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What Happens to Bonds in a Stock Market Crash?

A reader writes in, asking:

“I have one friend who is paying 1% to have her assets managed for her. When I looked at the portfolio the advisor had her in, it seemed riskier than one might like given that she hopes to retire one year from now. I encouraged her to ask him, ‘If the market were to crash tomorrow and drop by half, will that change my plan to retire?’

I want to give a simple example and wanted to check something with you first. Let’s say she has $1,000,000, half in stocks and half in bonds. So if the market were to drop by half, then she would wake up tomorrow having lost $250,000, right?

So my question is, when assessing risk tolerance, is it sensible to assume the bonds will hold steady?”

The “if the stock market fell by half and bonds stayed level” scenario is one that I use myself, as I think it provides a very rough but quick and useful metric of how reasonable a person’s overall allocation is.

So, yes, I definitely think it’s sensible to consider such a scenario.

However, I wouldn’t say that it’s a good idea to put oneself in a real-life situation where you’re 100% reliant on bonds not falling when stocks fall. Because they could. On the other hand, they could increase in value while the stock market falls, thereby offsetting the loss somewhat.

In short, what happens with the bond holdings depends on a) the immediate cause of the stock market decline and b) the type(s) of bonds in question.

For instance, it may be instructive to look at what happened with the last big market decline in late 2008. The chart below (made using the Morningstar website) plots four different mutual funds from 1/1/2008-12/31/2010.

Mutual Fund Chart

  • The blue line is Vanguard Total Stock Market Index Fund (VTSMX),
  • Green is Vanguard High-Yield Corporate Fund (VWEHX),
  • Yellow is Vanguard Intermediate-Term Investment-Grade Fund (VFICX), and
  • Orange is Vanguard Intermediate-Term Treasury Fund (VFITX).

The stock fund obviously falls by quite a bit in late 2008.

The high-yield corporate bond fund (green) falls right along with it, though not as much. This is more or less what you’d expect, as a situation in which businesses suddenly look more risky is a situation in which people might not want to hold bonds from the riskiest businesses (i.e., high-yield bonds).

The investment-grade corporate fund (yellow) also falls, though not as much as the high-yield fund. Essentially, you have the same thing going on with investment-grade corporate bonds as with high-yield bonds, but investment-grade bonds are from less risky companies, so people aren’t running from them as much as they are from the riskier choices.

The intermediate term treasury fund (orange) goes up over the period in question, as people “flee to safety” — pushing up prices for the safest bonds (and pushing their interest rates down).

So that’s how different types of bonds behaved in one particular stock market decline scenario. But other scenarios can have different results.

For instance, the following chart shows the same four mutual funds from 1/1/2000-12/31/2003. In the dot-com crash, all three bond funds did just fine — even the high-yield fund had only minor bumps. And that’s about what you’d expect given that most businesses weren’t particularly in danger of failing to pay their obligations.

Dot Com Crash Chart

Alternatively, one could imagine various scenarios in which the market decides not that “U.S. businesses look much riskier than they did a month ago,” but rather that “the United States looks much riskier than it did a month ago.” In such a scenario, it seems likely that the investors who choose to “flee to safety” would not flee to Treasury bonds — and some would even flee away from Treasury bonds. So we would see a case in which Treasury bonds would fall (to some extent) while stocks and corporate bonds fall as well.

So, to summarize, yes I think it’s often helpful to think about a scenario in which stocks fall by half and bonds go nowhere. But it’s also a good idea to think about and prepare for other scenarios. (And in general, diversification is the tool to prepare for such scenarios.)

Investing Blog Roundup: Your Good Habits Aren’t Helping

Most of us with an interest in personal finance make conscious efforts to develop habits that will lead to financial success (however we each define it). As behavioral economist Meir Statman points out, however, the habits that serve one well during the accumulation stage are not necessarily a good fit for the spending stage. In some cases they can be directly detrimental to financial success or to happiness.

Investing Articles

Other Money-Related Articles

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How Do You Know if You Need an Annuity?

Last Monday’s article briefly touched on some of the factors involved in whether or not it makes sense for somebody to purchase a single premium immediate annuity (“SPIA” — essentially a pension from an insurance company) with part of their portfolio. Several readers wrote in with related questions, such as this one:

“My question is related to SPIA and when to buy them. How do you know if you need a SPIA? Example: If you have a $1 million portfolio (60% bonds 40% equity) and you need to take 4% a year out are you a candidate for a SPIA?”

Generally speaking, a SPIA is useful when you want to increase the amount that you can safely spend from your portfolio per year. Said differently, it’s useful when your desired spending level might not be safe, given your portfolio size and given the other characteristics of your situation.

Based on the example the reader provided, there’s no way to know whether the person is a candidate for such an annuity. Much more information is needed. I would ask the person in the example the following questions.

How old are you? What kind of health are you in? Are you married? If so, how old is your spouse and what kind of health are they in? The key point with all of these questions is that the longer your life expectancy — or joint life expectancy — the riskier that 4% withdrawal rate is. If you’re 80 and single, a 4% withdrawal rate is super duper safe. If you’re 55, married to a 52-year-old, and you’re both in great health, that 4% withdrawal rate is quite a bit riskier.

Also, when you say that you “need” to spend 4% per year, what do you mean by “need”? For example, if the portfolio’s returns were poor within the first 5 or 10 years of retirement, how much of a disaster would it be to spend, say, 3% or 3.5% from the portfolio instead? The more flexibility you have, the safer the 4% initial withdrawal rate and the lower the need for an annuity.

And have you already claimed Social Security? If you haven’t, delaying Social Security (especially for the higher earner of the two of you, if you’re married) is a great way to increase your level of guaranteed income, and the payout is much better than the payout from annuities purchased from insurance companies. Conversely, if you’re already age 70 (or are already planning to delay until 70) and you are thinking (due to the factors discussed above) that your 4% necessary withdrawal rate is riskier than you’d like, a SPIA becomes more relevant.

And, speaking of Social Security, how much total safe income do you have? For example, if you’re planning to spend $40,000 from the portfolio per year but you also have $80,000 per year of Social Security/pension income, the impact of portfolio depletion would be much less dramatic than if you have $15,000 per year of Social Security/pension income. And, therefore, holding all else constant, a 4% withdrawal rate is much riskier if you have a lower level of guaranteed income from other sources than if you have a higher level of guaranteed income. (This was the major point of the article from David Blanchett that we discussed last week.)

And how strong is your “bequest motive”? That is, how much do you care about leaving money to heirs? One of the big drawbacks of purchasing a SPIA is that it reduces the size of your portfolio, so if you die soon after purchasing the annuity, your heirs will receive less than they would have received otherwise.

Overall point being: In some cases, a person with a $1,000,000 portfolio who plans to spend $40,000 per year (adjusted for inflation) from that portfolio has absolutely no need for a SPIA. Another person with different circumstances — but still with the same portfolio and still planning to spend the same amount from it — should think very seriously about purchasing a SPIA.

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

Investing Blog Roundup: The Price of Socially Responsible Investing

Socially responsible investing is a hot topic — and getting hotter. This week, Larry Swedroe explains something that many SRI investors overlook: if the goal is to drive up the cost of capital for “bad” companies (however you define that), that is the same thing as driving returns up for investors in those companies (and down for investors in “good” companies).

Other Money-Related Articles

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The Relationship Between Guaranteed Income and Safe Withdrawal Rates

Spending from your portfolio in retirement is always a balancing act between two competing goals:

  1. Minimize the likelihood of depleting your portfolio during your lifetime (i.e., don’t overspend), and
  2. Have as high a standard of living as possible (i.e., don’t underspend and end up with a giant pile of unspent money when you die).

In a recent paper David Blanchett of Morningstar looked at how that balancing act is affected by the portion of your spending that comes from guaranteed sources (e.g., Social Security, pension, lifetime annuities) as opposed to from a portfolio of stocks/bonds with unpredictable returns.

If your spending is primarily portfolio-funded (rather than coming from guaranteed sources), you cannot afford to take significant risk of depleting the portfolio. That is, Goal #1 (don’t overspend and deplete your portfolio) is so much more important than Goal #2 (don’t underspend) that you can’t really afford to think about Goal #2 very much. Conversely, if your overall spending is funded primarily by guaranteed sources, then Goal #1 becomes less important relative to Goal #2 and the “just right” rate of spending from your portfolio is going to be higher.

A lot higher, as it turns out. Here’s one of Blanchett’s findings:

“Results from this analysis suggest that optimal initial safe withdrawal rates varied significantly when guaranteed income was considered, from approximately 6 percent when 95 percent of wealth was in guaranteed income, versus approximately 2 percent when only 5 percent of wealth was in guaranteed income.”

In other words, holding all of the other variables constant, it’s reasonable for a person with a very high level of guaranteed income to spend from their portfolio at roughly three-times the rate of a person with a very low level of guaranteed income.

An important takeaway here is that if you are basing your own spending rate upon one or more specific pieces of “safe withdrawal rate” research, you should check that their assumptions are a good fit for your own personal circumstances. Does the research demand a higher (or lower) level of safety than you require given your own circumstances?

Another important point is that this factor (i.e., the percentage of your spending that comes from guaranteed income sources rather than from a stock/bond portfolio) is under your control to a significant extent. If you want to increase your level of safe income, you can delay Social Security and/or purchase a lifetime annuity with part of your portfolio. These are not things that everybody should do. But they do meaningfully increase the amount you can safely spend per year, because:

  1. The payout on the part of the portfolio that gets annuitized (or the part that gets spent down to delay Social Security) is higher than the safe withdrawal rate from a stock/bond portfolio, and
  2. As Blanchett discusses in the paper, your safe withdrawal rate from the rest of the portfolio can now be higher because it’s less problematic if the portfolio is ultimately depleted.

To be clear though, while this one factor does have a big impact, it’s not the only thing influencing the appropriate spending rate from a portfolio. The appropriate spending rate also varies significantly depending on:

  • The expected returns from stocks and bonds,
  • Your life expectancy (an 85-year-old can safely spend a higher percentage of their portfolio per year than a 65-year-old),
  • Your flexibility to adjust spending, and
  • The strength of your “bequest motive” (i.e., your desire to leave behind a lump-sum for your heirs).

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

Investing Blog Roundup: The Future of Financial Advice

Over the last few decades, people have come to realize two things about mutual funds:

  1. Costs matter, and
  2. Most people don’t need anything fancy. (So paying a low cost for a cookie-cutter solution is usually just fine.)

This week John Rekenthaler of Morningstar predicts that, eventually, people will come to realize the same two things about financial advice.

Other Money-Related Articles

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