Close to retirement and panicking about the market crash? Here’s how to avoid locking in losses

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Few long-term investors ever enjoy going through a bear market like the current one we’re dealing with. Not only are stocks more than 20% off all-time highs that were seen just last month, but the whipsaws in volatility from day-to-day are enough to make your head spin.

But how you feel about living through a bear market also has a lot to do with where you fall in your investing life cycle.

If you’re a young person who has little experience dealing with market crashed and economic turmoil, this is a trial by fire. But young investors also have the most to gain from falling stock prices. Those who are just starting out on their investment journeys have many decades ahead of them to save and invest their capital.

Young investors should pray for bear markets because it allows them to buy more shares at lower prices. Human capital is your biggest asset as a newbie investor, meaning your future earnings potential should allow you to save money over time and allow compounding to do the heavy lifting for you.

Read: How to prepare your personal finances for a coronavirus recession

Those who are further along on their investment journey who are either retired or fast approaching retirement don’t have the luxury of leaning on human capital. Financial assets are typically the main holdings for this group, who don’t have nearly as long to wait out bear markets or slowly put capital to work over many years.

Lower stock prices are scary for older investors because they are at the point where they must begin drawing down their portfolios for living expenses. So how should older investors feel about their portfolios now that stocks are well off their highs and potentially heading lower?

Here are some things to remember if you’re retired or approaching retirement when it comes to your portfolio:

Diversification is key

Stock-picking is sexier but asset allocation will always be the most important decision you will make as an investor in determining your risk profile. This decision is paramount for retirees and balance can make all the difference.

While you don’t have as much time as those just starting out in the markets, retirees could potentially have two to three decades in retirement to invest their money. This means you must balance out the need for current income with the need for future growth.

The simplest hedge against a falling stock market is holding some of your assets in high-quality bonds or cash. Since reaching all-time highs in late-February, the S&P 500 is down close to 20% through last Friday. In that same time, 7-10 year U.S. treasuries (as proxied by the IEF ETF) are up more than 12%.

Bonds don’t pay as much interest as they once did but they still provide a hedge against falling stock prices as investors rush to one of the safest, high-quality assets available.

Always think in terms of spending first

The asset allocation can’t be made without first understanding what your spending levels will be and if other sources of income are available. The typical rule of thumb for a safe withdrawal rate from your portfolio is 4% of the value, increased each year by a reasonable inflation rate. This is not bulletproof but it’s a decent starting point to put your portfolio’s spending power into perspective.

Assuming you kept 40% of your portfolio in bonds or cash equivalents, that would give you 10 years’ worth of your first year of spending in assets that can protect you during a bear market. Those assets also allow you to rebalance into the pain by buying stocks are lower levels.

How much you keep in cash or bonds depends on how flexible you can be in regards to your spending. Lifestyle creep could be a bigger problem than a bear market if you have no clue where your money goes or potential ways to cut back during a crisis. Having a handle on your personal finances can help dictate portfolio decisions in terms of how much risk is necessary to take depending on your spending habits.

Give yourself more time

A bear market at the outset of retirement can make things more challenging than a rip-roaring bull market but there are ways to prepare yourself for the current scenario.

The average bear market since World War II has seen the S&P 500 fall roughly 29% and last for 331 days from peak-to-trough, on average. The average breakeven for stocks to recoup all lost gains from the bottom of a bear market in that time was just shy of 17 months, on average. So the average bear market took nearly a year to play out and then another year and a half to recover.

So a minimum of at least 3 years’ worth of spending cash in high-quality bonds or cash would give you enough coverage so you don’t have to panic-sell stocks at the worst time. Those approaching retirement could at a minimum begin funneling some of their savings in their later years into a safe savings account to cover their first year or two of expenses in retirement.

Of course, this doesn’t help those who have retired but didn’t take this into account but are living through the current bear market. One of the best returns you can get on retirement income is delaying social security payments until you’re 70 years of age. For those who were using that strategy but are now staring big stock market losses in the face, taking social security early could be an option.

You have to run the numbers to ensure this makes sense for your particular set of circumstances but this could offer investors some breathing room to avoid locking in stock market losses.

Life would be much easier if the stock market cooperated and didn’t throw you a curveball right when you need your financial assets the most. Your portfolio decisions as it pertains to asset allocation can help but you must get your personal finances and spending habits in order to give yourself enough options to wait out a stock market route.

Ben Carlson, CFA is the Director of Institutional Asset Management at Ritholtz Wealth Management. He may own securities or assets discussed in this piece.

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