Even as the market continues to set new highs, investors feel increasingly nervous about living through the next downturn.
This is particularly true for people in retirement or approaching it, since a market drop can threaten the comforts of their existing lifestyle.
While it’s never fun to see your portfolio take a hit, losses are a normal part of investing. We should spend more time planning for volatility and potential losses than trying to predict when the next downturn will happen.
Part of that planning includes running a safety-net analysis. This allows you to understand how long you can withstand a downturn given your current situation and what changes might be appropriate at this stage in the bull market. Here are four steps to consider.
Step 1: Determine your annual after-tax expenses. To know your safety-net number, you need to know your total after-tax expenses. If you have multiple years of spending data, then take the average of your annual expenditures from the past three years.
If you haven’t been tracking expenses, sign up for an expense aggregator like Mint.com to begin collecting data on how much you spend each year. Meanwhile, most bank accounts and credit cards have annual statements you can print off to figure out what you spent in the previous calendar year.
As you list your annual expenses for each of the next 10 years, you can adjust future expenses for inflation of 2% or 3%.
Step 2: Make a list of all income you expect to earn outside of your portfolio. Total all nonportfolio income you expect to receive over the next decade — such as pension payments, deferred compensation, Social Security, rental income and so on. This is relatively simple if you only have a few recurring payments that don’t change from year to year.
However, many investors have variable income in the years before and after their retirement date. For example, you may not take Social Security immediately upon retiring. You and your spouse may take your benefits in different years. Maybe you’re a business owner who starts retirement by receiving payments from the sale of your ownership interest. Or perhaps you’ll retire next year, but will be owed income from production in the previous calendar year.
Think carefully about the different sources of your income and list out your projected annual income for each specific year.
Step 3: Estimate a yield on your portfolio. You can get a little creative here, but it’s important to remain conservative.
Let’s pretend that the market has fallen and is never coming back. Take your total portfolio and assume it loses 30% or 40% of its value. This is the ultimate doomsday scenario that is highly unlikely — and, thus, extremely conservative.
Now, let’s assume your depressed portfolio value will yield 2% each year, which is not that far off from the yield on the S&P 500 index and 10-year U.S. Treasury bonds.
The assumptions made at this point are meant to simplify the process. If you have the information readily available, I’d encourage you to separate out equities, fixed income and cash. This allows you to apply different permanent losses and yields to the three portions of your portfolio.
Additionally, it becomes easier to draw from cash and fixed-income assets in the next step if necessary.
Step 4: Add up the income and compare to your expenses. Total your expected portfolio income with your outside income, and subtract that amount from your projected expenses in year one. Ideally, you have enough income to meet your liquidity needs to support your lifestyle. If not, then remove funds from your portfolio to cover the difference between your annual after-tax expenses and total income.
In years that you draw from portfolio assets to meet lifestyle expenses, remember to dial back portfolio income in the second year. If you’ve separated your portfolio by asset class, then draw down on your cash assets first, followed by bonds.
Continue this exercise year by year for 10 years. Remember, we built conservative assumptions into this basic model by assuming your entire portfolio declines in value and never recovers. Now we want to know how many years you can last without drawing on your portfolio during a downturn and avoid drawing on stocks at depressed values.
The basic safety-net analysis described above can be further customized to meet reality, but its primary purpose is to plan for downturns rather than predict them.
Safety nets don’t come in one-size-fits all. The average bear market lasts about two years, so that’s a useful starting point. Ideally, you want enough cash and bonds on hand to go several years without needing to touch your equity portfolio.
If your safety net doesn’t seem sufficient, consider having a financial adviser run a Monte Carlo analysis to test the likelihood of meeting your goals without running out of money. This deeper analysis might uncover the need to change your allocation, retirement-spending expectations or time horizon until retirement.
The article “How to Make Sure You’re Ready for a Market Downturn” first appeared on WSJ.com.