This article post is the result of numerous comments and questions regarding my posts on recession-proofing yourself. I hope it is helpful!For investors still fighting with themselves over whether to stay invested or head for the hills, a fascinating new study sheds light on exactly why these decisions are so hard to make.
It's not just the "in or out" decisions, but also the ones revolving around whether to save for retirement or the kids' college education, whether to take a minimum IRA distribution from cash holdings or stocks and more. In this kind of market, everything seems a bit tricky, and has the potential to go against conventional wisdom.
The November issue of the Journal of Financial Planning features a piece by finance professors Robert Weigand of Washburn University in Kansas and Robert Irons of Dominican University in Illinois, looking at the effect of "withdrawal sequencing on the longevity of retiree's portfolios."
In plain English, that means it's looking at whether you should unload your stocks or bonds first in order to make your money last the longest. The authors looked at three possible withdrawal strategies: one where the retiree sells all of their bonds first, another where they sell stocks first, and a third strategy where they pull the money they need to live from each asset class in a 50/50 split.
Based on 136 years of historical data, the professors concluded that consuming the entire bond portion of one's retirement portfolio first results in the portfolio lasting longer than the other two strategies roughly 90% of the time. The strategy - which eventually will leave a retiree with an all-equity portfolio - on average extends the life of the holdings by 2.3 to 3.8 years.
Portfolio preservation
A number of charts on the historical returns of stocks and bonds, show a past performance that equities outperform bonds over the long run; consuming bonds first gives stocks more time to deliver that edge. That's why there is plenty of retirement research and conventional wisdom suggesting that retirees keep a big slug of their money in equities regardless of market conditions.
The 50-50 split is the second-best choice historically, because it captures at least some of the equity edge, with the sell-the-stocks-first strategy providing the fewest years until the portfolio is depleted. With that research in hand, it would be easy to assume that the authors would push investors to stay fully invested in equities.
But these are interesting market times that sometimes require going against conventional wisdom and history. The authors suggested that retirees go against the grain and consider selling stocks first, even if it has the potential to exhaust a pool of assets more quickly.
Specifically, the professors found that the bonds-first approach worked best at times when the spread between stock and bond returns was biggest. They found a sure-shot indicator of when to go bonds-first by studying the 10-year trailing earnings for stocks and bonds and looking for the widest possible spreads.
Right now, that indicator shows that, despite the historical results, it's not worth the risk to sell the bonds first in a retirement portfolio.
Retirement minds
Without getting too deep into the study, the results come back to the crux of decision-making problems. Many investors believe they know the "right way" to go, but market conditions make it so other decisions not only feel good and look tempting, but may in fact turn out better. An investor who has stayed in the stock market, for example, clearly knows that it's a bit late to head for the exits now, without becoming the poster-child for buy high, sell low.
But they lacked the foresight to get out of the stock market a year ago (or longer), and they can't rewind the clock. They can only go forward, balancing the decision between the way conventional wisdom says things will turn out versus the way they feel when they open their 401(k) statement.
Likewise, I recently received an email from Nanci F. in Natick, MA, whose oldest child will head off to college next year, but whose retirement nest egg has been gashed roughly by the amount she has set aside in a college-savings account meant to pay tuition. She's wondering whether she might want to dump the 529 plan in favor of plugging the big gap in her retirement savings.
There's no "right" decision. Joseph Hurley, who runs SavingforCollege.com, notes that if the 529 account is in the red, the money can be withdrawn without penalties or taxes (otherwise, any profits in the account could face a 10% penalty plus ordinary income tax).
But the real issue, he points out, is "What are you going to do with the money, and how do you make sure that it pays for something you value - like college for the kids or retirement for you - rather than just making a move because it feels good right now."
Similarly, many seniors facing required minimum distributions on their individual retirement accounts are wondering whether they should take the payout from cash or whether they should liquidate stocks. The longevity argument - as detailed in the Journal of Financial Planning article - would indicate that someone who doesn't need the money might want to let the long-term investments ride. (An investor can withdraw money from the account without liquidating securities, so that shares in stocks or mutual funds are simply transferred to taxable accounts.)
"Either way, cash or stock, the taxes are the same, because they are based on the value of earnings in the account," says Ed Slott of E. Slott & Co. in Rockville Center, N.Y. "It comes down to what someone can get comfortable with.
"That's the way it is with a lot of decisions right now," Slott added. "There is what you have done to now, and what you have to do to be comfortable next, and it's not always as easy as looking at some formula or figuring out the tax rules. Sometimes, it's just what it feels like in your gut."
michelle_desalva@yahoo.com
Journal of Financial Planning, E. Slott & Co., SavingforCollege.com
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