Wednesday, February 25, 2009

Avoiding the Near-Retiree Stock Market Crash Freak-Out


I'm seriously afraid of being one of the near-retirees who freak-out in a serious market downturn and pull out all of her money from the stock market. (Actually, I'm more worried of becoming one of those crazy, old, cat-ladies. But that's another post.) Is there anything I can do to prevent the "near-retiree-stock-market-crash-freak-out"?

Money Magazine's latest issue highlights a 61 year-old whose retirement account asset allocation before the 2008 market crash was 85% equities and 15% bond funds. (Egads! I'm half his age plus 6 and even I'm not that aggressive!) As you may have already guessed, his portfolio got slammed 40%. Ouch.

My current 401k asset allocation is primarily based upon using CNNMoney.com’s asset allocator. And I also compare my allocation against the conventional wisdom of subtracting my age from 110% and putting that amount in equity funds. This should work fine while I'm young or while the market's going up.

But asset allocation won't necessarily protect me when I’m 57 and my account drops 25%+ with a possibility that the market won't recover in the next 10 years. But at the same time, the money will probably need to last another 30+ years, so I can't panic and suddenly become too risk averse either.

This got me thinking about Jim Cramer's advice that money you need in the next 5 years need to be out of stocks, which is similar to Motley Fool's advice of :
  1. Any money you need in the next year should be in cash.
  2. Any money you need in the next two to five (or even seven to 10, depending on your risk tolerance) years should be in a safe fixed-income investment, such as certificates of deposit or bonds.
  3. Any money you don't need in the next five to 10 years is a candidate for the stock market.

Currently, retirement is decades away, so I can be as aggressive in my asset allocation as I'm comfortable of being. But, perhaps as I get older, maybe I need to stop looking at my 401k as a monolithic account and I need to think of it more like 5 different "buckets of assets" with different time frames and apply a different allocation to each bucket.

For example, suppose I'm 55 with a target retirement age at 60. (Let's also assume that I already have 8 months' emergency fund saved up and I'm also on track to saving 1 year's living expense in cash by the time I'm 60.)

In this scenario, bucket #1 will account for 20% of my total 401k asset that I'll be planning to tap between ages 60-66. I have a time frame of 5 years so the asset allocation in bucket #1 will have 30% equities and 70% bonds/stable fund. As I get closer to 60, bucket #1 will eventually be all stable fund.

Bucket #2 will have a longer horizon of 10-15 years, so the asset allocation in bucket #2 will be 75% stocks and 25% bonds/stable fund. Eventually, as bucket #1 gets depleted, the asset allocation in bucket #2 will move towards 30% equities and 70% bond/stable fund. So on and so forth.

Based upon a rudimentary number crunching I did over the weekend, this is what my asset allocation could potentially look like in my mid-50s:

TOTAL ALLOCATION RISK (Age 55): High

    Equity Fund: 75%
    Bond/Stable Fund: 25%

    Consisting Of:
    Bucket #1 (20% of total funds): Equity 30%/Bond-Stable Fund: 70%
    Bucket #2 (20% of total funds): Equity 75%/Bond-Stable Fund: 25%
    Bucket #3 (20% of total funds): Equity 90%/Bond-Stable Fund: 10%
    Bucket #4 (20% of total funds): Equity 90%/Bond-Stable Fund: 10%
    Bucket #5 (20% of total funds): Equity 90%/Bond-Stable Fund: 10%

TOTAL ALLOCATION RISK (Age 61): Medium

    Equity Fund: 57%
    Bond/Stable Fund: 43%

      Bucket #1 (20% of total funds): Equity 0%/Stable Fund: 100%
      Bucket #2 (20% of total funds): Equity 30%/Bond-Stable Fund: 70%
      Bucket #3 (20% of total funds): Equity 75%/Bond-Stable Fund: 25%
      Bucket #4 (20% of total funds): Equity 90%/Bond-Stable Fund: 10%
      Bucket #5 (20% of total funds): Equity 90%/Bond-Stable Fund: 10%

    TOTAL ALLOCATION RISK (Age 66): Low

      Equity Fund: 31%
      Bond/Stable Fund: 69%

      Bucket #1 (0% of total funds): DEPLETED
      Bucket #2 (25% of total funds): Equity 0%/Stable Fund: 100%
      Bucket #3 (25% of total funds): Equity 30%/Bond-Stable Fund: 70%
      Bucket #4 (25% of total funds): Equity 75%/Bond-Stable Fund: 25%
      Bucket #5 (25% of total funds): Equity 90%/Bond-Stable Fund: 10%

    TOTAL ALLOCATION RISK (Age 72): Low

      Equity Fund: 35%
      Bond/Stable Fund: 65%

      Bucket #1 (0% of total funds): DEPLETED
      Bucket #2 (0% of total funds): DEPLETED
      Bucket #3 (33.4% of total funds): Equity 0%/Stable Fund: 100%
      Bucket #4 (33.3% of total funds): Equity 30%/Bond-Stable Fund: 70%
      Bucket #5 (33.3% of total funds): Equity 75%/Bond-Stable Fund: 25%

    TOTAL ALLOCATION RISK (Age 78): Low

      Equity Fund: 14%
      Bond/Stable Fund: 86%

      Bucket #1 (0% of total funds): DEPLETED
      Bucket #2 (0% of total funds): DEPLETED
      Bucket #3 (0% of total funds): DEPLETED
      Bucket #4 (50% of total funds): Equity 0%/Stable Fund: 100%
      Bucket #5 (50% of total funds): Equity 30%/Bond-Stable Fund: 70%

    TOTAL ALLOCATION RISK (Age 84): Low

      Equity Fund: 0%
      Stable Fund: 100%

      Bucket #1 (0% of total funds): DEPLETED
      Bucket #2 (0% of total funds): DEPLETED
      Bucket #3 (0% of total funds): DEPLETED
      Bucket #4 (0% of total funds): DEPLETED
      Bucket #5 (100% of total funds): Equity 0%/Stable Fund: 100%

    I'm not sure if this type of mental planning will help me avoid the "near-retiree-market-crash-freak-out" I dread. If anything, perhaps I can take some solace from reading about another couple in Money Magazine:
    In 2000, a year after David McMickens retired from his 40-year job as a State Farm supervisor, he and his wife Judy lost half of the $500,000 portfolio when the tech bubble burst. It’s not hard to see how: At the time, they had 90% of their savings in stocks – a risky allocation for their age and retirement status.

    But the McMickens didn’t panic. Between their Social Security benefits, pensions and ample cash in the bank, they simply delayed tapping their nest egg, giving it time to bounce back. By 2005, it had, and they began working with financial planner Stephen Iaconis to create a more balanced portfolio, now 60% in stocks and 40% in bonds. Though they’ve lost 24% in the past year, their experience taught them not to worry; once again, they’re relying on pensions and Social Security ($80,000/year), plus a cash cushion ($75,000), to help them postpone tapping savings. Says David: “We can just sit tight and wait for our nest egg to grow again.” – Ismat Sarah Mangla for Money Magazine, March 2009 issue, Page 69

    What I can't take solace in, however, is that I won't have a pension and I may not get any Social Security.

    Now what?

    6 comments:

    Miss M said...

    The other issue is how long you need those funds to last. One of my co-workers is a former retiree, she had an aggressive portfolio because she needed her money to last 40+ years (long lived family). I'll have the same problem, my grandma is 92. My plan is to be rather conservative at retirement and instead save a LOT so I don't depend on growth as much. Your staged plan is a great approach I think.

    paranoidasteroid said...

    My plan is to save as much as I can and be really aggressive while I'm young. Chad and I are pretty risk-averse, so I think once we get to an amount we think will last,we'll stick most of it into bonds.

    Yeah, we'll be missing out on growth, but I don't want to see my portfolio crash because I got too greedy.

    jpkittie said...

    EEK - We actually had made a bit of $ last year towards the end of the year - then pulled most of it safe. It is so hard to think about what to do --- I almost just want to put it in my matress! Atleast what I put there will still be there when I need it!

    And I am sure that you will make a wonderful old cat lady ;)

    Sharon Rose said...

    Hi there-you have a great plan mapped out my dear, good news indeed!

    Louise said...

    we are working on the same sort of plan at the moment, i really like the detail you have got here, you've given me some good ideas.

    frugalCPA said...

    What a great post, Shtinkykat! I just hope I can remember this kind of thinking and strategizing about thirty years from now. :)