Concerns Many Savers Have – and How to Reduce Them
Part of investing successfully is accepting that the stock market is volatile and that market downturns — and even crashes — happen.
Young investors with long time horizons have years or decades to recover from this correction, but retirees do not. That’s why many people fear that there will be a market crash during their pre-retirement and retirement years, leaving them bankrupt later on. While that’s an understandable concern, there are strategies you can use to help your portfolio weather volatile market conditions and make your savings last longer.
What is the sequence of return risk?
The fear comes down to what’s called “sequence of returns risk,” or the risk that market losses in the early years of retirement coupled with withdrawals can cause your portfolio to suffer for years to come.
For example, a retiree will have to sell more stocks to get a certain amount of money when the market is down than a retiree who sells when the market is doing well. That will reduce your total number of stocks that have the potential to grow in the future.
While that’s the same situation for a young investor, retirees don’t have the same flexibility as investors decades into retirement since retirees often rely on their withdrawals from the market to fund their lifestyle.
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How to reduce your risk
In order to reduce the sequence of return risk, retirees can structure their portfolios to adapt to their new lifestyle and the fact that they no longer have a regular income from work. That doesn’t mean selling all stocks and putting that money into low-risk bonds, but it also doesn’t mean doubling down on growth stocks.
Financial advisors often recommend the three-bucket strategy, which involves grouping your money into categories based on when you’ll need it. The first bucket contains cash that can cover your living expenses for one to three years. This money should be kept in a safe, liquid account, such as a high-yield savings account, certificate of deposit (CD), money market account or short-term bonds, or a combination of several of these accounts.
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The second bucket contains money that you will need in the next three to ten years. These funds go into low-risk assets such as conservative bonds and mature stocks. These assets can generate good returns and cash flow, but will not be buffered by short-term market uncertainty.
The last bucket contains growth stocks and index funds. This bucket contains long-term growth capital that you won’t need to touch for at least ten years.
Remember that these buckets should be tailored to your needs and goals. Buckets allocated for daily expenses up to five years, short-term savings for six to 11 years and long-term growth beyond 11 years can also make sense.
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Why the bucket strategy works
Ideally, the bucket method will allow you to avoid selling stocks during market corrections, as you will have enough money in your first bucket and short-term reserves in the second to stay the course.
The strategy reduces volatility in your entire portfolio as only a portion of it is allocated to growth stocks and currencies, but you will still benefit from rising markets.
