While the equity markets have been on a years-long bull run, investors are growing increasingly concerned about a market downturn. Some may want to avoid losses, while others want to avoid leaving money on the table. But whatever the case, it’s not a question of if, but when — and how prepared people are for one.
“While it’s never fun to see your portfolio take a hit, losses are a normal part of investing,” said Peter Lazaroff, chief investment officer at Plancorp, in a piece published by the Wall Street Journal. “We should spend more time planning for volatility and potential losses than trying to predict when the next downturn will happen.”
An important part of that planning, according to Lazaroff, is a safety-net analysis, which gives an idea of how long one can withstand a downturn given their current financial situation. While different stress tests are available, he recommended a four-step approach.
The first step, he said, is to determine annual after-tax expenses. Those who already have multiple years’ worth of spending data can average their expenses for the past three years; those who haven’t can sign up for an expense aggregator. Bank account and credit-card statements can also provide valuable information. For expense projections covering each of the next 10 years, he suggested using an inflation factor of 2% or 3%.
The second step involves listing all the income someone expects outside of their portfolio. Those who are not yet retired will want to consider their salary if they’re employed, or income from their business if they own one. For retirees, income can include pension payments, deferred compensation, government-provided benefits, rental income, and so on. Annual income projections must also be made for each source.
Third is estimating a yield on one’s portfolio. In visualizing a downturn, Lazaroff assumed a total portfolio loss of 30% to 40% — an unlikely and therefore conservative scenario. He also assumed the depressed portfolio would have an annual yield of 2% each year, which he said was not far off from that on the S&P 500 and 10-year US Treasury bonds. He also recommended that the portfolio be separated into equities, fixed income, and cash, if possible, so that different losses and yields can be applied.
Finally, the expenses should be compared with the total of the portfolio income and the income from other sources on a year-by-year basis, over a period of 10 years. In years when the income is less than the expenses, there should withdrawals from the investment portfolio; accordingly, portfolio income should decrease in years following such withdrawals. The objective is to determine how many years one can last without drawing on their portfolio during a downturn.
“The average bear market lasts about two years, so that’s a useful starting point,” he said, adding that the ideal situation is to fund several years’ worth of expenses using cash and bonds on hand, without touching the equity portfolio. In cases where an investor’s safety net seems too small, he recommended that an additional Monte Carlo analysis be performed by a qualified financial advisor.
For more of Wealth Professional's latest industry news, click here.
Getting to the root of financial stress
Making the difference for clients in wild markets
More market talk: