Why you should not lose sleep over market volatility

Since World War 2, on average the stockmarket has fallen by 20% or more every five years.  As we have previously examined, the timeframe for markets to bounce back can vary greatly: covid-19-update-no3

This can be a daunting reality for clients who are about to retire from the workforce and rely on their accumulated savings for income into the future.  For the duration of their retirement, most people can expect four or more significant falls in the value of their share portfolio.

It is important we remind our clients their investment strategy has already considered and factored in the expectation of future stock market falls.  We do this via a three step asset allocation process.

Step 1 - Risk Tolerance

Risk Tolerance concerns how you feel when you see the value of your investments moving up and down and at what point you can no longer “stay in your seat.”  We make this assessment in a number of ways, including risk questionnaires, one-on-one discussions and a review of your investing history.

Most investors only consider risk tolerance when determining their asset allocation. Unfortunately, this means they fail to consider the most important factor.

Step 2 - Risk Capacity

Risk capacity is the most crucial element to ensure you are well placed to deal with inevitable  stockmarket volatility.

When stock prices fall, we know they will rebound, we just do not know when.  Having enough cashflow to meet your income needs without needing to sell any part of your share portfolio for 5 or more years places you in a strong position to weather market volatility.

Factors that impact your risk capacity include how much you have invested out of the stockmarket (e.g. in bonds), your income from paid employment plus income from other sources (including conservative dividend yield assumptions from your share portfolio).

It is important to understand the role of bonds and fixed interest in context of risk capacity.  We do not invest in bonds to chase yield – indeed, share portfolios are currently yielding more than bonds.  The role of bonds is to be a source of cashflow when your stock portfolio has fallen in value.  Selling stocks at distressed prices has a material impact on the longevity of your money.

If you are in your 40s and have a net income surplus each month, it is unlikely you will require any bonds in your portfolio, unless your risk tolerance is particularly low.  However, if you have retired from paid work, it is imperative you have an allocation to bonds and fixed interest in your portfolio.  As noted above, holding bonds equivalent to 5 years of cashflow needs is often a prudent starting point (i.e., spend $100,000 per annum, have at least $500,000 invested in bonds).

When the GFC hit in 2008 and the pandemic impacted stockmarkets in Q2 2020, for clients who had retired, we sold down their bond portfolios to meet their monthly pension/income needs.  This provided time for their stock portfolios to recover – in the case of the pandemic, the rebound was quicker than most anticipated.  The ability to control your asset allocation in this manner is of critical importance to your investment strategy.

This is one reason why we do not recommend industry super funds to our clients.  Industry funds are Master Trusts.  If you start a pension with (say) a 70% growth allocation, every month when your pension is paid, every dollar drawn from the portfolio comprises $0.70 shares and $0.30 bonds. This pro rata draw down continues even when stockmarkets have fallen.  Consequently, industry fund members lose most of the benefit of asset allocation – i.e., being able to leave their share portfolio untouched after a significant fall.

Step 3 - Risk Required

The final step is a mathematical calculation to determine the average annual return you require from your portfolio to meet your goals.  This figure changes over time, and needs to be monitored.  For example, you may start your strategy requiring an average annual return of 7.0% pa, but after some years of good performance, this figure may fall to 6.0% pa. At this point, you have a decision to make – do you take less risk to increase the probability your goals will be achieved, or decide to amend your goals and spend a little more?  It is our role to help you make an informed decision.

Summary

Leaving the workforce is a significant life transition.  Knowing you are now entirely reliant on your accumulated savings requires a mindset adjustment – you are going from accumulation to spending mode.  You also ‘feel’ stockmarket falls more – they inevitably have a bigger emotional impact on you.

If you have a prudently developed investment strategy in place when you retire, you have already prepared for the next stockmarket fall, and the one after that and the one after that. Hopefully as your adviser, we can give you the comfort you can enjoy your retirement without needing to read the Australian Financial Review ever again.

Author: Rick Walker