With the current volatile economic environment, it is difficult for investors to know what they should do with their investments.
It is important to note that whether someone is an accumulator, a pre-retiree, or a retiree (definitions below), these decisions would be much less difficult for the investor if they had: 1) a solid plan, 2) the proper distribution, 3) appropriate asset allocation, and 4) the discipline to keep going back to the plan.
It is easy to make these things complicated and investigate alternative investment strategies as an example, but what it comes down to is the four steps listed above.
Investment plans in the face of high-interest rates and an inflationary environment suggest different strategies for 20- to 40-year-olds (accumulators), 50- to 64-year-olds (pre-retirees), and the over 65s (retirees), which is why we will highlight the strategy for each in this article today.
This article lists the definitions of accumulators, pre-retirees, and retirees below.
Accumulator Definition: A 20 to 50-year-old primarily accumulating for longer-term investments on the horizon, specifically their 401ks and IRAs (Individual Retirement Accounts) and other long-term money. Not someone is saving for a down payment for a house or a car.
Pre-Retiree Definition: 51 to 64, or 1-15 years to retirement
Retirees Definition: 65 plus
Interest Rates and Accumulators
My mom talked about how high the CD rates of return were in the early 1980s when I was in high school. At that time, the highest CD rate was a three-month CD in December of 1980, earning 18.3%.
In today’s times, that sounds like a high rate of return, but because nominal rates were high, the actual rate of return when subtracting the 14.5% inflation rate was 3.8%.
Today a one-year CD rate of return is approximately 2.5%. When you subtract the 8.6% inflation rate, your real rate of return is negative 6.1%, which creates a lot of pain for those on a fixed income as they are not offsetting Inflation.
How long will high Inflation last? We do not know, but the pain point right now is that interest rates have not caught up. They must come higher than where they are now. A 30-year mortgage of 3% is now 5.5%, but it needs to go higher.
CD rates have gone from zero to something but not high enough. The Fed has talked about curbing Inflation by raising interest rates, which will happen, but the pain that those higher rates will cause is not being discussed. It will slow down the consumer’s spending because their credit card payments will increase.
Auto loan payments will go up, food prices will go up, and before you know it, people will not go out to eat as much or want to make that new car purchase. Said another way, “demand destruction”.
The next shoe to drop will be jobs. Right now, most people have jobs, so even at inflated prices, filling up your Chevy Tahoe for $140 is doable, so people can still take that vacation they had been planning. At some point, though their job becomes questionable, people may have to forgo that trip.
The consumer is 70% of the GDP of the economy. So higher interest rates will surely slow down the economy. The slowing economy will affect confident investors more than others.
An Opportunity for Accumulators
The current economic environment provides the most significant opportunity for accumulators. If a person is a long-term investor, they should hope the market keeps going down because they will be dollar-cost-averaging over time.
If they put the same dollar amount in, they will buy more of those lower-price shares as the market goes down so that when the market recovers, they will have a lot of shares that they accumulated at a much lower price.
The accumulators, especially 401k participants whose employer matches the contribution should glide through.
Accumulator Example:
If an accumulator has $300,000 in their 401k and the market goes down 20%, that takes their account down $60,000 to $240,000.
If in that same year they put $20,000 into their 401k and their company matched their contribution at $6,000, half of their decline was replaced with the contribution, and they end up with $266,000 at the end of the year.
So, the statement risk was there, but it was smoothed out for the accumulator. Assuming they had an appropriate allocation for their age and the younger they are, they would typically have more equities than the pre-retirees and retirees.
Pre-Retirees and Retirees
In this economic environment, when it starts to get more necessary to take action, is when you are looking at pre-retirees and retirees. For pre-retirees and retirees, the extra layer added is their sizable portfolio with the same market risk as accumulators. Additionally, retirees are taking income.
Pre-Retiree Example:
Instead of $300,000 in their 401k, the pre-retiree now has $1,000,000, so when their account is down 20%, they have lost $200,000.
With a $20,000 contribution (as with the previous example), they are still down $180,000, which is when it begins to feel painful, and it becomes harder for them to stay the course.
Retirees Example:
Their portfolio is now $2,000,000; when it goes down 20%, they are now down to $1,600,000.
If they were planning to take 5% off their original $2,000,000 as income ($100,000), it would create a lot of stress.
Instead of taking $100,000 off a $2,000,000 portfolio, they are now taking $100,000 off a $1,600,000 portfolio which creates a negative sequence of returns.
(Sequence-of-returns risk definition is the risk that an investor will experience negative portfolio returns late in their working lives and early retirement.)
What Retirees Need to Keep in Mind:
In this economic environment (in addition to what we discussed earlier, having 1) a solid plan, 2) the proper distribution, 3) appropriate asset allocation, and 4) the discipline to keep going back to the plan), the next most important thing you need to remember is that you need to have an appropriate withdrawal rate.
No asset allocation in the world will fix you spending too much money!
A big problem that frequently happens is that people think they can trade their way into high investment rates of returns, but what is paramount is asset allocation and the withdrawal rate against the portfolio, which can make or break wealth accumulation plans.
If a 65-year-old retired with $1,000,000 and says he will withdraw $60,000 a year to pay himself, that may not be sustainable when the rate of return on his investments is so volatile in economies like the one we have currently.
Guarantees:
Retirees almost must do something with part of their portfolio that has a guarantee that will allow them to stay the course of their distributions. If they choose moderate growth in income, that strategy has a higher risk of going down.
If they were still working, that would not be so bad, but when that person is not working, and that is their nest egg, it is much harder to, without protection, to say, “I’m just going to stay the course.”
**Pre-retirees have some wiggle room, but they must be careful because of immense market volatility.
Why volatility makes CDs “risky”:
What is the risk of a CD? To answer that question, one must understand what an investment is and what it is not.
By purchasing a CD for $100,000, with a 1% yield of $1,000, the risk is that it does not grow enough to meet the future needs due to Inflation.
If the CPI (Consumer Price Index) is 7.5%, the 1% return of one thousand dollars will be $6,500, short of the $7,500 needed.
So, Inflation is the silent thief of doing nothing and not investing in the stock market.
If a person says, “I’m going to buy a CD because there is no risk,” the risk is that you will be stuck. Things will cost more than you can afford.
At that point, that person is forced into the stock market, but the stock market is volatile. It goes up and up, up and down, even though it has an upward bias.
80% of the time since World War II, the S&P has posted a positive total return, but you must consider the other 20% of the time.
If a person is out of the market because they said to themselves:
“I’m going to wait until the war is over.” “I’m going to wait till the Fed is done raising rates.” “I’m going to wait until inflation gets under control.” “I’m going to wait until whatever” you could likely be wrong.
The times that it goes down can be painful, so that is where diversification and asset allocation come into play.
Diversification and asset allocation:
Being and staying invested is appropriate most of the time. You can aim for the appropriate mix and should talk with your advisor.
If you do not have an advisor, we would be happy to help you, but we would need your risk number and then prune and rebalance that risk number.
We can help you align your allocations.
You may have a problem if you are older and closer to retirement and have a heavy stock allocation.
You will have to work much harder if you are younger and do not have enough stock. You may need to consider saving more money to build your assets.
You should consider a diversified mix that gives you some of the ups and some of the downs. You must accept too, there will be market volatility.
Examples from 2007-2009, 2017-2018, and 2020-2021 Looking at different asset classes including EM Equity, Commodities, Fixed Income, US Large Cap, Cash, High Yield, Small Cap, & Reits, asset allocation (an equal weight of all the above asset classes):
Looking at asset classes from 2007 to 2021 including emerging market equities, international stocks, a mixture of all the asset classes, investment-grade bonds, large-cap stocks, cash, high yield bonds, and small-cap, it was impossible to guess which asset class would be the hot performer, as it varied. The one that was #1 one year was at the bottom the following year in a lot of cases. But if you look over the last 15-year period, the one with the best total return turned out to be large-cap us. large-cap stocks from 2007 through 2021 had annual average return of 10.6%
The small-cap was up 8.7%, and real estate was up 7.5%, but take the large-cap, for example; the large-cap had an average annual of 10.6%. In the best year, it was up 31.5%, and in the worst year, it was down 37%.
A lot of people would be scared when their portfolio is down 37%, if you cannot handle the risk of loss you may never benefit from a potential gain. That is why if you just had a diversified mix of all of those in our example above (equal weight in each of the asset classes mentioned), you would never have the top performer, and never the worst performer, a diversified portfolio of all those average 6.1% per year.
In its worst year, it was down 25.4% in that period. That is where finding the right comfort level for your age and your station in life is so important. Your risk factor will change if you are close to retiring or are a long way from retiring.
There will always be a certain amount of volatility. There is usually a 10 to 20% pullback every couple of years in the market. It is almost impossible to avoid it.
You can invest the bulk of your money but make a tactical tilt. That is what we like to try to do is with part of the portfolio, we will make a tilt-based upon interest rates or based upon oil to lean a, a little bit one way or, or the other, but we will not make a wholesale radical sell and sit in cash or go all-in on stocks.
If you try to time the market, you are doomed overall because you would have to get two things right. Selling is easy, and then you would need to time when you buy back in?
You might think that it might go lower whenever you buy and that is the challenge. You must make some tilts. Selling a little bit is okay, but how do you get the allocation right?
Sticking to your allocation and rebalancing is a big one that was overlooked when us large-cap was booming.
You do not sell all your winners, but take some of the profits, and buy the underperforming asset classes.
For example, world allocation underperformed for years; we used to joke that it was called “diversification” because anything other than US, large-cap growth, you underperformed. World allocation was up, but not as much as us large-cap.
Bottom line:
Volatility is part of the process. You must be able to come to grips with it.
*Source: J.P. Morgan Guide to the Markets Asset Class Returns
*The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may no be invested into directly.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
All investing involves risk including loss of principal. No strategy assures success or protects against loss.
Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect against loss.