You invest for the long-term.  Long-term, stocks outperform bonds.  Why do you care about short-term volatility?  Shouldn’t you invest 100% in stocks and wait out any market underperformance?  Yes, and no.  It depends on how much you need to protect it from “retirement date risk” and “sequence of returns risk.”

Why does volatility matter?

Below are four examples of portfolios with increasing volatility and their resulting decreasing returns.¹

Volatility can impact your compound returns because percent changes have a larger impact on large balances.  The larger your portfolio, the more money you’ll lose if the market declines.  It can take awhile for a portfolio to recover from a market crash.  If your portfolio loses 50% of its value, it now needs to grow by not 50%, but 100% to return to its original value.

What are retirement date risk & sequence of returns risk?

Most portfolios are largest at time of retirement.  Any market crash shortly before retirement could severely delay your target retirement date.  This is known as retirement date risk.  Any market crash shortly after retirement could severely limit the amount you can safely withdraw from it for expenses while ensuring you don’t run out of money for the remainder of your life.  This is known as sequence of returns risk.²

To mitigate retirement date risk and sequence of returns risk caused by volatility, it becomes prudent to invest in low-volatility assets in addition to high return but high volatility stocks.  Of the options available, bonds (particularly intermediate term treasury bonds) provide portfolios the best return for the lowest volatility due to their low correlation with stocks.  But how much of our portfolio should be in bonds and when?

Percent Allocation To Bonds

Think of bonds as a hedge that they might outperform stocks in the short term.  Therefore we will want to know what percentage of the time bonds outperform stocks over shorter and longer terms.

As you see, stocks outperform bonds more than 99 percent of the time over 30 years.  Therefore, if you are 30 or more years away from retirement you should not allocate any of your portfolio to bonds.  But as the number of years decreases, so does the percent of the time stocks outperform bonds and as you approach 1 year the faster the percent outperformance decreases.³

This decelerating outperformance makes the case of having a decelerating stock allocation glidepath as you approach retirement.  For instance, once you are 30 years from retirement you might consider decreasing stock allocation by 1 percent a year until you are 20 years from retirement, then by 2 percent a year until you are 10 years from retirement, then by 3 percent a year until reaching a 40 percent stock allocation upon retirement.

A 40 percent stock allocation at the start of retirement is actually ideal for minimizing sequence of return risk according to Monte Carlo analysis⁴ and historical simulation⁵.  In a future post, we’ll discuss how increasing your stock allocation as sequence of return risk diminishes over retirement can give your portfolio the added return needed to push the longevity of your portfolio.

Putting Volatility Protection into Practice

If you’ve estimated your years until retirement and you are either under-protected (have too much of your net worth in stocks) or over-protected (have too much of your net worth in bonds), you should adjust, but not all at once.  Short term market fluctuations could cause sudden stock allocation changes to be risky.  Instead, slowly dollar cost average your allocation changes over the course of 6-18 months to ensure volatility doesn’t cause you to buy stocks high or sell stocks low.⁶

Works Cited

¹ https://www.investopedia.com/articles/06/compoundingdarkside.asp
² https://www.kitces.com/blog/managing-portfolio-size-effect-with-bond-tent-in-retirement-red-zone/
³ https://www.vox.com/personal-finance/2014/7/22/5877329/less-than-a-quarter-of-americans-get-the-most-important-investment
⁴ https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2324930
⁵ https://earlyretirementnow.com/2017/09/20/the-ultimate-guide-to-safe-withdrawal-rates-part-20-more-thoughts-on-equity-glidepaths/
⁶ http://www.efficientfrontier.com/ef/997/dca.htm