The question – what happens to your investments in the next recession – has been on my mind a lot lately.
I’ve been thinking about it as it relates to those in the FIRE community?
Heard of them?
It’s a vibrant, active group of bloggers and investors looking to become financially independent and, for many, retire early (FIRE – Financially Independent/Retire Early).
Most advocate investing in low-cost index funds (primarily Vanguard). That’s a great idea. Keep costs low. Own the market. Leave portfolios alone.
Here’s my concern for this group (hence the post title). Do you know what happens to your investments in the next recession?
If so, are you prepared for it? If not, have you thought about it?
I’d like to shed some light on what it’s like to go through these kinds of events.
When FOMO enters the picture
FOMO (fear of missing out) causes us to make bad decisions.
It’s the kiss of death for investors. It causes folks to follow the herd. It’s among the worst kinds of emotions IMO.
Think about getting tickets for a concert with your favorite artist. Or about getting tickets for a game featuring your favorite team against their archrivals.
You’ve waited until the last minute. Ticketmaster shows the event sold out. But you can’t miss this game!
So what do you do? That’s right. You go to a ticket broker and pay exorbitant prices to get seats.
What makes you do such an irrational thing? FOMO!
You want to be able to tell people you were there. Even if that means you paid hundreds of dollars for tickets in the nosebleed section, you buy them anyway.
So, now you can say: I WAS THERE!
FOMO and Investing During a Recession
Now let’s transfer that emotion to investing.
You’ve been sitting on the sidelines waiting for the right time to invest. You’re hearing everyone around you talk about the killing they’re making in the market.
FOMO causes you to go all-in.
Granted, that’s not the nature of most in the FIRE community. Most have been saving and investing all along to achieve their financial independence.
For those in my generation, it’s a bit different.
When FOMO took hold in the late 90s and 2007, many people jumped in with a pile of cash.
And it cost them dearly.
Many didn’t understand the risk they were taking. Unfortunately, this caused people to accept the “this time is different” storyline.
Losing value so quickly after investing brought a change in behavior (amazing how this works, isn’t it).
We’ve lived through some nasty markets and know how much they hurt – emotionally and financially.
What those years looked like
Just how bad were those years?
Take a look at this chart of the S & P 500:
Let me break down the red numbers for you.
2000 – -10.14%
2001 – -13.04%
2002 – -23.37%
Total – -46.55%
What that means in dollars
Now let’s translate that into dollars, shall we?
Many in the FIRE community point to $1 million as the benchmark for FI. Of course, many factors would make that number change.
For now, let’s go with it. Here’s the math (arithmetic, actually).
- Beginning portfolio value: $1,000,000
- Cumulative loss: $465,500 (assume a buy and hold, no rebalancing)
- Ending portfolio value: $534,500
What does this number do to your financial independence?
The financial crisis of late 2007 to early 2009 was even worse.
2008 alone saw the S&P 500 drop by -38.49%. So, in one year, your million bucks dropped by just under $400,000 and is now $600,000.
If you count it from the start of the drop on October 9/10, 2007 to March 9, 2009, when it ended, the S&P 500 lost -56.8%!
From Wikipedia, here’s how the other markets did during the same period.
That’s real money folks! It’s not a hypothetical percentage.
My concern for FIRE investors
Since the community is mostly made up of Millennials and Gen Xers, my guess is most have yet to experience this kind of market turmoil.
It’s one thing to say you’re prepared for it conceptually. It’s quite another to live through it.
I remember in both of those periods how hard it was to endure. For me personally. And in talking with clients.
It wasn’t pretty, especially that last financial crisis.
In the fall of 2008, there were double digits drops literally on a daily basis (see chart above).
People had legitimate concerns that this was the next Great Depression. Both Congress and the Federal Reserve took decisive, unprecedented action to stem the tide.
Whether this action was appropriate and necessary is a much-debated topic. I’ve no interest in re-entering that debate here.
Suffice it to say; it was exhausting emotionally. Media, both financial and mainstream, pounded the negativity all day every day.
It seemed impossible to escape.
People who planned to retire in 2009 or 2010 had to extend their work lives longer to gain back what they lost.
Many invested in target-date funds in their 401(k) plans. They thought their investments became more conservative as the neared retirement.
In many cases, they were wrong.
It took me a while to get here but here’s my concern for FIRE.
It’s not just that most haven’t experienced this type of downturn.
It’s that most invest near 100 percent in stocks. Whether that’s via Vanguard, ETFs or other vehicles when the markets go haywire, stocks get hit the hardest.
If you have international and emerging market stocks in your portfolio (if well diversified, you should) those get hit even harder.
Granted, in the FIRE community, early retirement affords you more time to recover.
Think about how you would feel, though, if you just resigned from your corporate job and entered early retirement when the market fell out from under you.
I’m guessing it would be challenging.
In both of these bear market periods, that’s what happened to many.
How to prepare for bear markets
A bear market is loosely defined as a period when stocks fall by at least 20%.
Permit me to offer two ways to get ready for these bear markets.
Take the stomach test
First and foremost, you should stress test your portfolio.
What does that mean?
Take your current portfolio and put it to the test for various market conditions. If you’re with Vanguard, they can help you.
Most fund companies or custodians (TD Ameritrade, Schwab, Fidelity, etc.) have tools to help.
First, test your portfolio to see how much it would have fallen during the same period from October 2007 to March 2009.
When you look at that number, see if it passes the stomach test?
Pass or fail?
If you look at the dollar drop in your portfolio (let’s say a million bucks becomes $450k) and you get a queasy stomach, you’ve failed the stomach test.
I’m completely serious here.
I wish I would have done this personally and taken my clients through this test. We would have all been better off.
If you fail the stomach test, it offers the opportunity to adjust your portfolios to reduce the downside risk.
Remember, risk and return are related. The higher the risk, the higher the expected return. That’s why stocks offer higher expected returns.
How do you moderate the risk?
Add some high quality, short-term bonds to the portfolio.
My preference is 60% in high quality, intermediate-term US bond funds (like BND or AGG) and 40% in short-term high quality (like BSV).
Let’s say you decide you need 20% in bonds to soften the downside. In the above example, you’d put 12% into the intermediate-term fund and 8% into the short-term fund.
Run these scenarios through the same stress test to find a mix that passes the stomach test.
The final step in preparation and, in general, a good thing to have in place is a rebalancing strategy.
What is rebalancing?
It’s a way to keep your portfolio from getting too much or too little risk over your targets.
Here’s an example of what that looks like with a 50% stock/50% bond portfolio. Granted, that’s much more conservative than most FIRE portfolios.
The point is to look at how rebalancing works.
|U.S. Market Equity||15.0||20.0||25.0|
|U.S. Large-Cap Neutral||0.0||0.0||0.0|
|U.S. Large-Cap Value||3.8||5.0||6.3|
|U.S. Small-Cap Neutral||0.0||0.0||0.0|
|U.S. Small-Cap Value||3.8||5.0||6.3|
|TOTAL DOMESTIC EQUITIES||25.0|
|International Market Equity||7.5||10.0||12.5|
|International Large-Cap Growth||0.0||0.0||0.0|
|International Large-Cap Value||3.0||4.0||5.0|
|International Small-Cap Growth||0.0||0.0||0.0|
|International Small-Cap Value||2.3||3.0||3.8|
|Emerging Market Equity||2.3||3.0||3.8|
|Emerging Markets Large||0.0||0.0||0.0|
|Emerging Markets Value||0.0||0.0||0.0|
|TOTAL INTERNATIONAL EQUITIES||15.0|
|International Real Estate||0.0||0.0||0.0|
|Real Estate (directly owned)||0.0||0.0||0.0|
|Short-Term Fixed Income (includes cash/money market)||15.0||20.0||25.0|
|Intermediate-Term Fixed Income||22.5||30.0||37.5|
|Fixed Income — Inflation Protected|
|Short-Term Fixed Income||0.0||0.0||0.0|
|Intermediate-Term Fixed Income||0.0||0.0||0.0|
|TOTAL FIXED INCOME||45.0||50.0||55.0|
Interpreting the chart
To keep it simple, let’s use the bond assets as an example. This allocation sets the bands on either side of the target at 25%.
What does that mean?
If your short-term bond allocation gets above 25% or below 15% (target is 20%), it will trigger a rebalance.
In this case, we also assume the stock market is going up (it has been), and your stocks went up by the same percentage as the bonds went down.
Looking at the allocation, let’s say the short-term bond allocation dropped to 15% (target is 20%) while the US market equity allocation grew to 25% (target is 20%).
To rebalance, you would sell 5% of the US market equities, and add 5% to short-term bonds.
Though this seems counterintuitive, it isn’t. Why would you sell something when it’s going up?
Simple. It allows you to execute a buy low and sell high strategy systematically.
And isn’t that what everyone says is the winning strategy?
Here, though, you aren’t trying to time the market. You’re only doing this when the target allocations get outside the upper and lower ranges.
The other significant benefit is this keeps your portfolio in the allocation that, hopefully, allows you to pass the stomach test.
As a baby boomer, I love the FIRE community.
They’ve watched my generation pretty much create the consumption-based economy. We’ve wracked up personal debt.
Congress (both major parties) has been on a deficit spending spree that is now almost four decades long.
We’ve allowed the government to operate in a way that would bankrupt any family.
So, the FIRE community gives me great hope in the coming generation. It’s changed my mind and view of Millennials.
I wish those bashing this generation would take the time to read some of the blogs I read. They would change their minds too.
However, I would submit to you that we Boomers can also help you FIRE folks.
As for the market, this time is NOT different. This fantastic bull market run that’s now ten years old will come to an end.
It may come to a dramatic end rather than gradual. If so, it’s best to do what you can to prepare for it in advance.
Follow some of the steps I’ve outlined here:
- Stress test your portfolio.
- Pass the stomach test.
- Get a rebalancing system in place.
You’ll be glad you did when the next crisis comes.
Happy saving and investing!