The Anxiety Many Savers Have — and How to Lower It
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Part of successful investing is accepting that the stock market is volatile and that market downturns — and even crashes — happen.
Young investors with long time horizons have years or even decades to recover from these corrections, but retirees don’t. That’s why many people fear a market crash happening during their pre-retirement and retirement years, causing them to run out of money over time. While that's understandable anxiety, there are strategies you can implement to help your portfolio weather volatile market conditions and make your savings last.
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What is sequence of returns risk?
The fear comes down to what’s called the “sequence of returns risk,” or the risk that market losses in the early years of retirement paired with withdrawals can cause your portfolio to suffer for years to come.
For instance, a retiree will need to sell more stocks to get a certain amount of cash when the market drops than another retiree would if they’re selling when the market is performing well. That will reduce your total number of shares that have the opportunity to grow in the future.
While that’s the same case for a young investor, retirees don’t have that same flexibility as investors with decades until retirement since retirees aren't often relying on their withdrawals from the market to fund their lifestyles.
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How to lower your risk
To mitigate sequence of returns risk, retirees can construct their portfolios to adjust to their new lifestyles and the fact that they no longer bring in a regular income from working. That doesn’t mean selling every stock and putting that money into lower-risk bonds, but it also doesn’t mean doubling down on growth stocks either.
Financial advisors often recommend the three-bucket strategy, which entails grouping your money into categories based on when you will need it. The first bucket contains cash that can cover your living expenses for one to three years. This money should be kept in a safe, liquid account, like a high-yield savings account, certificate of deposit (CD), money market account or short-term bonds, or a mix of several of these accounts.
The second bucket consists of money that you will need over the next three to 10 years. These funds go into low-risk assets like conservative bonds and mature dividend stocks. These assets can generate positive returns and cash flow, but they won’t be as rattled by short-term market uncertainty.
The final bucket contains growth stocks and index funds. This bucket has funds for long-term growth that you won’t have to touch for at least a decade.
Keep in mind that these buckets should be adjusted for your needs and goals. Buckets that are allocated to everyday expenses for up to five years, short-term reserves for six to 11 years and long-term growth for more than 11 years could also make sense.
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Why the bucket strategy works
Ideally, the bucket approach will allow you to avoid selling stocks during market corrections, since you’ll have enough cash in your first bucket and short-term reserves in your second to stay the course.
The strategy reduces the volatility across your portfolio since only a portion of it is allocated toward growth stocks and funds, but you’ll still benefit from rising markets.