Question:

My well-diversified portfolio is down 30 percent from October of last year. I took a similar beating in 2000-2002, but back then I was not well diversified. I thought things would be better this time, and I’ve taken your advice by not buying or selling anything so far. However, my losses are more critical to me right now. In the 2000-2002 bear market, I was still working. Now, I am 20 months into retirement and I cannot keep adding money from earnings. Is buying and holding still appropriate for me?  I have an acquaintance whose adviser moved him into cash, and he is down only 7 percent instead of 30.

I know there are people who have lost more than I have. But the math looks daunting. It takes a 50 percent gain to recover from a 33 percent loss, and a 100 percent gain to recover from a 50 percent loss. Under today’s market conditions, it’s anybody’s guess how long that might take, especially since I am taking 4 percent withdrawals from my IRA based on the previous year-end balance.

I have had to reduce my withdrawals by about 20 percent and am looking at another 15 percent reduction starting in January. At that level, I will be hard-pressed to meet my reduced cost of living.

My question: Is there some threshold beyond which it is foolhardy to keep hanging on and losing money? Looking back, I wish I had cut my losses at 10 percent or 15 percent. I recently saw a Jim Cramer video clip in which he said it is not too late to sell because the market could still get a lot worse. I’ve followed your advice since I attended a workshop earlier this year. I wonder if I should move to cash now and save what’s left of my portfolio. Or should I hang on and hope things get better?

Click here to read Merriman's answer! 

PAUL MERRIMAN:

First, let me admit that the only way to give you the “right” answer to your question is to know the future. Some people may claim that knowledge, but I certainly don’t. Therefore, you are in the uncomfortable but unavoidable position of having to make very important choices with incomplete information. 

I can give you some guidance but I can’t give you the perfect answer. These are extraordinary times in the financial world, and the future looks very uncertain in many ways. Fortunately, the problems finally have everybody’s full attention. Unfortunately, the problems are very challenging ones without quick, easy solutions.

Your well-diversified portfolio shows that you have good judgment. While the diversification has not protected you from serious losses in the past year, everything we know about the past indicates that diversification is likely to be your friend in the future. The past has to be our guide, since there really is no factual alternative.

I’d like to briefly address three issues for you to consider. First, how much equity should be in your portfolio? Second, how much can or should you withdraw from it? Finally, should you move to cash now?

Portfolio allocation: From the size of the loss you report, I’m guessing your portfolio was allocated 60 percent to equities and 40 percent to fixed-income. You have experienced an uncomfortable loss, and I wonder if you need to be that aggressive. If you had had a 30 percent equity portfolio, It would have held up much better this year, probably with losses no more than 15 percent.

The table of past returns in the workbook you got at our workshop indicates that a 30 percent equity allocation is perfectly capable of generating good results in a recovery. (The table is available as part of an article called “Fine tuning your asset allocation. ”)  In the five years from 1982 through 1986, that portfolio gained a cumulative 123 percent. And after three major bear markets, the 30 percent portfolio had five-year gains of 74.4 percent (1975-1979), 66.7 percent (1988-1992) and 51.2 percent (2003-2007).

Withdrawal rate: You are taking a withdrawal rate of 4 percent, which we regard as conservative. In addition, you are basing that on your portfolio’s value. Even with only 30 percent equity, past returns indicate such a portfolio can grow over time at the 4 percent withdrawal rate. I don’t of course know how much you must have every year to live on. But to some extent your living costs are under your control. Everybody, including my own family, is having to learn to live on less these days. If you can make it on 4 percent of your portfolio value, adjusted annually as you have been doing, I expect your nest egg will grow over time – and along with it your yearly withdrawals.

To see how this and other withdrawal plans held up in the 38 years from 1970 through 2007, see our article “Retirement: When your portfolio starts paying you.”

Go to cash? Another way to frame this question is: Are you a buy-and-holder or a market-timer? So far you are the former, but it sounds as if you are tempted by the lure of the latter. Your friend is a timer, or at least is taking advice from one.

I am very familiar with the pros and cons of both buy-and hold and timing. About 20 percent of the money we manage for clients is in timing that’s based on mechanical models. Those accounts have had lower losses in the past year. The timing we do for clients is very different from timing based on market “calls” made by brokers, advisers and TV personalities.

The whole topic of timing is very interesting, and our educational web site has some good articles on the subject. I’ll take just enough time to make a few points.

First, we have found that market timing is much more psychologically challenging than being a buy-and-hold investor. In about two of every three years, the stock market is up. Yet timing systems inevitably take people out of the market during some of that time. It can be extremely difficult to stick with a timing discipline when you are watching other investors make money while you’re in cash waiting for a signal to buy. 

Second, if you decide that you want to be a timer, now is not the best time to start. If you want the full benefit from a market rally (which we expect but cannot guarantee), you will need to be invested when it starts. The type of timing we advocate will not get you into a rally until after upward trends have been established. (And they won’t get you out of a decline until downward trends are established.)

If you take Jim Cramer’s advice and go to cash now, you will turn your present losses into permanent losses. If you want to eventually recover from those losses, you will have to get back into the stock market at some point. You (and millions of other investors) didn’t recognize the “right”  time to get out of the market late last year and early this year. How will you (and they) know the “right” time to get back in? All my years of experience tells me that you (and they) probably won’t.

From the situation you have outlined, I would rather see you reduce your equity exposure, perhaps as far as 30 percent, and do your best to live on 4 percent annual withdrawals based on your portfolio value.

Every investor has two primary jobs. First, you must manage your risk. A 30 percent equity portfolio certainly does that. Second, you must manage your emotions. Your message tells me you have done a good job of that so far. If you can keep your cool through what we have experienced so far, I think you can continue to do so in the future. I hope I am right. 

Paul Merriman is a financial educator and founder of Merriman