Everyone Should Fear a Drawdown

01/17/2020 9:22 am EST

Focus: STOCKS

Landon Whaley

Editor, Gravitational Edge

Contrary to popular opinion, drawdowns hurt and do great damage to retirement portfolios, says Landon Whaley.

Headline risks are everywhere, much like bloated credit card statements in January after a holiday spending spree. 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 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.

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,” apparently you needn’t worry because, “Believe it or not, the average recovery time was ‘just’ 3.2 years.”

Where do we even begin to unpack this sack of garbage!

Let’s do a little case study to debunk the idea that retirees shouldn’t fear a bear market.

Most of the people we know with accounts at the Old Institution lost between 8% and 12% during the final quarter of 2018. 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 watermark 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 $895,104.

For the next two years, you get the same gains (and you take identical distributions and the advisor gets the same fee), and as 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 $849,976.09.

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 if they were withdrawing more than 3% each year or are paying their advisor more than 1%.

Beyond that, a vital, and often overlooked, aspect of any drawdown is the recovery period following the decline. As Hulbert says, the average recovery time is “just 3.2 years.”

I don’t care if you’re a 26-year old millennial who thinks you’re going to live forever, a 45-year old going through a midlife crisis, or a 90-year old hoping the next trip to the mailbox won’t be your last, getting zero return on your money for 36 months is a non-starter.

Remember, every day your account spends in a drawdown is a day that you are neutralizing the most powerful concept in all of finance, the power of compounding.

The “Headline Risk” bottom line is that Mark is dead wrong. You should not only fear bear markets; you should fear drawdowns in excess of single digits regardless of the overall market environment. 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 golf to “Hi, welcome to Walmart.”

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