Are stock market crashes inevitable before retirment?
October 10, 2014 2:35 PM   Subscribe

I invest in my company's 403b retirement plan. I can use an investment calculator to estimate what things will look like by retirement, assuming a certain rate of return, and the numbers look fine. Does it make sense to assume that some sort of market crash or downturn will significantly affect this estimate before retirement in the next 30 years?

In other words, to what extent can I trust the final retirement calculation without factoring in some sort of market disruption, given a long enough period of time? Or, is the common consensus that based on historical trends, some sort of significant downturn will happen given a particular length of time? My fear is that the next 30 years is far enough out that the likelihood of a crash increases as I near retirement, and I'm interested in whether I need to think about ways of mitigating this likelihood.
posted by SpacemanStix to Work & Money (13 answers total) 5 users marked this as a favorite
Some sort of downturn is almost inevitable. I (a non-expert) think of dealing with this in two ways: (1) the overall rate of return you assume is higher or lower depending on your assessment of how many downturns there will be and how severe the will be and (2) as you get older you gradually shift the mix of assets in your portfolio so that (hopefully) you have less risk (so-called lifecycle funds are set up to try to do this automatically).
posted by Area Man at 2:44 PM on October 10, 2014

The stock market doesn't run on assuming certain rates of return, and you can't retire off of "expected returns".

Every 30-year period from 1871 to 2013 has had a period with negative growth. If you retired and sold all your assets in 1901, you'd be pretty lucky - the worst you'd ever have seen is -18.79% and you would have retired after two years of ~20% growth. If you retired and sold all your assets in 1931, you'd be pretty unlucky - you would have seen three consecutive years of negative growth culminating in a loss of -44.2% in 1931.

The more useful way to approach this is via Monte Carlo simulation. You'd be over-cautious to plan for retiring in the middle of the Great Depression. You'd be under-cautious if you plan on retiring in the exact middle of an economic boom. You need to decide your risk tolerance and plan appropriately. The point of Monte Carlo simulation is to see how your portfolio will do against a range of historically appropriate scenarios. It's not perfect, but it at least acknowledges that money doesn't grow at x% every year like clockwork.
posted by saeculorum at 2:52 PM on October 10, 2014 [3 favorites]

The best thing to do is put as much as you're comfortable living without right now into your retirement account and forgetting that money exists for 30 years. Don't worry about market timing - you can't control it. And there is no such thing as realistically mitigating the likelihood of a crash that happens 25 years from now.

I forget how 403(b)'s work, but if you can put all your funds into a market index fund (which invests your money in every stock that comprises the Dow, or NASDAQ, or any other major stock market), do that, set it to re-index as you get older (so your investment mix shifts from high risk when you're young to conservative as you age), and seriously just forget about it while it builds.
posted by pdb at 3:03 PM on October 10, 2014

These calculators go on long view historical averages. So it includes crashes, yes.

What you want is a retirement date fund. It will balance to have higher risks and higher returns while you are young, and lower risks when you are nearing retirement. These rebalance automatically. They are set and forget.

The real worry is if you reach retirement age and have lots of stocks in your portfolio and then there is a market crash. Diversity is key for this reason. As you are older you should hold more bonds and annuities.

Target date funds diversify and rebalance for you. They're great but feel free to eventually look beyond your employers match and find a lower fee target date fund.
posted by fontophilic at 3:34 PM on October 10, 2014 [1 favorite]

My fear is that the next 30 years is far enough out that the likelihood of a crash increases as I near retirement, and I'm interested in whether I need to think about ways of mitigating this likelihood.

Yes, you do need to think about this. It is strongly recommended that as you approach retirement, you shift your assets out of straight stocks into less volatile classes like bonds - there are rules of thumb like 'you should have the same percentage of assets in bonds as your age - 30% at age 30, 70% at age 70'. You can do this manually, or if you are not interested in managing this yourself and your retirement plan is with Vanguard/Fidelity or perhaps others they have plans called a Target Date Fund (named something like LifePath), where you pick the date of your expected retirement and they will take care of this rebalancing.
posted by the agents of KAOS at 3:37 PM on October 10, 2014

It is strongly recommended that as you approach retirement, you shift your assets out of straight stocks into less volatile classes like bonds

This is no longer the recommended strategy. The math shows that your money would last the longest if you kept it at a 70/30 or 60/40 stock/bond ratio and, starting at age 65, took no more than ~4% out every year. Full stop. (Here is a blog post about this study.)

That thing where you get more conservative is VERY YMMV.

If you'd like a more personalized analysis, it might be worth it to pay a fee-only financial planner for an hour of their time to look your specific situation over. (Online strangers' answer should always be, "Well, it depends.")
posted by small_ruminant at 4:02 PM on October 10, 2014 [5 favorites]

well, never mind what I said then. Guess I'll go re-evaluate!
posted by the agents of KAOS at 4:48 PM on October 10, 2014

This is no longer the recommended strategy.

I think this is vastly overstating your case. What you are recommending is very much a fringe strategy. The overwhelming preponderance of asset managers still recommend more conservative investments as you approach retirement. The general belief is "If you've already won the game, why keep playing."

When you are 65 and no longer have a job, you don't get any second chances, so being able to sleep at night is worth more than the grief from volatility. But, as you said, your mileage may vary. Perhaps you want to be the richest person in the graveyard.
posted by JackFlash at 5:39 PM on October 10, 2014

Obviously I disagree, JackFlash. I don't know too many advisors under the age of 60 who still stick to that old recommendation.
posted by small_ruminant at 5:52 PM on October 10, 2014

Though if you have a pension already, maybe you don't need to treat your retirement accounts as a sort of annuity, which is what this does. The Bengen strategy assumes you have about 30 years left of retirement. I don't know anyone who would recommend it to an 80 year old.

If the OP is 30 years away from retirement (am I reading that right?), s/he's 60 years away from his or her life expectancy. That's a long, long time.
posted by small_ruminant at 5:56 PM on October 10, 2014

When you plug in to your calculator a rate of return, do a sensitivity analysis on different rates. Break up the period into two or three, and see how a period of low return, capital loss affects your outcome.

Remember that cumulative investment GREATLY benefits from boosting the investment initially/in the early years - 30 years is a long time for compound interest effects to work their magic - again, explore that in your calculator, you may be surprised at the result.

I am a fatalist about recessions, I think that the best you can do is accept risk while you have a period to recover and reduce your risk as you approach retirement.
posted by GeeEmm at 6:00 PM on October 10, 2014

I don't know too many advisors under the age of 60 who still stick to that old recommendation.

I wouldn't be surprised. Young people tend to vastly overestimate their tolerance for risk, particularly for a distant retirement they can barely envision.

I would recommend sticking to the conventional wisdom.

The OP might try another calculator like firecalc just as a second opinion. Make sure you try some of the alternate scenarios on the top ribbon menu.

Calculators typically work using one of two methods. The first, like firecalc, looks to see how successful you would have been if you have retired on any year since 1871. It includes good times and bad, crashes and booms. There is no guarantee that the future will be like the past, but it does give you a handle on the range of possible outcomes.

The other type of calculators do a monte carlo simulation. It simulates thousands of possible futures based on a rolling of the dice for good years and bad.

So the answer to your question is that you need to know a little bit how your calculator works. Most of them, however, will have already taken into consideration the possibility of market crashes occurring along the way. They should give you some indication of worst case and best case expectations.
posted by JackFlash at 6:38 PM on October 10, 2014 [1 favorite]

There are really two different calculations involved here - one is calculating how much money you will have at retirement, given assumption about savings rate and return on investment (hopefully after inflation returns - otherwise it makes it much harder to figure out what the numbers mean). The best will give you different risk/return for different types of assets so you can see how your asset mix affects the return. If you have access to financial engines through your retirement plan their product is one of the best for this. The second calculator tells you given how much money have at the start of retirement whether it is likely to last as long as you will. Some people just use a "safe withdrawal rate" as a proxy for this calculation.

However, the best thing you can do it manage your spending and income sources. As you can see in fincalc, when the time comes, if you can avoid retiring during the very worst year, you will do much better. If you have paid off your mortgage and controlled your fixed expenses, you can allow your retirement expenses to fluctuate with market so bad years don't hurt as much. And of course, anything extra you can save now will, with magic of compound of interest, produce substantially more for you when you need it. (Note - not all of that savings needs to go into official retirement accounts - you want a buffer for current emergencies so your retirement savings will be protected if you get laid off, have a medical emergencies or some other expensive crisis. The best way to have a good retirement is to avoid consumerism and figure out how to have a good life on less money.
posted by metahawk at 11:44 AM on October 12, 2014

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