Your Retirement Portfolio Needs a Fire Drill Before the Next Market Drop

Are you prepared for the next stock market correction? If not, you could be tempted to panic sell, which can be especially harmful to retirees.

That's because seeing red in your investment portfolio can lead to heightened emotions and stress, which can in turn lead to poor investing decisions. If you sell during a downturn, you're not only locking in losses but also taking away your portfolio’s opportunity to take advantage of the market recovery. Retirees can use a simple “fire drill” exercise to test if they can withstand a prolonged correction before it occurs.

Why retirees need a different kind of market plan

No long-term investor likes it when the stock market drops, but it can be an especially scary moment for retirees who need to withdraw from their portfolios to cover living expenses. Retirees don’t have a steady paycheck that can help out with ongoing expenses.

They also deal with a special type of risk known as the sequence-of-returns risk, which is the danger that a market correction early in retirement could require a retiree to sell more investments to generate cash, leaving them with a smaller nest egg for the duration of their retirement. It will take longer to recover what they lost since they must continue to withdraw to cover living expenses, and that can force some people to live on less or get a part-time job.

It’s important to know how much risk you can tolerate and what amount of cash you should have on the sidelines.

How to run a retirement portfolio fire drill

The first step of the drill is to review your current portfolio mix to see how you have allocated capital across stocks, bonds, cash and other assets. Then, test a hypothetical drop. For instance, assess how your portfolio and withdrawal strategy would change if your stock portfolio lost 20% or 30% of its value.

In that situation, it’s good to have a large cash buffer that can cover monthly living expenses, so you don’t have to withdraw from your portfolio as much. Income sources like Social Security, a pension or gig work can also make you less reliant on portfolio withdrawals.

It’s also a good idea to review your portfolio’s concentration in specific sectors and stocks. Some investors rely too much on a single stock or industry, which can result in additional losses if their favorite stock or sector enters a significant correction.

This drill also lets you determine how you would respond in this type of situation. Did you feel a sense of panic at the thought of a 30% drop, or did you feel confident in your ability to navigate that scenario? Investors who felt some panic may want to rebalance their portfolios.

What to fix before the next sell-off

Trying to time the market is risky, especially for retirees who are depending on their portfolios to cover their everyday essentials. You can rebalance your portfolio to build a sufficient cash reserve so you don’t have to sell investments during a downturn. Assessing income streams and expenses will also help you determine the gap you have to cover with your portfolio and cash reserves.

Many financial advisors recommend that retirees keep enough cash available to cover one or two years of expenses. Then, you could invest money in fixed-income assets to cover shorter term needs and growth-oriented assets like stocks to help ensure you don’t run out of money deep into retirement.

You should also plan how you will withdraw funds from various retirement saving accounts to minimize your tax impact. Tax treatment is different for Roth plans, traditional plans and brokerage accounts. A tax professional or a financial planner can help you coordinate your withdrawals to trim your taxes.