Key takeaways
- Given how big one’s portfolio typically becomes, there is a lot riding on market returns during the last 10 years of a typical 40 year investing time horizon
- As a simple example, for a person who reaches a million by the age of 65, typically would have accumulated only half a million at age 55. i.e. in just the last 10 years the portfolio doubles
- As another example to illustrate the point, in the final year 40 of your savings, 90% of the increase in the value of your portfolio came from the returns you earned on your investments and only 10% came from fresh / new investments you made in the 40th year.
- So the last 10 years leading up to retirement are highly vulnerable to low market returns in that decade
- Similarly, Kitces has shown that the first 15 years once you are in retirement are vulnerable to low market returns
- So one possible equity glidepath to de-risk the entire retirement danger zone is V shaped: Steadily decreasing equity exposure in the last 10 years before retirement & then steadily increasing equity exposure in the first 15 years of retirement. Kitces also calls this a Bond tent
Heavy market returns dependency as one approaches retirement
The chart below shows how wealth typically builds over a 40 year period of investing from say age 25 until age 65.
The interesting point to note is that the portfolio reached only half a million dollars in the first 30 years and then rapidly doubled to 1 million in just the last 10 years.
This clearly shows how important the last 10 years in the run up to retirement are.
This is where things get potentially risky. What if stock market returns are poor for the last 10 years as you approach retirement?
Looked at from another angle, as one approaches retirement, the returns you are earning from your accumulated investments (reddish brown portion in chart below) over the past 30 years or so are much larger than the amounts you are investing as an SIP say every month (blue portion of the chart below)
As an example, notice that in year 40, 90% of the increase in the value of your portfolio came from the returns you earned on your investments and only 10% came from fresh / new investments you made in the 40th year.
What this implies is that as you approach retirement the value of your portfolio is more & more heavily dependent on returns from the stock market in those years.
As you can see from the above illustrations, your investment portfolio is significantly exposed & vulnerable to market risk in the decade before retirement.
However, as detailed in this earlier article of mine (based on Kitces’ research) the portfolio’s safe withdrawal rate over 30 years is also significantly exposed & vulnerable to market risk for the first half (i.e. 15 years) of retirement.
I paste below Kitces’ chart on the above for easy reference:
In summary then, retirement has 2 major danger zones:
- Last 10 years leading up to retirement
- The first 15 years (of a typical 30 year retirement)
So we need to find a way to mitigate the risks of both the above danger zones if we are to navigate retirement relatively safely.
De-risking in the decade BEFORE retirement
This is pretty straight forward. As we approach any financial goal, (e.g. funding our children’s education) we know that we should be steadily & systematically taking risk off the table to ensure we meet the goal. So when investing we constantly decrease the percentage of equity as we approach the goal – in this case retirement.
De-risking in the years AFTER retirement
Given that the returns you earn on your portfolio during the first 15 years of retirement affect retirement outcomes greatly, it would be prudent to adopt a strategy that minimizes your risk during the first 15 years of retirement.
If one wants to play it safe, one has to plan for the worst case i.e. assume stock returns will be poor during the first 15 years of your retirement.
One sure fire way to ride out a poor equity market over the first 15 years then would be to keep buying into it.
The results of this strategy (i.e. steadily increasing equity during the first 15 years of retirement) are validated by Pfau & Kitces’ research results pasted below:
Notice that the best success outcome was from a portfolio that started at 30% equity and ended at 70% equity allocation.
If you’re interested, more details on the above in my article here
Solution: Two phased equity glide path for de-risking retirement
Given all of the above, we can see that we need to de-risk the decade BEFORE retirement by steadily reducing equity exposure & de-risk the first 15 years AFTER retirement by steadily INCREASING equity exposure: something like what Kitces has shown in the chart below.
Disclaimer: I am not a financial advisor. My articles are meant for people who are not savvy or well versed with personal finance and investing and find it difficult to grasp all the jargon typically used when discussing such topics. I hope to be able to demystify investing and make it as simple as possible for everyone. I’ve invested in Mutual funds for approx. 24 years. I’ve also been a diligent student of the subject of investing over the past 24 years learning & applying the writings of luminaries in the field. In these articles I’m merely sharing my experience & learning from that investing journey and the books of luminaries in the field in the hope that it might help others in some way. I am in no way directly or indirectly claiming to be a hot shot investor who has generated exceptional or even above average returns during my investment journey. However, I am quite confident that even if all you do is learn from my mistakes, educate yourself on sound investment principles & develop good financial habits you will benefit greatly. Please ensure that you consult a financial advisor before taking any decisions or actions concerning your personal finances or investments. I shall not be liable.