How do you mitigate risk of investment loss?

[lucija]

In other words, how do young dreamers set their equity to bond/cash allocation? To put things in perspective: our retirement will be fully funded with our investments (no pensions, etc.).

In general, folks tend to list something like “your age in bonds”, “your age – 10 in bonds” etc. I find such rules of thumb are not very useful when one is planning for an early out. Similarly, one can cut exposure to equities based on “the number of working years left”. Again, this is somewhat useless in our case, since we’re not waiting for some magic age/tenure (for us, the range is 9-17 yrs to go).

So, anyone else run into this problem? How do you handle it? Do you simply follow your gut feeling? I would really appreciate to hear your thoughts and any feedback you may have on the following method!

I settled on using the percentage of current portfolio vs. final portfolio needed (in today’s $) as a trigger for asset allocation. For example, assuming you need $1MM (today’s dollars) to attain FIRE, then you could:

• Be 100% equities up until $100K
• Be 85% equities between $100K to $250K
• Be 75% equities between $250K to $500K
• Be 65% equities between $500K to $750K
• Be 50% equities when you reach FIRE

A method like this would align risk based on portfolio's relative size vs. actual age or number of work years left.

Obviously, the actual percentages can/should be tweaked to reflect each individual’s situation and risk tolerance.

 

[Gumby]

Based on my reading and studying, I decided that 70-75% equities was on the efficient frontier, so that's what I did. I don't plan to change it even after retirement. I also ran Firecalc a few times and that was the range that gave me the greatest probability of success.

 

[twaddle]

The best risk mitigation is to keep working if the market blows up. Go balls out on risky investments until you're ready to pull the trigger on retirement, and then go conservative on that portion of your nest egg that is required to meet your basic expenses.

 

[brewer12345]

I am gradually reducing equity exposure as I get closer, but it is nothing so scientific and I will and have dialled up equity exposure in response to buying opportunities. What I have done:

- Gradually start buying a few more bonds and other non-equity investments over time.
- Pay down more debt. This may sound unrelated, but paying down debt is effectively the same thing as buying a risk free bond. By the end of the year or shortly thereafter, I will be down to just a low rate mortgage and maybe a small, low rate student loan.
- Diversify more broadly. As I get closer to FIRE, I am monitoring sector and security concentrations much more carefuly than before.
- Keeping more liquid cash around. This varies according to buying opportunities.

FWIW, I think trending up to 50% bonds is too conservative/risking inflation problems if you intend to retire before age 55.

 

[W2R]

The best risk mitigation is to keep working if the market blows up. Go balls out on risky investments until you're ready to pull the trigger on retirement, and then go conservative on that portion of your nest egg that is required to meet your basic expenses.

Wow! You're a brave guy, and I'd bet that you have done well with your investments.

Personally, I have decided that I'd almost rather jump off a cliff than continue working for more than two more years. My asset allocation is pretty conservative (only 60% equities) and I intend to continue LBYM in ER. That is the percentage that lets me sleep at night.

 

[twaddle]

Personally, I have decided that I'd almost rather jump off a cliff than continue working for more than two more years. My asset allocation is pretty conservative (only 60% equities) and I intend to continue LBYM in ER. That is the percentage that lets me sleep at night.

You have mentally pulled the trigger, so it makes sense for you to start preserving capital.

Bonds preserve wealth, but there's no one-size-fits-all allocation. It depends on your nest egg size (i.e., your need for high returns), and the term of your retirement more than it does on your psychological tolerance for short-term losses.

 

[FinanceDude]

Bonds preserve wealth, but there's no one-size-fits-all allocation. It depends on your nest egg size (i.e., your need for high returns), and the term of your retirement more than it does on your psychological tolerance for short-term losses.

I don't think bonds preserve wealth, maybe TIPS do............

 

[Lusitan]

Interesting phased approach you have come up with there, lucija. It'll probably follow something similar, although the percentage of my portfolio in bonds will be lower than in your example.

Since I'm planning on an early retirement (age 45 would be nice) I don't expect my bond holdings will make up more than 25% of my portfolio when I reach FIRE.

I'm holding 15% bonds right now and I'm still over 10 years away; I should probably consider reducing this to 10% at some point, but I'll probably do that by increasing my equity contributions going forward in the near future as opposed to rebalancing.

 

[lucija]

Thanks for the perspective and some of the suggestions… the numbers, themselves, are illustrative only.

We are and will continue to take on more risk than outlined in the example. Currently, we have about ¼ of the assets and hover around 10% bonds/cash. However, in my heart I know, if we continue to see the recent returns over the next 3-5 years (wishful thinking, right) and continue contributing at the current rate, I will be cutting the equity exposure to max 70%. I guess, as someone mentioned, I have mentally checked out already. My ultimate safety net is the fact that (at this time at least) my husband is not opposed to working till 50-55 (or later is the %$#^ really hits the fan).

Personally, our plan is to have an option to quit by age 45 (earlier, would be better), so I seriously doubt we’ll FIRE with less than 65% equities. It would be nice, though, to limit SWR to less than 3.5%.

 

[Lusitan]

My ultimate safety net is the fact that (at this time at least) my husband is not opposed to working till 50-55 (or later is the %$#^ really hits the fan).

Good idea, I gotta talk to my wife about that one ...

 

[maddythebeagle]

Thanks, OP...something to think about...and have been thinking about as my portfolio gets larger and nearing FIRE..

 

[SecondCor521]

I'm 38 and will likely FIRE by 50 (OK, the current spreadsheet says 52.XX, but my spreadsheet is conservative). Currently I am 100% equities. When I retire I plan to be at something like 85/15.

My theory is to go all out equities to the degree that I can still sleep at night when the market drops. I've been following that plan religiously and have been able to stomach the drops so far, but I have lately been considering a 5-10% bond position to take a little of the edge off.

So not really scientific on the period between here and FIRE; more gut feel. The 85/15 ratio is somewhere close to the optimal survivability frontier for a 40 year retirement.

2Cor521

 

[Milton]

Bonds preserve wealth

Can't agree with you there.

 

[twaddle]

If I hold a bond to maturity, I get my original principal back + interest. As long as the interest rate exceeds inflation for the period, my wealth has been preserved, right? And if we're talking about TIPS, the risk of inflation exceeding interest has been removed.

Are there any such guarantees for stocks? Let's ask the Japanese:

Nope, no such guarantee for stocks. Of course, the probabilities favor stocks over the long term, but that's not a guarantee of wealth preservation.

When bonds really help is when short-term losses in the stock market aren't so short-term and you need to sell off assets to pay the bills. That's why older folks are advised to have a higher allocation in bonds -- they can't afford to ride out potential losses over their remaining lifespan.

 

[maddythebeagle]

I'm 38 and will likely FIRE by 50 (OK, the current spreadsheet says 52.XX, but my spreadsheet is conservative). Currently I am 100% equities. When I retire I plan to be at something like 85/15.

My theory is to go all out equities to the degree that I can still sleep at night when the market drops. I've been following that plan religiously and have been able to stomach the drops so far, but I have lately been considering a 5-10% bond position to take a little of the edge off.

2Cor521

I believe that the "gurus" (Paul Merriman and Bogle) talk about a 10-20% bond allocation and dont give up much in return....

 

[Gumby]

I'm 38 and will likely FIRE by 50 (OK, the current spreadsheet says 52.XX, but my spreadsheet is conservative). Currently I am 100% equities. When I retire I plan to be at something like 85/15.

My theory is to go all out equities to the degree that I can still sleep at night when the market drops. I've been following that plan religiously and have been able to stomach the drops so far, but I have lately been considering a 5-10% bond position to take a little of the edge off.

So not really scientific on the period between here and FIRE; more gut feel. The 85/15 ratio is somewhere close to the optimal survivability frontier for a 40 year retirement.

2Cor521

I don't know where you were at in the Spring of 2000, but I was 100% equities. It was painful. I learned then that it is worthwhile to put a small drag on performance to decrease volatility.

 

[zebageba]

I'm 40 and have set my 401k to 80/20. Two Roths, one an index fund the other domestic growth. Taxable account maybe 5% bonds and a REIT, Large blend, small cap, Mid-cap and Intl. I'm more aggressive in the taxable. I probably won't touch my allocation until I'm 50. I've tried to cover all my bases.

 

[Milton]

As long as the interest rate exceeds inflation for the period ...

Is that guaranteed?

Of course, the probabilities favor stocks over the long term, but that's not a guarantee of wealth preservation.

There are essentially no guarantees in investing (or life!), and there are pros and cons to all asset classes. IMHO, it is better to play the (historically-proven) odds, especially if one has sufficient capital to ride out any downturns.

 

[SecondCor521]

I don't know where you were at in the Spring of 2000, but I was 100% equities. It was painful. I learned then that it is worthwhile to put a small drag on performance to decrease volatility.

In the spring of 2000, I had a chunk in my employer stock and the rest was 100% equities; in fact 100% S&P 500 index equities.

I sold off a chunk of my employer stock near their all time high in order to buy a minivan. This call, however, was my ex-wife's, not mine. I wanted to take out a low-interest rate loan at the local credit union and play arbitrage. (Credit where credit is due.)

I remained with a smaller chunk in my employer's stock and 100% S&P 500 index between then and now. The employer stock went to my ex in the divorce.

It was somewhat painful but with the increasing equity in my home and my additions to savings, we basically went sideways net-worth wise from about 2000 through 2002 or so.

Then in 2003 it looks like the index went up 28% or so. That year was good to me.

Many people talk about the 2000-2002 slide. If you were in dot-coms or sold on the way down, yes, you didn't do well. If you stayed reasonably diversified, held on, DCA'd into it, and waited for the rebound, you did OK.

But like I said, the heartburn for me the next time may be too much.

2Cor521

 

[trixs]

Currently I am 100% equities but I all new money is going to bonds until I reach +-20% bonds. This summer I think I realized my stomach for risk is not as big as I expected.

 

[Bimmerbill]

I am 90% equities (SP500 index, EAFE index, small cap index), but consider my two COLA'd pensions as my "bond" allocation. With them as an anchor, I feel I can invest a bit more aggressivly.

 

[kaudrey]

I'm 38 and will likely FIRE by 50 (OK, the current spreadsheet says 52.XX, but my spreadsheet is conservative). Currently I am 100% equities. When I retire I plan to be at something like 85/15.

My theory is to go all out equities to the degree that I can still sleep at night when the market drops. I've been following that plan religiously and have been able to stomach the drops so far, but I have lately been considering a 5-10% bond position to take a little of the edge off.

So not really scientific on the period between here and FIRE; more gut feel. The 85/15 ratio is somewhere close to the optimal survivability frontier for a 40 year retirement.

2Cor521

My situation is similar to 2Cor (hi!). Same age, same general retirement plan. But I am a little more conservative - I have about 10% in bonds, plus I will get a pension (which is like having bonds, IMO). I don't plan to decrease my stock holdings over the next 10 years at all.

 

[lucija]

Personally, I have decided that I'd almost rather jump off a cliff than continue working for more than two more years. My asset allocation is pretty conservative (only 60% equities) and I intend to continue LBYM in ER. That is the percentage that lets me sleep at night.

Want2retire - I like your reference about jumping of the cliff...

As our investments grow, I am less and less inclined to be aggressive. We were 100% equities at the beginning of the decade, not a problem at the time, but loss of 30-40% of our current portfolio would be extremely unnerving. At this point, a small drag in returns (i.e., bond exposure) seems a reasonable trade-off for a smoother ride.

 

[kcowan]

It is funny how people are more OK with risk as long as the numbers are small. Are we at the edge of a cliff (like the one that happened in the summer)?

If all us intelligent people think so, it will be so! How many are ready to jump when the next decline begins? Maybe it is best to beat the rush?

 

[lucija]

It is funny how people are more OK with risk as long as the numbers are small. Are we at the edge of a cliff (like the one that happened in the summer)?

If all us intelligent people think so, it will be so! How many are ready to jump when the next decline begins? Maybe it is best to beat the rush?

My comment had nothing to do with the current state of the market.

Everything is relative... In 2001/2, I was probably making $65K/year, had about 30-35K in retirement savings (a very optimistic figure) and was saving about 15/year. A market drop of 40% at the time equates to 12K or less than one year worth of my contributions. Why fret?

At this juncture however, my recovery time from a similar slump would take much much longer... I would be an idiot not to consider the implications of a potential drop.