If you're invested in stocks, you aren't looking forward to seeing your first-quarter financial statements. If you're already retired, though, you might well be on the verge of panic as you watch your life savings dropping in value.
Falling markets are tough for any investor to endure. When you're just starting out, it's painful to watch any of your hard-earned savings disappear. But when you're depending on your savings to provide you with income for the rest of your life, you can't afford to take the same risks younger investors can. That makes any losses you suffer even harder to bear.
No matter how much you've managed to save, the universal fear among retirees is that you'll run out of money. But by anticipating the ups and downs in various markets, you can keep the odds in your favor.
Can you trust the 4% rule?
Those who've read the Fool's Rule Your Retirement newsletter service know about the 4% rule. In simple terms, based on past historical market returns, a portfolio of stocks and bonds has always been able to support withdrawals of 4% of the initial portfolio value for 30 years or more. So if you have $1 million when you retire, you could take withdrawals of $40,000 each year, adjusting upward for inflation every year, and expect to have money left 30 years later
That makes plenty of sense during good times. With stocks returning 8%-10% per year on average, a 4% withdrawal seems quite conservative when the market is rising.
But when stocks fall, it's hard to believe you can sustain withdrawals based on a nest egg whose value is dropping. If you're unlucky enough to retire at exactly the wrong time, it can take some fortitude to count on having history repeat itself.
The worst-case scenario?
Consider, for example, someone who retired at the top of the market in 2000. A Rule Your Retirement article from last summer showed that depending on exactly what investments you made, following the 4% rule could have left you looking at a reduction of more than 25%. After mild gains in 2007 and significant losses so far in 2008, a portfolio with 75% invested in an S&P 500 index fund and 25% in a short-term bond fund would have lost a full third of its value in just over seven years -- and annual withdrawals would now represent more than 8% of your remaining assets.
That isn't too surprising, given the recent drop that took 20% off the S&P 500's value. Even after yesterday's big rally, several major index components, including Apple
The 4% rule was designed with these sorts of historical drops in mind. After all, the market has gone through long stretches of so-so performance before. Even so, counting on history to repeat itself isn't necessarily reassuring after you've seen a big chunk of your net worth go up in smoke.
Spreading out the risk
But there are things you can do to avoid that worst-case scenario. A more diversified portfolio that the RYR article discussed owns more than just the large-cap domestic stocks you'll find in the S&P 500 -- and it has performed much better over the same time period with less risk. By including small-cap stocks such as Take-Two Interactive
You shouldn't keep all of your eggs in one basket, especially during retirement. By building a diversified retirement portfolio that includes assets that will do well when others are performing poorly, you can avoid the anxiety that comes from down markets that come soon after you retire.
To learn more about protecting yourself in retirement, read about:
To get more details on structuring your portfolio to get maximum benefit from diversifying, sign up for a 30-day free trial of Rule Your Retirement. You'll get access to back issues, including the June 2007 newsletter that discussed withdrawal rates during tough markets. Try it out today, and start sleeping better at night.
Fool contributor Dan Caplinger isn't counting on Social Security or Medicare to be around when he retires, but he's still confident. He doesn't own shares of the companies discussed in this article. Take-Two Interactive and Baidu.com are Rule Breakers recommendations. Actuant is a Motley Fool Hidden Gems pick. Apple is a Stock Advisor pick. The Fool's disclosure policy never runs out of information.