By Derek Moore
With the market at all time highs, what are you supposed to do from here? You may feel the urge to do something.
If you are hedged, you’ve already done something. You’ve made the decision to protect and mitigate risk in the event of a major market sell off. If you aren’t hedged, that would probably be the thing to do. But let us explore a little deeper. And a few assumptions.
There are two games you can play when you think about protecting your assets. You can try and play the market timing game where you attempt to predict the best times to enter and exit the market. Market timers do this in an attempt to TRY and protect themselves against substantial losses.
Or you can hedge and stay invested. You’ve probably already reviewed your situation and risk tolerance with your advisor to create a game plan for your assets. In Something like our Buy and Hedge Retirement Strategy that is designed for protection, you could potentially limit equity losses to 8% to 10% over a 12-month period. Investors in this strategy understand they have a floor in their portfolio so if the market should retrace materially below that level, they have protection.
Jay Pestrichelli and I recently did a podcast around how difficult this market timing is. Plus, how bad returns are impacted if you miss only the 2 best days of the year in the market. You can click below to check out that podcast.
The better approach we think is to just buy and hedge. Thus, putting a floor in your portfolio. This is also in our opinion potentially more optimal than the traditional 60/40 portfolio given low-interest-rate environment we are in. We also covered in a separate podcast the notion of risk in the bond portion of the traditional stock/bond portfolios. You can listen at your convenience to that one below.
Let's hammer home the value of hedging in just two graphs below. For my assumptions, I will have someone who is turning 66 and retires. They have held assets of $1,2500,000. Their first-year retirement expenses will be about $86,700 and will rise each year by inflation of 2%. This is the amount outside of one-time expenses (or income) that will be withdrawn each year. We estimate social security starting at $20,808 when they first take it at age 67 and also increasing by 2% percent annually. I also assume a constant compounded annual growth rate of 6% in retirement.
Scenario 1: 50% Drawdown In Year 2 of Retirement
Source: Authors Calculations Using Hypothetical Scenarios (Real World Actuals May Vary)
So a 50% drawdown in year 2 (and resuming 6% compounded growth rate going forward) of retirement at age 67 means they run out of money at age 79. Plus, and I want to stress this, by age 68 they are down to beginning held assets of only $618,000. Do you think your behavior and comfort level would change going forward?
Now consider instead a drawdown of only 10% at age 67 in year two of retirement.
Scenario 2: 10% Drawdown in Year 2 of Retirement
Source Authors Calculations Using Hypothetical Calculations (Real World Actuals May Vary)
Wow! So theoretically adjusting our hypothetical to only a 10% drawdown, you don’t run out of money until 95 and at age 68 you still have around $1.1 million.
Now, we use assumptions here, but I wanted to show just how much the impact can be from buying but being hedged with a floor in the portfolio vs. trying to time the market or being diversified. Or worse, being in the market 100% without any hedges or other means of adjusting risk.
So with being hedged, it takes away some of the angst about investing and potentially may allow you to sleep better at night. Especially when you are most at risk pre-retirement and post-retirement. This by the way is a little small preview of a tool ZEGA will be making available soon that you can use to change various inputs and assumptions to calculate hypothetical graphs. Stay tuned for more on that.
So again, just be hedged!