One of the surest signs that we are in a stock market bubble is the growing number of people rushing to reassure you that frothy prices don’t really matter.
The optimists’ argument is simple: They point out that investing even at the worst possible times still produces decent results if you just hold on long enough.
This is mathematically true. It is, however, a bit misleading for investors who aren’t immortal or independently wealthy.
Put it this way: If you won’t need to touch your money for the next 30 years or so, stock market bubbles are just a passing annoyance. They can be safely ignored. Like any calamity, they tend to fade into the background once enough time has passed.
The problem, though, is what happens if you need to tap your portfolio for income over the next few years. In this case, a popping bubble can seriously disrupt your plans.
If you’re near retirement, or early in retirement, you should spend a few minutes pondering the unfortunate math of stock market bubbles. The past quarter-century demonstrates some of the risks you face.
Consider the case of a hypothetical Canadian investor who is swept away by the dot-com hype of the late 1990s. At the start of 2000, this affluent optimist puts his entire life savings – say, an even $1-million (in Canadian dollars) – into the S&P 500 index of large U.S. stocks.
What happens next? Nothing good. The dot-com bubble pops. The S&P 500 plunges. It starts to recover, then gets smacked again by the financial crisis in 2008. In 2010, a full decade after our hypothetical investor plunked his money down, his $1-million portfolio has shrunk to $720,000.
Granted, things then start looking up. Beginning about 2012, the S&P 500 embarks on one of the greatest runs in stock market history. If our investor holds on tight, he finishes 2023 with $4.7-million – an average gain of 6.6 per cent a year since 2000. This is the happy conclusion the market optimists like to focus on.
Remember, though, that this assumes our investor hasn’t had to touch his savings for nearly a quarter-century. It also assumes he reinvests every penny of dividends and does all of his investing in a tax-sheltered account.
Let’s imagine a slightly different and perhaps more realistic scenario for most middle-class investors. In this case, our investor is retiring in 2000 and intends to tap his portfolio for 4 per cent of its value every year – a reasonable enough plan. Given the booming market he has experienced in the late 1990s, he figures it will be a snap to start out withdrawing about $40,000 a year from his $1-million portfolio. He expects that withdrawal amount to steadily grow as his portfolio swells in value.
Unfortunately, things don’t work out quite as smoothly as he had hoped. The reason? The market immediately craters, yet he is still withdrawing 4 per cent of his portfolio’s value every year even when his portfolio is down in the dumps. The steady drip of annual withdrawals saps his savings.
Sure, the gains he makes post-2012 are huge in percentage terms. However, they still take a long time to make up for the damage inflicted during that ugly first decade of his retirement.
In fact, it’s not until 2016 that his portfolio is once again worth a million bucks – and that is not accounting for the bite of inflation. If you adjust the numbers to reflect the rising cost of living, he finishes 2023 pretty much back where he started 24 years earlier in real terms.
Worse yet, our investor’s plans to tap his portfolio for regular income don’t turn out nearly as well as he had hoped. He is withdrawing a steady percentage of his portfolio, so as his portfolio shrinks, the amount of cash he can pull out also shrinks.
If he sticks to taking out 4 per cent of his portfolio’s value every year, his income from his portfolio shrinks to under $24,000 a year in real terms in 2002. That is a far cry from the $40,000 or more that he was counting on annually to help fund his retirement. Things improve only slowly. In fact, it’s not until 2020 that his annual withdrawal finally reaches the $40,000 a year, inflation-adjusted, he had hoped for 20 years earlier.
What can we learn from this sad tale? The first few years of your retirement matter a lot. If you are heavily invested in stocks and are also relying on your portfolio for income, a market crash early in your retirement can punch a big hole in your portfolio and have ripple effects for years. Actuaries call this sequence-of-return risk and it should be on your mind if you are in or nearing retirement.
To put that another way, a frothy market, a stock-heavy portfolio and an impending retirement add up to a risky combination. Many metrics show today’s U.S. stock market is back in the same bubble territory it was in 2000. That is a fact worth pondering if you are over 55 and have a portfolio loaded with Wall Street’s finest. Maybe tilting a bit more toward safety wouldn’t be such a silly idea.