Don't Be Fooled: Drawdowns are Bad

02/07/2019 11:22 am EST

Focus: RETIREMENT

Landon Whaley

Editor, Gravitational Edge

A simple case study debunks the idea that retirees shouldn’t worry about a bear market, says Landon Whaley. He's presenting at MoneyShow Orlando Feb. 9.

This week’s “Headline Risk” comes courtesy of yet another person perpetuating the “it always comes back” belief about the U.S. stock market.

Columnist Mark Hulbert starts out by quoting stats from an Allianz Life survey that found people are more scared of running out of money in retirement than they are of dying.

And although he acknowledges that “Retirement planning projections made at the end of the third quarter [2018], right as the stock market was registering its all-time highs, now need to be revised,” you needn’t worry because, “Believe it or not, the average recovery time was ‘just’ 3.2 years. Assuming the bear market that began at the end of September ends today, and assuming the recovery time lives up to historical averages, the stock market will once again trade in new-high territory in December 2021.”

Let’s unpack this sack of garbage.

A simple case study debunks the idea that retirees shouldn’t worry about a bear market. Don’t fear it, prepare for it because it is inevitable.

Most of the people we know with accounts at the Old Institution lost between -8% and -12% during the final quarter of last year. To keep things simple, let’s say your retirement nest egg entering Q4 2018 was a cool $1,000,000 and that your portfolio strategy takes the same 3.2 years to regain the high water mark it reached before the -10% decline in Q4 2018.

At the start of January 2019, you had $900,000, and it was time to withdraw the 3% you rely on from this account to live during the year. And for the sake of this illustration, your advisor takes his fee upfront, which is another 1%.

You’re now starting 2019 with $864,000, which is down -14.6% from your Sept. 30, 2018, statement. During 2019, you earn a +3.6% gain, which is one-third of the 10% loss you experienced (remember that compounding means you need to gain +11.1% to recoup a 10% loss) and you end the year with $859,299.84.

For the next two years, you get the same gains (and you take the same distributions and the advisor gets the same fee), and as Mr. Hulbert predicts, at the end of 2021 your strategy (and “the market”) is back where it started, but your account value to start 2022 is only $854,625.

Even though your portfolio strategy has clawed back its 10% loss, you’re getting further and further away from your $1,000,000 high-water mark.

Folks, the math is simple, and it highlights a very real market fact that the Old Institution would rather you not know: drawdowns kill portfolios.

Even a -10% drawdown can have long-ranging consequences, and in this example, I used conservative numbers for investor withdrawals and advisor fees. Imagine the hole someone would dig for themselves if they were taking more than 3% each year or paying their advisor more than 1% — both likely scenarios.  

The “Headline Risk” bottom line is that Hulbert is dead wrong. You should be concerned over bear markets, and you should prepare for drawdowns. You don’t need a full-fledged bear market in U.S. equities to put your portfolio in a retirement bind. Believing “it always comes back” is the quickest way to transform your retirement from pottery classes and bridge every afternoon to “Hi, welcome to Walmart.”

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