Nobody knows whether the recent stock sell-off triggered by fears of an economic slowdown in China will turn into a full-fledged rout. Which is why it’s a good idea to review your retirement strategy to determine how you might fare if the latest bout of market volatility turns out to be the start of something big. The key question in deciding what moves, if any, you should make: How much time do you have before you actually retire?
The prospect of a meltdown in stock prices—and the feeling of anxiety and insecurity that major market setbacks bring—is naturally unsettling for most investors. But if you’re young and investing money to build a retirement nest egg that you won’t tap for, say, 20 or more years in the future, a decline in stock prices, even a steep one, isn’t necessarily cause for alarm. In fact, a rout could work in your favor.
How? Well, once stock prices hit a trough in the wake of a big market setback, they typically rebound very sharply. For example, since stock values bottomed out nearly seven years ago after falling by more than half in the financial crisis, the Standard & Poor’s 500 has returned just under an annualized 20%, or roughly twice its long-term average. So as long as you’re investing money you don’t plan to touch for many years, a severe market meltdown represents a chance to snap up shares at beaten-down prices that can generate above-average gains and fatten the size of your nest egg down the road. That assumes, of course, that you don’t flee stocks altogether once the going gets rough and miss the eventual rebound.
In short, if you’re in the early-to-middle stage of your career, a market setback isn’t something you should necessarily dread. You want to review your stocks-bonds mix to make sure it jibes with your tolerance for risk and that you’ll be able to stick with even if the market enters a prolonged slump. But once you’ve done that, you should focus less on the ups and downs of the market and more on building the eventual size of your nest egg by continuing to save and invest.
The calculus changes, however, if you’re into or nearing the home stretch to retirement, say, 10 to 15 years before you plan to call it a career. Like someone starting out, you can still benefit somewhat from buying cheaper shares in the wake of a crash with the new money you invest. But the bigger issue if you’re in the latter half of your career is making sure that the money you’ve already accumulated, which likely accounts for the bulk of your nest egg, isn’t totally decimated.
So basically you want to ensure that you go into any market slump with enough invested in stocks to provide long-term capital growth, but enough also stashed in bonds to provide a measure of downside protection. One way to arrive at a stocks-bonds blend that provides an acceptable tradeoff of risk and return is to complete a risk tolerance-asset allocation questionnaire like the free version Vanguard offers online.
After answering 11 questions that get at issues such as how large a loss you think you could handle in a market setback, you’ll come away with a suggested stocks-bonds mix, as well as performance results that will show that recommended mix as well as others both more conservative and more aggressive have performed in both good and bad markets. You can then go to a retirement income calculator and plug in several different stocks-bonds portfolios to see how different mixes, as well as other factors, may affect your prospects for a secure and comfortable retirement over the long term. Based on that information, you can decide whether you need to make changes to your current portfolio.
A severe market downturn has the potential to be the most disruptive, however, if you’re already retired or on the verge of calling it a career. That’s because the combination of investment losses from a market setback plus withdrawals from savings can so erode the value of your retirement accounts that you run a heightened risk of outliving your nest egg.
Which is why its especially important that retirees and near-retirees assess how a market meltdown could affect their retirement plans. You can do that by estimating how much a severe decline in stock prices—say, something along the 50%+ dip prices took in the last two bear markets—might shave off your retirement account balances. By then plugging the estimated post-crash value of your savings into a retirement income calculator, you can get an idea of how long your nest egg might last given how your savings are allocated between stocks and bonds and much of your nest egg you plan to withdraw annually.
If it appears you might run through your savings too soon, you can consider moves that might boost your nest egg’s longevity, such as investing more cautiously to alleviate the impact of a market downturn or devoting a portion of your savings to an immediate annuity that can generate guaranteed income. Or for that matter you could decide to maintain your current asset mix and just trim withdrawals as necessary, at least until the market recovers.
The point, though, is that whatever stage of retirement planning you’re in, you’ll improve your chances of having a secure post-career life if you think ahead about how a market downturn might affect your retirement and consider ways to improve your prospects rather than reacting on the fly after the carnage occurs, when your options will be more limited and less effective.
Walter Updegrave is the editor of RealDealRetirement. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at email@example.com. You can tweet Walter at @RealDealRetire.