Monday, March 30, 2020

How a Retirement Plan Responds to Market Volatility

To illustrate my retirement plan in action, let’s go through an example of how it handles a big stock market drop. My plan certainly isn’t for everyone, but you may find elements of it you like. Hopefully, this post is what reader KT had in mind when asking for a detailed example.

Imagine a hypothetical couple, the Carsons, who are following the same retirement plan my wife and I are following, but they’ve just turned 70, so they’re much further along than we are. Our portfolio is currently split 80/20 between stocks and fixed income, but this will change to 76/24 by the time we’re 70. So the Carsons’ current asset allocation is 76/24.

The Carsons deferred both their CPP and OAS to age 70. In total, they get $4000 per month or $48,000 per year. If this sounds high, then welcome to the power of deferring CPP and OAS. They could be getting a lot more if they both got maximum CPP benefits.

The Carsons have a million dollar portfolio ($760,000 in stocks and $240,000 in fixed income). The fixed income portion represents 5 years of their safe spending level, or $48,000 per year (4.8% of their portfolio). With CPP and OAS, this is a total of $96,000 per year. Like my wife and I, the Carsons actually spend less than this. They saved up more than they needed to give them a cushion before they retired years ago.

Before they retired, the Carsons always spent from the income of the spouse making more money. So their assets and income in retirement are nearly equally split between them. And some of their spending comes from non-registered accounts and TFSAs. So, they each declare a little under $45,000 in income per year. This means their income taxes are quite low.

The Carsons aren’t concerned about being forced to take more than they want out of their RRSPs each year. They’ll just save any excess in their TFSAs or non-registered accounts. It sometimes takes some juggling, but as long as the total amounts across all their accounts add up to their 76/24 asset allocation, all is well.

Each month, the Carsons spend from their fixed-income savings. Whenever their desired fixed-income amount is off by more than 10%, they rebalance. Their current fixed-income target is $240,000. So, if it is ever 10% too high (above $264,000), they buy some stocks. Whenever it is 10% too low (below $216,000), they sell some stocks. When markets are calm, their fixed-income allocation gets too low a couple of times per year, triggering rebalancing.

Unfortunately for the Carsons, their stocks recently dropped 25%. This sudden market crash has many people fearful and trying to decide what to do in response. The Carsons decided to just stick with their plan.

Their stocks are down to $570,000, and with little change in their fixed income savings, their total portfolio is worth $810,000. Their fixed-income allocation should now be 24% of this, or $194,400. So, it is too high by $45,600. This is more than 10% off, so the Carsons rebalance by using $45,600 of their fixed income savings to buy stocks.

With their portfolio going down, the Carsons’ safe spending level dropped to 4.8% of $810,000, or $38,880 per year. Adding in their CPP and OAS, their safe spending level dropped from $96,000 to $86,880 per year. This is a substantial drop. Fortunately, the Carsons weren’t spending their whole $96,000 each year, so the reduction isn’t too painful.

Let’s assume that stocks stay down for a year before starting to rise again. During that year, the Carsons can spend up to $38,880 from their portfolio (plus their CPP and OAS benefits). When their fixed-income allocation drops 10% below its target, they’ll sell some stocks. But remember that they bought $45,600 worth of cheap stocks right after the market crash. During this whole sideways year for the stock market, they won’t have to sell any of the stocks they had before the crash.

Hopefully, this answers a question reader Art had. In an earlier post, I answered Art’s question of what to do about the recent stock market crash. He expected that after a market crash I’d hunker down leaving my stocks alone, spend exclusively from fixed income, and wait for stocks to rebound. When I said I am maintaining my asset allocation, he followed up by asking what role the fixed-income component plays in this case.

One answer is that it reduces my portfolio’s overall volatility. Another answer as suggested by the worked example above is that the rebalancing process automatically halts the selling of stock for a period of time. In this example of a 25% stock price drop, the Carsons don’t touch the stocks they had before the crash for just over a year. In a more severe decline, the stocks remain untouched longer. This protects a portfolio against having to sell stocks after violent price drops.

So, why don’t I just hunker down and not do any stock trading at all until stocks rebound or all the fixed income money is gone? The answer is that I find this to be too much of an all-in bet. It works very well when stocks cooperate and rebound in time. But what if stocks crash again as your fixed-income money runs out? Now you’re in trouble having to sell stocks when they’re very low. I prefer to maintain the moderating effect of having my fixed-income allocation intact.

During the long bull market leading up to the stock crash, the Carsons had to sell stocks frequently to maintain their fixed-income allocation at its target. A big benefit of sticking to your asset allocation is that it has you selling stocks while they’re high and later buying them when they’re low. The benefit of this buying low and selling high partially compensates for the opportunity cost of not being 100% in stocks.

So, even if my approach can’t protect my stocks for a full five-year bear market, it can protect them for a year or so, depending on the severity of the market crash. I’m giving up some protection against a 5-year bear market to perform better in an unusually long-term bear market. Others may make a different choice.

Friday, March 27, 2020

Short Takes: Cash Reserves, Deferred Pensions, and more

Here are my posts for the past two weeks:

It’s Too Late to ‘Re-Evaluate Your Risk Tolerance’

Reader Question: What to do about the Stock Market Crash

Many “Experts” are Wrong about Risk

Here are some short takes and some weekend reading:

I enjoyed this brilliant letter from Warren Buffet’s grandfather explaining the value of maintaining a cash reserve. A great many people today are in need of a cash reserve.

Robb Engen at Boomer and Echo has a big choice to make about whether to take a deferred pension or take it’s commuted value. The deciding factors are how long the pension would be deferred and the current health of the pension plan.

Tom Bradley at Steadyhand says that if you choose to get out of the market, expect some tough choices on when to get back in.

Preet Banerjee explains the Canada Emergency Response Benefit (CERB) in a 3-minute video.

Ben Felix discusses how to handle the recent market crash. Stay calm and think.

Canadian Mortgage Trends describes the big banks’ mortgage referral relief. It’s hard to see how this differs very much from normal operation for banks. I used to get skip-a-payment offers from my bank when I had a mortgage. I don’t know if I could have done it 6 months in a row, so maybe that’s new. This CBC article confirms that interest accrues on the mortgage during the 6 months without making payments. Mortgage deferral will definitely help many people, but it’s not free. Banks will make money from this.

Big Cajun Man has a guest post from his daughter explaining how COVID-19 is affecting her small business.

Joseph Nunes at the C.D. Howe Institute quantifies the power of working longer to save for retirement. With people living longer, it makes sense that we can’t all retire in our late 50s or early 60s. Someone has to provide the goods and services we all need.

Jim Yih at Retire Happy tries to gently steer people away from selling stocks in fear.

The Blunt Bean Counter explains the impact of the coronavirus on small business owners.

Wednesday, March 25, 2020

Many “Experts” are Wrong about Risk

COVID-19 has brought a stock market crash and widespread unemployment, two things that often go hand in hand. None of the specifics of this crisis were predictable, but it was inevitable that the stock market would crash at some point. Now we have a vivid picture of what is wrong with a lot of financial advice.

I frequently argue with bloggers, financial advisors, and others about mortgages, borrowing to invest, and emergency funds. Some so-called experts say it’s fine to max-out your mortgage to invest more in stocks, or borrow to invest, or plan to use a line of credit instead of having an emergency fund.

Imagine what it’s like to have huge mortgage payments without a paycheque coming in. Sadly, many people don’t have to imagine. Those who use leverage to invest in stocks are looking at 45-60% losses or more, and they don’t know if it’s going to get worse. In these circumstances, an emergency fund helps a lot more than piling up more debt on a line of credit.

The problem with most thinking on these subjects is that people imagine normal circumstances. You don’t need an emergency fund when things are going smoothly. Borrowing heavily for a house or stocks works wonderfully when the economy and stock markets are running well.

Many experts do elaborate calculations to prove that you’ll end up with more money if you keep a big mortgage, use leverage, and fail to keep some cash in a savings account. During normal times, these strategies do give an advantage. It’s times like now when the cost of being unprepared is so high that it overwhelms this advantage. When you’re forced to sell at huge losses to get money to live on, these losses are permanent.

Does this mean we should all push to eliminate all debt and ignore investing? Absolutely not. Balance is key. When people ask whether they should pay down the mortgage or add to retirement savings, the correct answer is usually to do some of each. Few people are cut out for leveraging their investments, and all of us could use some cash in a savings account just in case.

It does no good to blame people who have been seriously harmed financially by this crisis. But the truth is there are steps each of us can take to be better prepared. It’s too late to prepare for this crisis, but there will be another crisis, and it will come during good times when we least expect it. Limit your debts to amounts you can handle during bad times, not just good times.

Monday, March 23, 2020

Reader Question: What to do about the Stock Market Crash

Art asks the following (lightly-edited) question about what to do with his portfolio now that the stock market has crashed.

Like everybody, I guess, I've lost a lot of money. Life goes on and I'm surprised at my risk tolerance. I have no desire to sell low (I grew up on the game Stock Ticker).

But I do get monthly RIF and LIF payments. As I can't stop payment, due to current conditions (and assuming that things will get better), I'm thinking of switching from month to month to an annual withdrawal which would leave me having losses only on paper. That makes sense to me as I can live without my RIF and LIF for now. I set up some GICs and they will keep me floating for a couple of years.

My second idea is, if I stay month to month, is to sell bonds (in my case ZAG) as they have suffered less damage than the stocks. I'm using Couch Potato 50-25-25, XAW/VCN/ZAG. Along with that, I would start a new RRSP as things are certainly a bargain right now and plough back whatever I get month to month and as above, and live off my GICs.

This is WHY we have GICs, right?

If you can let me know what you think, I would appreciate it.

Let’s start with the important stuff: I played Stock Ticker as a kid too. I don’t know if it had any effect on my risk tolerance, but who knows what drives these things. It’s good that you’re not panicking, Art.

As for the rest of your questions, my choice has been to continue with my plan unchanged through this market crash. But it’s important to look at exactly what it means to stick with my plan, because parts of it look similar to your thoughts.

My plan involves maintaining an asset allocation currently at about 80/20 between stocks and fixed income (cash, GICs, and short-term Canadian government bonds). The stock market crash has thrown this balance way off, so I’m selling bonds to buy more stocks to restore my balance.

Now that your stocks have tanked, your allocation to ZAG and GICs is high. So it makes sense to either shift some bonds or GICs to stocks, or live off bonds and GICs until you’re back to your desired asset allocation.

You could decide to go further and just live off your fixed income longer than it takes to restore your target allocations. This would effectively increase your stock allocation percentage higher than it was before the crash. This would be an active choice, but not one I’d make myself.

As for what to do with cash flowing from your RIF and LIF that you don’t currently need to live on, keep in mind that the government is letting you reduce RIF payments by 25% this year. If you’ll still have more cash than you need, then it makes sense to invest the excess in a way that’s consistent with your overall portfolio’s target allocations. Whether you invest this extra money within an RRSP, a TFSA, or a non-registered account depends on whether you have TFSA room, RRSP room, and a high enough income to justify making an RRSP contribution.

Whether you should change your withdrawal frequency from monthly to yearly comes down to convenience for me. I prefer yearly because it’s less work and I don’t have tight cash flow. Your idea is to delay selling stocks right now, which is an active decision that I wouldn’t bother to make, but is mostly harmless.

The question about why we have GICs depends on your philosophy. There are certainly many people whose plans involve shifting all spending to GICs after a market crash while waiting for stock prices to recover. This is obviously an active decision based on when you declare a stock drop to be large enough to call it a crash. As you have probably guessed, Art, I prefer a mechanical strategy without any hard switches from one mode of handling a portfolio to another.

So you’ll have to decide whether you want to follow your gut or just follow a mechanical plan that can be coded into a spreadsheet. One benefit of the mechanical strategy is that it eliminates hand-wringing about what to do next.

Monday, March 16, 2020

It’s Too Late to ‘Re-Evaluate Your Risk Tolerance’

It’s not easy to know your true investment risk tolerance. Fred Schwed explained this problem wonderfully in his book Where are the Customers’ Yachts?:

“There are certain things that cannot be adequately explained to a virgin either by words or pictures. Nor can any description that I might offer here even approximate what it feels like to lose a real chunk of money that you used to own.”

Now that the stock market has tanked and investors are learning what it feels like to lose money, experts like financial planner Jonathan Bednar are saying “This is a great time to re-evaluate your true risk tolerance,” and “If you are nervous then you may be taking on more risk than you are really comfortable with and should rebalance into a more conservative portfolio.”

This advice amounts to “sell stocks while they are low.” The best time to figure out that you don’t have the stomach for a stock market crash is while prices are still high. It’s now too late to reduce your stock allocation without permanently locking in losses.

Unfortunately, when stocks are soaring it’s far too easy to convince yourself that your risk tolerance is high. So maybe we need a different strategy. Perhaps we should record videos of ourselves saying how we feel after stocks crashed, and set a calendar reminder to watch this video annually. The next time stocks are soaring again, maybe the video will help us lighten up on stocks while prices are still high.

In the meantime, we have a choice to make. Either sell stocks and permanently lock in losses, or try to gut it out until the recovery and reduce our stock allocation at better prices.

Friday, March 13, 2020

Short Takes: COVID-19 and a Life Insurance Primer

Here are my posts for the past two weeks:

My Asset Allocation in Retirement

The Ultimate Guide to When to Buy and Sell Stocks

Here are some short takes and some weekend reading:

The Canadian government is providing useful COVID-19 information. I’ve heard many opinions that Canada isn’t doing enough, and others saying that the risk is overblown. Amusingly, I heard one person with both of these contradictory opinions.

Preet Banerjee explains the different types of life insurance in more detail than the usual superficial explanations. Broadly, there are two types: term life insurance and permanent life insurance. There are many subcategories of permanent insurance. No one type of insurance is inherent;y good or bad; what matters are the numbers. I don’t claim to have investigated every type of life insurance, but when I’ve dug into the numbers, anything that wasn’t term insurance looked quite bad. I’ve had many insurance salespeople tell me there are good kinds of permanent insurance, but they’ve never been able to provide me with the details of an available permanent insurance policy that turned out to be a good deal.

Thursday, March 12, 2020

The Ultimate Guide to When to Buy and Sell Stocks

We’ve all heard that we should buy low and sell high. But when are stocks low and about the rise, and when are they high and about to fall? Here we reveal the secrets to when to buy and sell.

We begin with the short answer and then explain more fully.

When to buy. When you have the money.

When to sell. When you need the money.

The stock markets as well as markets for bonds, real estate, currencies, and other investments are complex systems controlled by many people whose collective actions cannot be predicted with accuracy. So we have to make choices without accurate predictions.

So, when I have money I want to invest, I don’t pay the slightest attention to my predictions about the near future (or anyone else’s predictions). Knowing that stock markets are volatile, I don’t invest any money that I think I’ll need within 5 years. When I do have some money to invest, I do so right away and don’t think about whether today is a good day.

Now that I’m retired, I sell stocks much more frequently than I used to. But I’m guided by the same principle. I try to predict how much money I’ll need over the next 5 years. If my current fixed income investments are too low to cover these needs, I sell some stocks right away without any regard for whether today is a good day.

This approach works best for index investors who own almost all stocks. Those who buy individual stocks have the additional problem of figuring out which stocks to buy or sell. I don’t worry about that. A happy side effect of this investment approach is that I don’t have to listen to any talking heads making stock market predictions that are just guesses anyway.

Sunday, March 8, 2020

My Asset Allocation in Retirement

Occasionally, I get questions about my portfolio’s asset allocation now that I'm retired. I’m happy to discuss it with the understanding that nobody should blindly follow what I do without thinking for themselves.

When it comes to the broad mix of stocks/bonds/real estate, my answer used to be very simple: 100% stocks. But now that I’m retired, I do have a fixed-income allocation that consists of high-interest savings accounts, GICs, and short-term government bonds.

My current mix is roughly 80% stocks and 20% fixed income, but I plan to increase the fixed income component over time. The way I think of it is that I have 5 years of my family’s spending in fixed income and the rest in stocks. Over time as I spend down my portfolio, the fixed income percentage will rise. For example, it will be up over 22% in a decade.

Some investors use a “bucket” strategy that resembles my approach, but there is a crucial difference. These investors typically plan to make active decisions about which bucket to withdraw from each year for spending. I don’t do that. I spend from my fixed income allocation and mechanically refill it without any regard for my opinions on the near future of the stock market.

When the stock market drops significantly (as it has recently), the drop in my portfolio makes the fixed income percentage grow above 20% faster than my family’s spending reduces it. In these situations, I can end up buying back some stocks to rebalance.

What I call my family’s monthly spending is calculated from my current portfolio size (less expected taxes). Currently, I take 20% of my after-tax portfolio and divide by 60 months. So, when my portfolio goes down, our monthly safe spending level goes down. So far this hasn’t been a problem for us because we rarely spend as much as my spreadsheet says we can spend. I guess that’s good for our sons’ inheritance.

My stock allocation consists mainly of 4 exchange-traded funds. The only exception is that after applying all my asset location rules, I still need more stocks in my taxable account where I’ve chosen to just buy the all-in-one fund VEQT instead of the 4 ETFs.

I’ve been asked why I don’t invest in real estate. The main reason is that I don’t expect it to outperform stocks over the long run. We’ll see over the coming decades if I turn out to be right about that. I do own a house, but I don’t think of it as part of my portfolio.

Overall, I’m pleased to handle my finances with a set of mechanical rules that can be coded into a spreadsheet. Some time ago a reader showed me how to have a spreadsheet email me if some aspect of my portfolio was out of balance and needed attention. So, I have little reason to monitor my finances on a daily or even weekly basis. Life is good.