I've had this question come up a couple times with friends and family members, and I imagine there are a lot of people out there wondering the same thing. Everyone wants to know what the market is going to do, if they should sell stocks, sit tight, or whatever. Particularly as a person approaches retirement and starts to look at this pile of money as something that will have to sustain them financially for the rest of their life, these issues loom large.
Let’s back up and remember some important context. Why are you in stocks in the first place? What purpose does your allocation to stocks serve, particularly since stocks are notoriously volatile in the short term?
Short answer: to grow your portfolio.
Growth produces three benefits for retirees, as I see it.
To replenish your portfolio’s capital when you take distributions.
To grow your portfolio’s value such that future distributions keep up with inflation.
To provide a margin of safety against future drawdowns.
How important are these first two? For most retirees, extremely. A portfolio that doesn’t grow is far more likely to run out of money at some point. And it is guaranteed to lose money to inflation.
But the third point about safety is interesting. There are many occasions where the "riskier" portfolio is actually far safer than the "safe" portfolio, even if it doesn’t feel like it moment to moment.
Let’s say you need to have $1,000,000 to be comfortable in retirement. (For some people it will be far less, for others, far more. I'm just using this as a round number). According to Morningstar, if you had invested that $1,000,000 entirely in the S&P 500 for the last 3 years, that $1,000,000 would have grown to $1,402,700. That’s an annual return of 11.94%. This rate of return is good but not unusual for stocks.
Compare that with having invested in T-Bills over that time, you’d have earned 4.07% annualized, growing your money to about $1,127,000. And that’s the highest return T-Bills have delivered over the last 15 years or so.
What’s the safer position to be in going forward? Well, with the all-stock portfolio, you’d have a $402,700 cushion between you and that minimum portfolio value. Your stocks would have to lose 28.7% of their value to get back down to danger territory. But the bonds only offer a $127,000 cushion, such that a drawdown of just 11.27% would put you back in jeopardy.
And that’s before portfolio distributions. Over three years of taking $40,000 annually from your portfolio, your bond portfolio would sit at just $1,027,000. You’re nominally ahead, and didn’t have to endure any drawdowns, but you’d have lost to inflation, and not had much money left to absorb any of life's surprises.
The all-stock portfolio, meanwhile, would have a balance of $1,282,700 after distributions. That more than replaces the distributions from your portfolio, and beats inflation. And it builds in a bit of cushion for the next drawdown, whereas the bonds portfolio has almost no cushion whatsoever, neither for high inflation, nor unexpected life events.
Moreover, that time horizon starts with a period in 2022 when the S&P 500 suffered a drawdown of around 25%, right at the start. In that moment, stocks looked very risky, if not downright stupid. But over the next three years of owning stocks, you ended up in a safer position overall. Stocks, though volatile, often produce greater security in the long run.
The advantage of owning stocks only widens with time. What if, 10 years ago, you had let fear get the upper hand and switched everything to T-Bills? Your portfolio would have grown at 1.68% per annum, turning $1,000,000 into roughly $1,181,300, lagging inflation badly. The sole advantage to this strategy is that you wouldn’t have had to worry about drawdowns. Specifically:
the 2015 pullback of 12%
the 2016 pullback of 9%
the 2017 pullback of 3%
the 2018 pullback of 20%
the 2019 pullback of 7%
nor the 2020 pullback of 34%
nor the 2021 pullback of 5%
nor the 2022 pullback of 25%
nor the 2023 pullback of 10%
nor the 2024 pullback of 8%
nor the pullback we’re currently in.
Please dwell for a moment on those numbers. See how big some of those drawdowns are? Too, over the last decade, there was a pullback in every. single. year. Market crashes are not abnormal, nor are they really something to worry about. They are inevitable. Why worry about something inevitable? Crashes are the price you pay in the short term to own stocks for the long run. No one can predict when downturns will happen or how bad they will be.
There’s a joke that says, “hedge fund managers have predicted 15 of the last 4 recessions.” In any given, actual, recession they get to sound smart and talk up their fund on CNBC. But when you look at their performance, you usually see a fund that has badly lagged stocks over any meaningful time period. They predicted the crash, but it didn’t make them or their clients rich. Often, you’re better off having a few good years and a few bad years in stocks than you are by trying to have only good years. That’s just the nature of the beast. You can’t have the good without the bad. Isn’t that just the way life goes?
Let’s look back over the last 10 years. If you were 100% in T-Bills, your portfolio never experienced any of those drawdowns. But that’s a short-term payoff, and it costs you in the long run because you never really build enough cushion to absorb inflation, nor life events. Nor did you have much extra capital just to enjoy life with! That’s the price you pay for “short-term safety.”
The good news is you didn’t lose any money (in nominal terms) but let’s have a look at what it cost you in the long run:
After 10 years in the T-Bills, you’d end up with $1,181,300. The S&P 500, meanwhile, turned $1,000,000 into roughly $3,311,400. How’s that for safety? Stocks could drop over 60% and you’d still be money ahead of the T-Bill portfolio.
As an aside, the S&P 500’s performance over that period, while strong, isn’t unprecedented. That 12.72% annualized return is only slightly ahead of the S&P 500’s long run average of about 10-11% a year. And a mere 10% would have turned $1,000,000 into $2,593,700. Still very good.
At this point, I hope you are asking yourself this question, “why own T-Bills at all? Why not accept volatility as an acceptable price to pay for truly massive wealth creation? Why not opt for long-term safety, while learning to accept and even expect periodic drawdowns of 20-30% as a normal fact of life?”
Well, I think for most people that’s easier said than done. It’s one thing to live with a hypothetical drawdown of 30%, and quite another to see $300,000 of hard-earned savings evaporate in a single quarter.
On top of that, it helps to consider some practical facts of life. First off, the whole point of money is to be able to spend it when you want to. Whether you’re buying basic groceries or a once-in-a-lifetime trip to France, it is really important to have some safe reserves that let you spend (and live) with confidence that your choices aren’t jeopardizing your future. It generally isn't a good idea to liquidate stocks when they are down. A healthy reserve can do you (and your portfolio) wonders.
Second, we live in an unpredictable, chaotic world. I think more people could have stuck with stocks over the last 10 years if they knew what the path looked like in advance. There were some rough patches, certainly, but I think those drawdowns are easier to bear if you knew that in the end you’d end up with over $3,000,000 (or a 3x return), and that none of the drawdowns turned into another Great Depression.
The future is unknowable. Looking into the next 10 years, I have no idea what the path will look like. I imagine stocks will probably deliver an 8-12% annualized return over that timeframe, but I really don’t know. All I know is that stocks have delivered similar returns most of the time, historically. But that’s no guarantee. Lost decades have been known to happen, as we saw from the peak in 1999 to the trough in 2009 when stocks lost value over a 10 year period. Likewise with the Great Depression. Depressions happen, stagflation happens, wars happen, financial crises happen, and bubbles pop.
Interestingly, though, the period from January 1997 to December 2009 saw positive returns of about 5.25% per year. That's noteworthy because 1997 was a frothy market, right in the middle of the Dot-Com boom. Yet it still was a reasonable time to be putting money to work. At least as measured over the next 13 years. While on the low end of average, stocks produced an acceptable return for most retirees to live on.
Even if, most of the time, things work out well, you still want to be prepared for the scenario where things go poorly. And that’s why you want to own T-Bills (or safe assets in general). Having a healthy reserve of “safe money” will drag down your long-term returns somewhat, but it will give you some much-needed cushion against unforeseen bumps and crises. That’s a reasonable trade-off to make, I think, given the unknowable and chaotic nature of our world. Owning a mix of stocks and bonds increases your odds of getting a good result over any given period.
The other piece to consider is that stocks tend to have stronger performance after a drawdown. This is classic “buy low, sell high.” When stock prices are depressed, they tend to be cheap or “on sale.” Hence, even if an all-stock portfolio doesn’t make much sense for you today, there may be a benefit in the long run of using a pullback to reallocate some “safe today” money into the “safe tomorrow” bucket. This turns a crisis into an opportunity. Gradually increasing your allocation to stocks over time strikes me as eminently reasonable, as it widens the cushion you have between “barely enough,” and “plenty” as I illustrated with the examples at the beginning of this article. Viewed through this lens, pullbacks are a wonderful time to buy stocks. You'd think more people would be excited about market drawdowns, but instead most of what you hear and see on tv is all doom and gloom.
What may make sense for a much wider range of retirees is simply choosing an allocation (ie, some percentage mix of stocks and bonds), and rebalancing to it on a regular basis. When stocks are high, you’re selling some stocks to buy bonds. When stocks are low, you’re buying more of them and selling bonds. A regularly rebalanced, diversified portfolio is an excellent vehicle for most retirees. It gives you cushion to ride out a wide range of scenarios, while still giving enough long term upside to keep your portfolio healthy. It lets you take advantage of drawdowns without getting overexposed to risk.
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