A friend called me the other day to ask a question that I know many share and that many financial advisors are hearing, especially from those who are currently in retirement. Here’s how the conversation went, along with a few notes specifically for financial advisors to help in the similar conversations you’re having with your clients:
Q: “Tim, my portfolio has done well enough in just the first quarter of the year that we’ve more than covered the income we need from our investments for the whole year. Should we just cash out and take our investment gains off the table?”
A: First, I understand how you feel. We’ve had so many years where gains were hard to come by and a few in which it felt like the bottom was going to fall out. It’s stressful, even in the best of times, so the temptation to take your winnings off of the table in a year where your income goals have already been met feels not only rational, but right.
And yes, you certainly could do exactly that.
Financial advisor note: Our clients are the hero of their story, we are only a guide. They are the boss, and we are the hired help. So in any circumstance, the client must feel free to exercise whatever instinct occurs, because they are literally in control. Furthermore, we take an important step in any form of coaching by reminding the coachee of their autonomy. A client might be inclined to expect their advisor to put up a fight when they suggest they’re considering cashing out of their portfolio—and they’re probably right to anticipate as much—but recognizing the very freedom they already possess often frees them to make the decision we’d prefer.
But here’s the problem we face: While you might apply an expected annual rate of return, a portion of which is used to derive your portfolio’s estimated annual income, these numbers, while evidence-based, are merely theoretical. In reality, the balanced portfolio that might have a 6% expected rate of return annually will likely never return exactly 6%. It might return 7% one year, 15% the next, and -8% in the following.
What this means is that a plan to begin every new calendar year fully invested in our balanced portfolio and then cash out as soon as we hit our return goal may well work out in many years. But what about the years where the market doesn’t reach our return goal? Or worse yet, what about when the portfolio declines? The net result over time would be a much lower expected rate of return that likely wouldn’t support your income goal.
In other words, we need the great years to offset the not-so-great years in order to reasonably expect a good long-term rate of return.
Q: OK, that makes sense, but what happens if all these gains evaporate and turn into losses later in the year? That would feel horrible.
A: Unfortunately, that is entirely possible, and yes, it would sting. It’s simply the nature of investing in equity markets, and if the possibility of loss didn’t exist, we’d have no reason to expect a higher long-term rate of return than we could reasonably get in an FDIC-insured CD at the bank. But we become more comfortable navigating these possibilities through experience, and by recognizing that we don’t really invest for quarters or years, but for lifetimes. The design of your portfolio is not just to provide income for this singular year, but for years into the future.
Financial advisor note: There is no benefit to painting an overly rosy picture of the future or suggesting that imminent losses are not likely. Doing so is more likely to create panic when those times inevitably occur. The fact is, as my colleague Larry Swedroe says, “All of our crystal balls are cloudy.” And we’re almost always better served to prepare clients for the worst even, or maybe especially, when times are good.
Think back through just your own experience and consider how many times you’ve seen markets overcome frightening losses from which you didn’t think it was possible to recover—like 2000 through 2002, 2008 into 2009, and, even more recently, in 2020, when the pandemic appeared to spark a market panic. But while those are easier to remember because they were painful, think also about the times when it seemed like the market couldn’t, and by any measures shouldn’t, go any higher, and yet it persisted nonetheless.
Indeed, one of the best ways to ensure that we don’t miss out on the long-term gains we hope will come is to demonstrate the willingness to accept the short-term losses we know will come.
Q: As hard as it is to acknowledge that uncertainty, I know you’re right. So is there any middle ground here, any compromise that we can make to bring a bit of comfort, if only emotionally?
A: Of course, and the benefits aren’t merely emotional, either. Just about any good investment philosophy, including yours, involves a discipline called rebalancing. This is when one or more of the slices of your portfolio pie has grown or shrunk by an amount significant enough that the portfolio is no longer balanced as it was initially intended. In these cases, you can redistribute the excess gains to the parts of the portfolio that have suffered losses or haven’t grown as much.
It’s effectively applying a systematic approach to buying low and selling high. And indeed, in the first part of this year, you’ve likely seen a couple parts of your balanced portfolio grow substantially more than others. Last year, it was large, growth-oriented companies that shined; this year, it is smaller, value-oriented companies that have done especially well. As it stands, the most conservative parts of your portfolio are likely the proportionate “losers”—so, in this case, you literally are taking some of your gains off of the table and moving them to the more secure allocations in your portfolio by rebalancing.
But furthermore, we know that much in the same way your portfolio returns are not linear, neither is your life. Therefore, it’s entirely appropriate in years when the market is struggling to tighten your belt financially and reduce your income withdrawals to the degree possible. Similarly, though, when you have outsized gains, like this year, it could be the right time to make that larger, one-time purchase you’ve been considering, like to replace a car or to take that nicer vacation you’d planned with the family.
By allowing your income to expand and contract with the market, you’re satisfying both a numerical and an emotional need. In down years, you feel like you’re making a difference, and in years like this one, you feel like you’re not leaving everything to chance by reaping some of your rewards.
And that’s entirely appropriate, because the only reason to endure the eccentricities of market investing is to have a better life.
Financial advisor note: One of the hardest things about our work is translating what we do and how we do it in such a way that it is both comprehensible and meaningful to our clients. Unlike us, clients likely don’t stoke an academic fascination with the markets; for them, it’s far from academic. Especially when they are retired, the market is simply a means to an end—and that end is an enjoyable life. Therefore, the degree to which we can translate everything we communicate into more common, life-oriented terms, the better. And better yet, look for every opportunity to use the client’s own terms and language, even when you deem it to be less accurate than yours.