This is the third part in a four part series exploring the usefulness of tactical strategies across generations. The first two parts of the series focused on Millennials and Generation X, respectively. Today, we will discuss Baby Boomers. Our one-pager on Baby Boomers can be found here.
When it comes to stock market crashes, the question really is not if, but when for most investors. Over the last 100 years, there have been four prolonged bear markets in the U.S equity markets1, or approximately one every 25 years.
While large drawdowns appear to be a universal experience for investors with a multi-decade investment horizon, the impact of these events on the achievement of financial goals can vary considerably from investor to investor.
The disparity in the impact felt as a result of a large drawdown originates from the way in which most people go about saving for a life event (retirement, college, etc.). If an investor saved $1,000,000 at age 25 and relied entirely on this initial investment to fund retirement at age 65, then the impact of a drawdown at age 40 would be exactly the same as that of a drawdown at age 60.
However, the average investor saves over a longer time horizon. When we think about retirement specifically, many people’s savings are extremely back-loaded. The years leading up to retirement tend to be when a person has the most earning potential and can put the most money to work in their investment portfolio. As a result, drawdowns that occur closer to retirement can be significantly more devastating than drawdowns that occur earlier in a person’s career.
The graph in the attached one-pager demonstrates this phenomenon. In this scenario, John Doe begins investing at age 25, has a starting salary of $50,000 a year and has an annual savings rate of 5%. We also assume that annual inflation is 2.5% and that portfolio returns are normally distributed with a mean of 9% and a standard deviation of 16.5%.
If we assume that the investor will experience a 30% portfolio loss at some point during his savings horizon, one trend immediately becomes clear. Experiencing a 30% loss closer to retirement is far more damaging than experiencing that same loss earlier on in the investment timeline. For example, if the drawdown happens immediately at age 25, the investor will on average end up with $1.8 million at the time of retirement. On the other hand, if the drawdown happens at age 60, the investor can only expect to have $1.1 million in his portfolio at retirement.
While assumptions that we used are very simplistic, the conclusion can be replicated even when a much more realistic model is employed. In reality, the relative impact of a drawdown later in life is probably much greater for the typical Baby Boomer for two reasons. First, we assumed that income only increased at a rate equal to inflation. Many individuals see greater increases in income over the course of their career. Second, we assumed a constant 5% savings rate from age 25 to age 65. In the earlier parts of this series, we discussed that savings rate are not constant and tend to increase over time. Both of these factors contribute to an even larger percentage of savings occurring later in one’s career.
When savings is more concentrated at the end of the retirement savings period, individuals become even more reliant on avoiding large portfolio losses in the years leading up to retirement.
The obvious response may be, “well why don’t we just reduce portfolio risk as we near retirement?” While we definitely advocate de-risking for those who can afford to do so, the unfortunate byproduct of savings being concentrated in the last decade before retirement is that asset growth in that period can be just as important as avoiding losses. It is in this dilemma, the need for Baby Boomers to continue to grow their assets while also avoiding large drawdowns, where we find the rationale for many Baby Boomers to incorporate tactical solutions in their portfolios.
1 From November 1916 to December 1920, the S&P 500 lost 47% in real terms. From September 1920 to June 1932, the S&P 500 lost 77% in real terms. From January 1973 to December 1974, the S&P 500 lost 50% in real terms. From August 2000 to March 2009, the S&P 500 lost 52% in real terms.