The next big stock market crash is right around the corner. Which corner? Who knows? Anyone who does claim to know exactly when the next stock market crash will occur is simply playing a probabilities game until he or she gets it right. In other words, it is just luck.
Jim Cramer for example, the famous host of Mad Money, shares stock picks every night but these stocks only returned 64.53% over the last 15 years (2001 to 2016) compared to 126.06% for the S&P 500 over the same period. He has a hedge fund manager background and actually invests in what he preaches but again, he cannot predict the next stock market crash.
Cramer, unlike many other TV finance personalities, actually manages a stock portfolio that invests in many of his stock recommendations made on his television show Mad Money. – Jonathan S. Hartley, Matthew Olson
We do not know how the market is going to behave but one thing is sure; one day it will drop. When it will fall 20%, 30%, 40%… we will be ready. We are both too young to have lived through any major recession as investors but we are mentally ready to withstand these kinds of losses.
In the latest major stock market crash in 2008, for example, the S&P 500 index lost 37%. The Bloomberg Barclays U.S. Aggregate Bond Index, the benchmark of the Vanguard Total Bond Market Index ETF, gained 5.2%. That year, a 50% S&P500 and 50% bonds portfolio would have lost roughly 16% while a 70% stocks and 30% bonds mix would have dropped 24% and a 90% stocks and 10% bonds mix would have taken a 33% hit on paper.
These last two words are key; on paper.
The value of your portfolio would have dropped drastically but the only ones who actually lost money are the ones who sold. If you have the guts to withstand the crisis and stay invested, you will be just fine. The market has recovered, and more.
The go phase
We already talked about this in the past; if you are just starting out and in your accumulation phase, the best thing that can happen is a recession. Buying in a stock market crash lets you enjoy a huge discount on high-quality investments. When others are fleeing, you can accumulate highly diversified investments such as index funds and stay put for the ride up.
Not only can you benefit from drops by purchasing more of your favorite funds but you can also magnify your returns with dividend reinvestments. Reinvesting your dividends is the easiest way to ride the wave.
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The smell the finish line phase
When you are so close to financial independence that you can smell it coming, less than 3 years or so, a recession can hurt and push away your finish line a bit. For this example, think of John who had $700,000 in a S&P 500 index fund as of January 1st, 2015 and was planning to retire in 3 years with $900,000. He would then live off a 4% safe withdrawal rate on a $36,000 per year budget, counting for inflation. Unfortunately, John had quite a surprise.
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|
Year |
S&P 500 Annual Returns |
End of Year Balance |
|
2005 |
4.83% |
$733,810 |
|
2006 |
15.61% |
$848,358 |
|
2007 |
5.48% |
$894,848 |
|
2008 |
-36.55% |
$567,781 |
S&P 500 returns source: Stern University
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This is striking; when using the 4% rule, John’s potential budget went from $36,000 to $22,680 a year. That is quite a difference!
John could choose to either; cut his expenses and live on less, or continue working a bit longer to survive the drop. Fortunately for him, it was not too long before the market shot back up.
|
Year |
S&P 500 Annual Returns |
End of Year Balance |
|
2009 |
25.94% |
$715,063 |
|
2010 |
14.82% |
$821,035 |
|
2011 |
2.10% |
$838,277 |
|
2012 |
15.89% |
$971,479 |
|
2013 |
32.15% |
$1,283,809 |
S&P 500 returns source: Stern University
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Once John was at or above his target, he could start taking out a 4% safe withdrawal rate or lower. If he pulled the plug in 2013, he could withdraw fewer than 3% of his portfolio ($38,514 per year) followed by inflation-adjusted withdrawals in subsequent years and would historically been safe from any stock market crash (100% chance of success according to FIREcalc with the lowest ending balance being $560,971 in the simulations).
Even a 3.5% safe withdrawal rate is considered to withstand any recession while a 4% safe withdrawal rate has very high probabilities of lasting over 50 years (96.6% chance of success according to FIREcalc). Here, we used FIREcalc for these fictional portfolios but to see your actual historical chance of success, we suggest Personal Capital’s Retirement Tool. Try it for free today and see how your portfolio rates.
If you are close to attaining your number and wish to preserve some of your assets, financial planners usually say to increase your bond allocation. As previously stated, this will lower the volatility of your portfolio but can also decrease potential returns over the long-term. A 50/50 stock and bonds portfolio would have lost roughly 16% in 2008 but you need to keep the 4% rule in mind.
It is appropriate to advise […] a stock allocation as close to 75 percent as possible, and in no cases less than 50 percent. – William P. Bengen
Unfortunately, a bond allocation over 50% drastically decreases the potential longevity of your portfolio. Historically, withdrawing the 4-percent rule allowed a 50/50 portfolio to last at least 30 years under almost all periods since 1926 with a 96.6% chance of success according to FIREcalc.
Source: William P. Bengen
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Rates are at their lowest right now with returns of bonds far below the historical average of 5.18% but a strong stock allocation should prolong your portfolio’s longevity. Holding fewer bonds did historically increase total returns but a 100% stock allocation is certainly not for everyone. If you are not sure about your risk appetite, we suggest you try Vanguard’s risk tolerance-asset allocation questionnaire to get a rough idea or try Personal Capital for free today to dig even deeper into your finances.
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The freedom phase
Now, if you are already in your withdrawal phase and enjoying retirement, a large decline in your portfolio might frighten you a bit more. Fortunately, you have a good nest egg to sit on and the 4-percent rule survived through almost all major stock market crash in the past so you will most probably be fine.
- Stay on course
- Only cash out what you need
- Be flexible
If you had already planned to live off $36,000, for example, you could continue to withdraw such an amount but you could also be slightly more flexible in down years to lower your spending. You can always tweak your budget or start a little side gig to generate a small income if you are worried about selling a fraction of your portfolio.
It might sound crazy but you could even go for a long-term travel through South-East Asia to lower your spending! Enjoy the ride, Xyz.
12 replies on “The Stock Market Crash is Coming!”
I really like this analysis, with all the buzz about a bear market looming, this helps to outline what someone near or in FI can do. I hadn’t considered slow travel in a low cost area before, but that does seem like a great way to cut expenses without being bare boned with a budget in a post FI downturn.
Hey, it’s better than eating Ramens at home! If the market sees its worse year yet, going on the beach in Thailand and living off $10 a day seems like a great plan to me 🙂
It’s likely that “John” could have taken out 4% of the starting balance, and continued to take out that same amount event through the downturn, and worked out just fine. The 4% rule actually takes 4% at the start, plus annual adjustments for inflation, and holds at that plan through ups and downs – and still has a high rate of success.
Personally though I’m a bit more conservative so I follow a 3.5% SWR. 🙂
Yes, the 4% rule did hold with a pretty high rate of success in the past but 3.5% is definitively rock solid!
Very useful article!
Because I am right on the cusp of early retirement, I am holding a little dry powder in the form of cash to invest during a severe crash. I am waiting for something like 25% decline or more. If the crash never comes, I will just use the cash slowly over several years as part of my regular expenses. My approach may not be for everyone, but I think it’s a sound in this environment. I’ve posted a lot of details about it.
I think it’s the right way to approach it, you will need a good cash reserve once you retire anyway…
I like the analysis. Many folks will react on emotions. We will continue to do exactly what we have done – invest on a regular cycle. I do think we’ll maybe look at having a couple tranches we can deploy around market corrections (a strategy Financial Samurai is using as well) mostly for craps and laughs, but they won’t be significant (maybe $15k total) and we’ll have systematic ways to deploy them to try to make the most of a market downturn.
We’re still a ways from being able to execute that, though.
Great way to do it! Keep at it and good luck.
Excellent post! Interestingly, I just posted an article on the same subject.
I think everybody who is in the stock market is thinking when it’s going to go down and how low it’s going to get. I think the best approach is to have some cash on the side to take advantage of the dips and while staying the course when it comes to payroll deduction based investing using dollar cost average model.
Yes, we just automate our investments and stay the course.
I’d love for us to ‘retire early’ in 2020 so the next 3 years will be very interesting. Staying the course and hoping for the best. Thanks for sharing!
Good luck on your journey!