Whenever the stock market wobbles even a little, some in financial media seem to panic, resurrecting the ghosts of 2008 and the dot-com bust of 2001.
From cable TV to “Finfluencers” on social media, these financial voices know that talking about a 50% market crash is likely to generate engagement. But, unfortunately, this kind of coverage also generates anxiety among older Americans and retirees.
If you’re approaching retirement, you or your financial advisor may be frequently stress-testing your portfolio for a 2008-style drawdown in the stock market. But when Ben Carlson, a portfolio manager at Ritholtz Wealth Management LLC, took a look at the actual data, he found something surprising.
“Bear markets and crashes are rare,” he wrote in a 2022 report for A Wealth of Common Sense (1). In fact, his data suggests that a truly catastrophic crash is so rare that many retirees might not live to see one in their golden years. And even if they do, their losses could be limited.
Here’s the surprising data, as well as a secret formula you can use to alleviate any anxiety you may have about experiencing a dramatic financial crash in retirement.
If you’re older than 30, you’ve probably lived through a few severe market downturns, including the dot-com bust of 2001, the financial crisis of 2008, the market correction during the pandemic, and the double-digit drop after Russia invaded Ukraine in early 2022.
The dramatic nature of these events may have convinced you that the stock market can be volatile and unpredictable. And while that is true to a certain degree, Carlson’s analysis of market data going back to 1928 suggests the frequency and depth of these corrections is actually far less horrifying than you may think.
A market crash of 30% or more has happened only 10% of the years between 1928 and 2021, according to Carlson’s analysis. A drawdown reaching 40% is even more rare, happening only 5% of the years during the same period.
Simply put, if you’re 65 years old and you live to the age of 85, you have a very small chance of witnessing a 40% drawdown within those two decades. And, depending on your asset allocation, the damage that a once-in-two-decades crash could inflict on your personal finances could be limited.
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For instance, if you only have 50% of your portfolio in stocks and index funds, a 40% drop in the stock market could reduce your nest egg by as little as 20%. The rest is probably secure in fixed income securities like bonds and treasuries.
With this in mind, there’s a simple formula that you can use to give yourself some much-needed peace of mind.
Given how rare a big stock market crash is, and how your exposure could be limited by your asset allocation, there is a simple formula that you can use to ease your financial concerns during retirement.
The first step is to figure out your personal risk tolerance. How much of your net worth can you afford to lose before it has a material impact on your annual withdrawals and retirement lifestyle? Once you have that percentage in mind, divide it by the ratio of equities allocation in your portfolio to figure out how much the stock market will need to crash before hitting your personal threshold of pain.
For example, let’s say you’re 60 years old, retired and have a portfolio that consists of 60% stocks and 40% fixed income securities. You believe your risk tolerance is limited to a maximum of 30% — which means your net worth would have to drop 30% or more for you to cut back on your lifestyle or make other sacrifices.
Here’s the secret formula that you can apply: risk tolerance ÷ equity exposure = implied stock market decline. In terms of the numbers mentioned above, the formula would become 30% ÷ 60% = 50%.
In other words, you would have to experience a massive 50% drawdown in the stock market — a once-in-a-generation event — before you may have to make adjustments to your retirement plans. Stock market corrections of a smaller magnitude may be more frequent, but given your risk tolerance, you can likely sail through these smaller storms.
The beauty of this formula is that it hinges on your personal preference and unique financial circumstances. So, if your appetite for volatility is much lower than what was mentioned above, you could consider slashing your equity exposure for some peace of mind. Alternatively, if your risk tolerance is significantly higher, you may have more room to maneuver with asset allocation.
Unlike the pundits on TV and social media, this approach is grounded in real data, as well as your personal situation. That should give you more peace of mind, which could potentially allow you to stop worrying and start enjoying your golden years.
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A Wealth of Common Sense (1)
This article provides information only and should not be construed as advice. It is provided without warranty of any kind.
