Originally posted on Forbes.com
If you follow the stock market’s daily action, do you react?
Even though year-to-date through June, the Dow Jones Industrial Average is up 15.4% (total returns), we’ve had 55 down days out of 124 trading days during the first six months of 2019.
The top five market moving days in the DOW so far in 2019 were Jan. 4 (+3.29%), Jan. 3 (-2.83%), May 13 (-2.38%), Jun. 4 (+2.06%), May 7 (-1.79%).
These days are nothing like those we saw during the Financial Crisis. As a quick reminder, the largest decline was 7.87% (10/15/2008)); the biggest up day was 11.08% (10/13/2008).
Thrill seekers may be better off riding the Steel Curtain at Kennywood Amusement Park, not the stock market. Riders on this new record-setting roller coaster race along 4,000 feet of track at 76 miles per hour through nine inversions, including the tallest in the world at 197 feet.
While this year’s stock market may not be as heart-pounding as a roller coaster, it may cause indigestion for retirees who are unprepared. There is a way to plan for volatility, as I described in an article that the American Association of Individual Investors (AAII) selected for inclusion in its celebratory 40th anniversary AAII Journal publication.
The secret is to lay a foundation for making decisions in uncertain times and situations. Here’s how.
Step One - Accept that uncertainty is an element of every investment.
Most people don’t like the idea of losing money in any amount. But history tells us that retirees with a 30 year horizon cannot avoid experiencing declines. Why? During a span of years, they will likely see periods of recession, depression, inflation, deflation, political instability, wars, disease, innovation, exploration, progression and regression, catastrophes and triumphs.
The fact is that times change and as they do, prosperity ebbs and flows.
In fact, short-term down movements occur even during years that produce double digit returns. For example, in 2009, the S&P 500 Index ended the year with a 23% return, even after a decline of 28% intra-year. In 2013, we saw a 30% return, after a decline of 6% intra-year. For other years (1980 through June 2019), here is a chart from First Trust that shows Intra-Year Declines vs. Calendar Year Returns.
Step Two - Accept that you will make bad decisions from time to time.
Instead of trying to achieve a perfect score, focus on finding and correcting mistakes. What is a mistake? An investment that does not meet expectations or an assumption that proves to be wrong.
Behavioral economists tell us that individual investors make classic mistakes when it comes to investing.
Individual investors may react to attention-grabbing events, such as earnings releases. They may hold on to their losers, waiting for the stock to reach the price they paid when they bought the stock.
Some behavioral economists suggest that lawyers, physicians, engineers, investment bankers, entrepreneurs may be more susceptible to overconfidence. And economists say that there might be gender differences as well, with more men exhibiting overconfidence than women (see “Boys Will Be Boys: Gender, Overconfidence and Common Stock Investment” in the February 2001 issue of the Quarterly Journal of Economics).
Keep these potential limitations in mind; challenge your assumptions.
Step Three - Set realistic expectations
Think about what you want to achieve for yourself and your family in the time that you have to devote to investing for retirement. There are many online tools you can use. Here are two sources from Vanguard that can help you calculate your needs, a longevity calculator to plan for a long retirement and a retirement nest egg calculator to determine how to make your savings last.
Step Four - Frame your goals in terms of consumption.
How much of your savings, or capital, are you consuming for current living expenses? Peace of mind in retirement starts with a spending plan. If your plan is to limit consumption to pension, Social Security, dividends and interest, you can preserve and grow your capital – something you will need to do to stay ahead of inflation and taxes – while maintaining your lifestyle. With a consumption plan like this, you are ahead of the game. Bad or volatile markets will affect you less.
Keep in mind, that needs during your working years may be higher than after you're retired. To see how expenses might affect you, check out to Vanguard’s Retirement Expense Worksheet. This worksheet goes through a list of common expenses and totals them for you.
Step Five - Think about your assets as a unified portfolio, not just a collection of accounts.
Until they retire, most people have a number of accounts and more than one financial adviser. That’s a collection of investments, not a retirement portfolio. To be able to meet your consumption needs over a lifetime while offsetting inflation and taxes takes a big-picture portfolio approach. Think in terms of desired outcomes. Think about how to unify your holdings and accounts into a master plan that accomplishes four things for you:
- Safely creates cash flow to cover your current consumption needs
- Adjusts over time in response to changing needs
- Lasts a lifetime – for you and your spouse or partner
- Extends even further, creating a legacy for your heirs, and for charity if you are charitably inclined.
That’s a retirement portfolio.
Step Six - Define how much risk you want to take.
Do you want to assume general market risk, as measured by the S&P 500 Index, or a higher or lower level of risk?
Without a risk measure, returns are without context. One method is to measure beta, a statistical construct. Assume that the market has a beta of one. An investment with a beta of 1.2 is 20% more volatile than the market. An investment with a beta of 0.8 is 20% less volatile. Beta is only one measure. The point is that you can not judge a return unless you understand the risk assumed to deliver that return.
Step Seven - Implement and monitor
Once reasonable objectives are determined, decisions can be implemented. Then, start paying close attention to the results of your decisions.
Look at each holding to see if it added to or detracted from your results. Did the holding meet expectations? Does it deserve a place in your portfolio or should it be replaced?
By following a systematic approach you make rational decisions without reacting to volatility or engaging in the risky practice of market timing – trying to miss bad days while participating in up days.
The cost of missing out can be significant. According to data from Morningstar, from 1997 to 2017, missing the best 10 days in the market would have cut an investors returns from 7.2% to 3.5%. Miss the best 30 days and you end up with a -0.9% return instead of 7.2% for the same period.
While the feeling of being left out should never spur someone to speculate in a rising market; neither should fear motivate an investment decision.
Leaving behind those emotions permits a rational approach to retirement investing – something everyone needs to survive and thrive through good markets and bad.