Retirees: Sidestep These 4 Pitfalls in a Declining Market

For young investors, weak markets should be reason to cheer rather than hand-wring, because they provide the opportunity to add to stocks when they're cheap(er).

Older and retired investors can profit during weak markets, too, by scooping up securities on the cheap. But declining markets can also be painful. Not only can big daily drops in the S&P 500 bring a little heartburn, they also have the potential to inflict lasting damage. After all, investors with shorter time horizons may not have the time recover from equity-market downturns; remember that it took the Nasdaq Composite 15 long years to find its way back to the high it scaled in 2000. Moreover, actively drawing cash from a portfolio that's declining in value can reduce its sustainability, because less of the portfolio is there to recover when stocks actually rebound. That's why you often hear that sequence-of-return risk--encountering a bum market environment early in retirement--is a particular problem for young retirees with too much staked in stocks.

Of course, there's no telling whether the recent market volatility will be a short blip or the start of something more prolonged. But if the volatility persists, here are four pitfalls that retirees should be careful to sidestep.

1) Bargain-Hunting Without Due Attention to the Downside Stocks have fallen in a hurry. Through Thursday, Jan. 14, the S&P 500 had lost about 6% for the year to date, and the typical company in Morningstar analysts' global coverage universe was about 11% undervalued. Other market segments have fallen even further and appear to be an even greater value today. Today, the typical energy stock under analyst coverage is trading at a nearly 20% discount to fair value. Emerging-markets and basic-materials stocks have also dropped precipitously.

Yet, even as market participants inevitably overdo it when marking down merchandise, many of the most downtrodden pockets of the market are reduced for good reason. Energy prices and stocks have fallen, in large part, due to sluggish global growth--especially in emerging markets--and few economic experts are suggesting that emerging markets or oil prices are apt to rebound sharply anytime soon. Indeed, many of the companies that have fallen the furthest over the past few years are highly cyclical and, therefore, unpredictable. Whereas 60% of the companies in Morningstar equity analysts' coverage universe have fair value uncertainty ratings of high--meaning that it's difficult to forecast their cash flows--82% of companies in the energy sector have high fair value uncertainty ratings. In short, while many stocks look cheap, a lot could go wrong along the way, and it could take a while for them to recover.

That's not to suggest that retirees should avoid bargain-hunting. But they should take even greater pains than younger investors to protect themselves on the downside. First, it makes sense to check their existing exposures to ensure that they're not doubling down on parts of the market that are already well represented; Morningstar's X-Ray tool can help on this front. Additionally, they might consider using a value-oriented stock fund or ETF to obtain broadly diversified exposure to unloved sectors rather than betting a large share of their portfolios on single companies or sector-specific funds. Finally, dollar-cost averaging into positions can help ensure a range of purchase prices in case some of these unloved holdings fall further still.

2) Binging on Credit Risk

Just as equity investors may be enticed by the prices on downtrodden stocks, income-seeking retirees may be eyeing some of the higher yields that have cropped up in beaten-down segments of the bond market. Yields that were shrimpy not so long ago now look enticing in areas like high-yield and emerging-markets bonds. Even high-quality high-yield funds like

. A similar phenomenon has occurred in the emerging-markets bond category, where yields above 6% are now commonplace.

It's usually better to be a buyer of lower-quality bonds when their yields spike than when their yields are low and their prices are higher; those higher yields provide income as well as a bit of a downside cushion in case something goes wrong. But any time you see a yield that's substantially higher than the Barclays U.S. Aggregate Bond Index (currently about 2.5%), that should be your cue to ask what the risks are and why investors are demanding that kind of compensation. The hardest-hit bonds have fallen for many of the same reasons that the hardest-hit stocks have: concerns over slowing global growth and falling energy and basic-materials prices. Those situations won't resolve themselves overnight, so the same advice that applies to bargain-hunting equity investors--have an adequately long time horizon, be diversified, and space out your purchases--applies here, too.

Moreover, the evergreen caveat of credit-sensitive bonds applies here: While it's reasonable to use them to supplant part of your portfolio's equity exposure and pick up a higher yield along the way, junk and emerging-markets bonds won't provide the same ballast for a portfolio's equity exposure as will high-quality bonds, as discussed here. (The typical funds in these groups lost 26% and 18% in 2008.) Think of them as an aggressive kicker for your core bond portfolio.

3) Going Overboard With Derisking At the other extreme, retirees could reasonably view the early 2016 sell-off as a call to derisk their portfolios once and for all, especially if they've been letting their equity winners ride over the past several years. And it's true that enlarged equity positions, combined with the fact that investors are seven years older than when stocks began their ascent in early 2009, suggests that many retiree and accumulator portfolios could benefit from rebalancing.

Yet, as appealing as reining in volatility might seem at a time like this, retirees need to be careful not to take it too far. While cash and high-quality bonds promise stability, their low starting yields mean they also promise meager long-term returns--likely 3% at the high end for bonds over the next decade. That might beat inflation, but just barely. For retirees who need at least some growth, stocks are one of the only ways to get it. That explains why even target-date funds geared toward investors who are already retired contain 30% in stocks, on average, and the Income versions of Morningstar's Lifetime Allocation Indexes hold anywhere from 19% to 43% in equities. My model "bucket" portfolios also contain healthy stock stakes. Retirees who are receiving a healthy share of their income from pensions and Social Security, or whose portfolios are so large that they're just barely sipping from them, could reasonably hold even loftier equity weightings.

4) Not Revisiting Your Withdrawal Rate Recent market weakness shouldn't necessitate that you stop going out to dinner or cancel the cruise you already paid for. But many retirees have been letting their spending trend up in recent years--a natural outgrowth of the "wealth effect" created by upward-trending balances. That higher dollar amount of withdrawals, as a percentage of your newly shrunken portfolio, may be getting too high and has the potential to reduce your portfolio's long-run sustainability.

The best withdrawal-rate systems build in flexibility to both take more in upward-trending markets as well as to adjust downward when your holdings are slumping. Taking a fixed-percentage withdrawal embeds that sort of flexibility, but naturally leads to a volatile stream of income that may not be palatable. Retirees who would like more stability in their income stream would do well to add "guardrails" to their fixed withdrawals, as Michael Kitces discusses in this video. (Here's a link to the research paper he references.)