A reader writes:
“Hi Nords, I have some fears about a market crash that would derail early retirement. If I retire now in my late 40s, it would be near impossible to get my job back in my line of work. It’s almost easier to retire even earlier… Because then one would not be too old to re-enter the workplace.
You’re right about extreme early retirement. I know several ERs in their 30s (and one in their 20s) who are confident that they’ll be able to freelance their way to more income if they need to. But if you can accumulate the assets to retire that early then you might always produce income through some entrepreneurial project. I’m lookin’ at you, Jim Wang and Pat Flynn.
My spouse and I have been through two “market crashes” during our early retirement: the tech recession of 2001-02 and the Great Recession of 2008-09. We’ve invested since the late 1970s but both retirement recessions felt more painful because we were no longer covering our expenses with a paycheck. Today, though, we have the experience and confidence born of the crucible. Another recession wouldn’t bother us much, but we might find some great investment bargains.
The biggest challenge of a recession is dealing with emotions: particularly fear. The first coping defense for your emotions is an asset allocation that helps you sleep at night. (Then you can lie in bed reciting the Bogleheads mantra “Stay the course!” until you doze off.) But seriously, watching your portfolio melt down through a recession is a test of mental toughness and stamina.
When you have your asset allocation plan then you can feel as if you’re in control.
When you rebalance during a recession, you’ll end up buying more bargains at the bottom of the market. That confidence keeps you from panicking and selling out at the worst time.
A second defense is educating yourself about asset allocation and recession investing. It’s more than merely following directions from a few excellent websites or books– it’s understanding some of the principles behind the advice and appreciating the history of markets. I started with Dimson & Marsh’s “Triumph of the Optimists” and William Bernstein’s most excellent “The Four Pillars of Investing.” You can browse more books from the “investing” and “retirement” categories on the blog’s “Recommended Reading” list. It doesn’t matter exactly what you read about asset allocation and recession investing as long as you read enough to have the reaction “Ho-hum, another swing of the pendulum.” Then turn off CNBC, step away from the computer, and go for a long walk.
Oddly enough, when you’re afraid it also helps to share the misery. One (free) approach is posting to financial independence forums where everyone else is worried about the recession. You’ll see some posters buying gold bullion and shotgun shells, but the experienced investors will be waiting for their criteria to rebalance their portfolio. You’ll also find plenty of reassurance. Other investors hire financial advisors just to have someone to hold their hand and tell them that everything’s going to work out fine.
The next challenge is financial: having the assets to survive a recession. Most recessions bottom out during the first year and start recovering during the second, so my spouse and I keep two years’ expenses in cash. We begin every January with about 8% of our portfolio in CDs and a money market fund and begin spending it for our expenses. At the end of the first year, if the market is up then we replenish the cash stash from dividends/interest or by selling a few appreciated shares. If the market is down at the end of the first year then we start cashing in the CDs. By the end of the second year, we might have to contemplate selling equity shares, and they might be off their peak value, but we’ve never had to sell at a loss.
Another financial defense against a recession is longevity insurance. Every retirement portfolio should include some annuitized income, even if it’s “just” Social Security. When you reach financial independence, if you do not have a pension then I strongly recommend creating one for yourself: plan for Social Security or put 20%-25% of your asset allocation in a single-premium index annuity. You’ll get a steady monthly income no matter what the stock market may be doing.
If you’re reluctant to trust an insurance company (and pay the fees for the longevity insurance) then I’d recommend a low-expense dividend equity index fund or a balanced fund or even rental real estate. (We have a portion of our portfolio in the iShares Select Dividend ETF DVY.) During the Great Recession, our dividend fund lost nearly two-thirds of its value from peak to trough, but its dividend payouts only shrank about 30% off their peak and then began to recover. A year later its share price was back near our cost basis and it’s risen steadily ever since. (When we rebalanced our portfolio, we actually bought more shares.) Today it’s above its 2007 levels but the dividends have grown faster than U.S. inflation (and a lot faster than our personal inflation!).
Other disciplined and diversified dividend investors who held on during recessions (only selling if a company froze or cut its dividend) saw minimal reductions in income. For even more stability (and less effort) you could buy a balanced fund like Vanguard’s Wellington or Wellesley, which combine both bond income and stock dividends and automatically rebalance their holdings. Landlords lost equity during the Great Recession but did well on cash flow because many of their tenants were former homeowners.
Another financial defense against recessions is variable spending. The 4% Safe Withdrawal Rate withdraws 4% during your first year and then boosts annual withdrawals for inflation every year afterward, but those assumptions are just easier for a computer to simulate. No human actually robotically follows that system.
Investor behavioral psychology says that the wealth effect inspires us to spend more during bull markets and cut our spending during recessions. You will also spend less during a recession, so your two years of cash for expenses will probably stretch to 2.5 years or even longer. If you find yourself tempted to boost your spending during a bull market, then at the end of the year you could try to raise your cash asset allocation to 9-10% to give you a little more buffer during the next contraction.
In “Work Less, Live More“, Bob Clyatt pioneered the 4%/95% version of variable spending. (Look for the book at a library.)
Bob’s system withdraws 4% of your portfolio value every year, no matter what that value may be. There are no inflation adjustments, and a 4%/year withdrawal works great during bull markets. However, if the portfolio drops during a recession, you’d end up taking a huge spending cut next year.
That’s where the 95% comes in: if the market is down at the end of the year and next year’s 4% withdrawal would be an amount of money less than 95% of last year’s withdrawal amount, then cut back your spending to 95% of the previous year’s withdrawal amount. (Your withdrawals will only shrink 5%/year when the market drops.)
This means that overall you might end up withdrawing 5%-6%/year of your portfolio for a couple of years during the recession, but eventually, the market will recover and your portfolio will rebuild. Bob hired a financial analysis firm to run the historical simulations (just like the 4% SWR), and he brought his own financial independence portfolio through the Great Recession in the same way.
When you’re financially independent then you’ll probably find your own passion (or at least a paying hobby) that will also help you feel more productive and confident during recessions. Bob’s “Armageddon” solution is a temporary job— even if it’s a temporary employment agency or running errands on TaskRabbit. However, since writing WLLM he’s rekindled his passion for art and he’s now one of NYC’s leading sculptors.
Mine is writing & blogging, and I could pull in at least $25K/year by working 15 hours/week. The FinCon personal-finance group is filled with hundreds of entrepreneurs doing at least that well.
Recessions during financial independence are just part of the economic cycle. Mild recessions happen once or twice a decade. Bigger recessions happen once every few decades. Statistically, you may be fearing a market crash that may never happen. Here’s the crux of the 4% SWR: at least 18 times out of 20, you end up with way more money than you need. Since we’re all (mostly) human, everybody immediately disregards the wins and zooms in on the 1 or 2 failures with laser-keen focus. We try to reduce that to “0 out of 20” by various schemes like “just one more year” or “the 3% SWR” or “living off the dividends and never touching principal”. However, the best way to avoid those rare failures is with some annuitized income from Social Security or a SPIA or dividends. The other winning situations will take care of themselves!
Recommended Reading: Books, research papers, and articles
Getting started on asset allocation
Questions On The 4% Safe Withdrawal Rate
REVEALED: Our Asset Allocation During Financial Independence
How much cash in a retirement portfolio?
How many years does it take to reach financial independence?
My Financial Independence: 2014 Review and 2015 Plans
Financial independence forums: MrMoneyMustache.com and Early-Retirement.org.