In an interview late last year, the esteemed portfolio manager Matthew McLennan commented on the impressive performance of the U.S. stock market over the last five years. He called this period the “window of U.S. exceptionalism” during which the U.S. dollar and the U.S. stock market demonstrated impressive strength, while other currencies, such as the Japanese yen and Chinese renminbi, lost value. In addition, although most foreign stock markets still have not returned to their pre-2008 levels, the U.S. market surpassed its own pre-2008 level years ago.
All of this has made the U.S. stock market a great place to invest; however, this window of strong U.S. market returns with low volatility may be closing. If we look at what happened in 2015 and what has happened so far in 2016, we find that the U.S. market could very well be more volatile in the coming years. In fact, McLennan has suggested that at current stock-price levels, the returns on U.S. stocks will fall into a range of 4 to 6% per year for some time.
Periods of low returns in the U.S. market are not unprecedented. Not so long ago, the U.S. market passed through a ten-year -period now known as the “lost decade.” From January of 1999 to December of 2008, the U.S. market, as measured by the S&P 500, posted an annualized return of -1.7%.
For those still earning income and saving, periods of this type will not derail a solid financial plan. Sometimes, in fact, they can even create the possibility of retiring into a period of exceptional returns, which is a nice trick for those lucky enough to pull it off. But for those starting the withdrawal phase of their financial plans, the effect of a low-return environment in the U.S. can be more dramatic.
If McLennan is right and we are heading into a period of lower U.S. market returns, then we should plan a response, an investment strategy that is flexible enough to take advantage of foreign markets. Returns on foreign stocks, however, as with U.S. stocks, do not work on a schedule.
Unfortunately, we can’t control the year-by-year returns of a portfolio, but there is something we do have control over: improving our portfolio’s stamina.
How to Build Portfolio Stamina
Portfolio stamina is the ability of a portfolio to last long enough to fund all of your goals. Strong risk mitigation improves portfolio stamina because limiting the losses in a portfolio during a market downturn preserves the capital needed to fund those goals. Additionally, strong investment return improves portfolio stamina. Clearly, it is helpful when a portfolio’s growth exceeds the cost of your goals.
It’s easy to see how limiting risk and having strong investment returns can improve portfolio stamina. However, people often view these two factors as the only important ones in assessing a portfolio’s stamina, but that’s not true.
Your Withdrawal Strategy
Designing and executing a dynamic withdrawal strategy, especially in a period of low returns, is a key way to improve portfolio stamina. There are many things to consider when looking at dynamic withdrawal strategies. Time horizons, withdrawal rates, and stock and bond valuations are all important, but a primary consideration is deciding on what to sell and when.
In research published in the Journal for Financial Planning, David Blanchett looked at a portfolio made up of sixty percent stocks and forty percent bonds. He subjected these portfolios to different withdrawal rates over different periods of time. (Thirty-year time periods are popular for these kinds of tests.)
He noticed that in periods of low returns, it often improved portfolio stamina to decrease stock exposure over time. An organic way to accomplish this is by raising cash to fund goals by selling stocks instead of bonds.
Blanchett saw that by emphasizing the sale of stocks in a period of low stock returns, the allocation of bonds would grow over time and so would the stamina of the portfolio. For portfolios subjected to an annual four percent withdrawal rate, the gradual decrease of stock exposure improved portfolio stamina by seven percent compared with other approaches.
At first glance, a seven percent difference may not sound like much, but it is, in fact, an important shift. Such an amount can be the difference between funding your goals or missing your targets.