times in the market for retirees. Thanks for joining me today.
Benz: Thank you, Jason.
Stipp: From Morningstar, I'm Jason Stipp. Thanks for watching.