Should You Fear The Next Bear Market?

The past several weeks were a wild ride for investors. The Dow experienced a daily drop of 800 points and there was an inversion of the yield curve. Trade disputes continue to persist and there are negative yields on the sovereign debt in many developed countries around the world. Furthermore, there are now impeachment proceedings and geopolitical challenges around the world.

If these news stories alone didn’t spark nerves, watching one’s investments fluctuate significantly over the course of such a short time period can make even the most aggressive investor feel a bit queasy. This short-term volatility in a year filled with extraordinary returns for most asset classes is enough to cause many investors to wonder, “Should I fear the next bear market?”

The answer boils down to an investor's stage of life.

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• Accumulation Stage: If you are in the “accumulation” phase of life, and have many years until you begin withdrawing from your nest egg, then a stock market downturn can be a blessing. You should not fear a market drop. In fact, you should actually hope for one in order to improve long-term returns by buying stocks at discount prices. Once investors get beyond their initial anxiety, they will realize that a market drop is actually a wonderful opportunity as long as they have an intelligently designed portfolio.
• Decumulation Stage: If you are in (or approaching) the “decumulation” stage of your life, where you are (or shortly will be) spending down your nest egg, a bear market can be much more detrimental due to “sequence risk.” Sequence risk is the order in which your investment returns occur. A string of bad market returns can be devastating for investors in retirement. Retirees have less opportunity to make up those losses, and the fact that they are drawing down their portfolio may cause them to run out of money much sooner than anticipated. This leaves them vulnerable in low/negative return markets.

Compounding this concern is that rates are at historic lows. The days of buying 5% to 6% triple tax-free AAA municipal bonds are over. Most retirees will have stock exposure and are faced with the sequence risk predicament.

Fortunately, there are several precautions that investors in the decumulation phase of life can implement to prepare for such an occurrence:

1. Take less risk when you first retire, but more risk later on

Decreasing risk early in retirement will minimize the sequence of return risk when it can be most impactful. Since longevity is a real concern for many retirees, it's worth considering changing strategy further in retirement by turning up portfolio risk a few notches later on. This risk off/risk on approach will position the portfolio to not run out of money later in retirement, while also allowing retirees to achieve any legacy objectives if applicable.

As an illustration of this strategy, imagine a couple in their mid-60s who decide to retire today. The market has been climbing steadily for the past decade. It’s not far-fetched to expect a meaningful downturn in the near-term. A prudent approach may be to enter retirement with a 40%/60% split between stocks and bonds. They can gradually increase risk by shifting their equity exposure up to 60% over time, or after at least a 20% drop in the market. This strategy will accomplish the dual objective of cushioning against the blow if the market does produce an unfavorable string of returns in early retirement while also protecting against longevity risk. Naturally, this is an overly simplistic example and one should consult their trusted adviser for a more fine-tuned strategy.

2. Decrease your withdrawal rate when you first retire

Taking more modest distributions early in retirement, and ramping up withdrawals later, will allow investors to mitigate a sub-optimal return environment similar to the above scenario. Furthermore, this withdrawal strategy mirrors the way many retirees actually spend in retirement. Cash outflows may be lower when one first retires as they stop commuting to work, may downsize their home, are hopefully still in reasonably good health, and their kids are generally self-sufficient. As the years go by, health care usually becomes a larger cost that will require a larger withdrawal rate.

3. Work longer

While this option may be unpopular with many and not possible for others, it is more of a sure thing than hoping for a certain rate of return from the market. A few extra years of work, even part time, will have the benefit of not needing to draw down the nest egg as early, allow savings to be invested and grow for a longer period of time, and create a shorter time horizon through which retirement money needs to last.

4. Rely on guaranteed income or cash reserves during lean market times

Robust pension plans are not as prevalent as in years past. However, if an investor is fortunate enough to have a guaranteed stream of income, either through pension or annuity products, if applicable, it can help mitigate a bad stretch of market returns. Having the income to cover a portion of basic living expenses allows the retirees to refrain from withdrawing on their portfolio during inopportune times. Similarly, having cash reserves that can cover several years’ worth of living expenses may be the perfect cushion needed to get investors through tough times.

The prudent level of cash reserves is situation dependent. The key is getting a retiree through a prolonged market downturn without having to liquidate their investments at a bad time. The average bear market since World War II has lasted 14 months. Consequently, having at least one year’s worth of your average expenses readily available in a checking account, plus another two years’ worth of expense money in short-term bonds within your portfolio, should leave the retiree with ample breathing room if the markets are unfavorable.

It’s impossible to say what the market has in store for investors over the next few years. However, like many areas of personal finance, the key to weathering the effects of a bear market is having a proper game plan in place. In the accumulation stage of life, implementing a process that will allow investors to capitalize on market downturns while removing emotions is the secret to building wealth. In the decumulation stage, a proper plan can manage risk, spending, income and cash reserves to ensure retirees do not outlive their money and keep them on track to achieve their financial objectives through challenging market environments.

Disclaimer: This article authored by Jonathan Shenkman a financial adviser at Oppenheimer & Co. Inc. The information set forth herein has been derived from sources believed to be reliable and does not purport to be a complete analysis of market segments discussed. Opinions expressed herein are subject to change without notice. Oppenheimer & Co. Inc. does not provide legal or tax advice. Opinions expressed are not intended to be a forecast of future events, a guarantee of future results, and investment advice.