Bear markets are a fact of financial life, but they’re riskier for those who are close to or in retirement. Retirees who pay expenses from their portfolios can get a double whammy: not only do they lose principal due to the stock market drop, but the depletion in savings cuts into the portfolio’s ability to rebound.
To determine how to “mitigate” this problem, UBS Financial Services designed the Bear Market Damage Index, largely “to assess how much portfolio depletion risk is [in a portfolio],” Justin Waring, investment strategist Americas for UBS, told IA. He authored the study with Michael Crook, head of Americas investment strategy for UBS.
That a diversified portfolio reduces risk is nothing new, but beyond that UBS suggests a “liquidity longevity approach” to prevent a bear market from taking a larger bite out of a retirement portfolio.
This means having a separate cash/short-term instrument account that “meets cash needs and keeps the lights on, and doesn’t expose savings capital,” Waring explained. It should be enough to last 74 months, which takes into account a market drop, plateau and rise.
However, to do this advisors must know a client’s lifestyle expectations and cash flow needs.
To calculate a portfolio’s BMDI, UBS runs “a simulation of the portfolio’s value after withdrawals up until the end of the longest-ever bear market window,” the paper states. This means BMDI is calculated as a percentage of the portfolio’s depletion, indexed to 100.
The example provided by UBS is of a client with a $1 million all-equity portfolio that experienced a 51% drawdown over a three-month period, as well as spent 22 months at a plateau before beginning a 49-month climb back to a new time high. That means the time from peak to peak is 74 months.
A liquidity strategy would mean, in this example, an ending portfolio value of $741,617 vs. $583,511 if the client would have to withdraw from a portfolio’s capital, according to UBS. A sufficient liquidity strategy is one way to manage a portfolio in a bear market, but also, as almost every advisor knows, a “healthy allocation to bonds” mitigates losses.
Whereas on one side of the scale, 100% equity holdings, there would be a 51% loss, 100% bonds would be a 3% loss. But as the paper notes, “taking too little risk can cause just as much damage as taking too much.”
A mixed portfolio of equities and bonds definitely mitigates risk, but another idea is to borrow to meet cash needs as opposed to pulling funds from portfolio capital. Waring notes too that “interest rates are lower during bear markets.”
This would allow clients to meet some of their cash needs and “manage bear market risk with less opportunity cost (foregone gains) during bull markets.” —Ginger Szala