How to Construct a Portfolio Without Relying on Bonds
In this second part of a two-part series, I will explain what to do in your portfolio instead of buying bonds.
In the first part of this series I explain why you may live too long to own bonds.
The challenge is to build a retirement plan and investment strategy that is not highly reliant on bonds or the glide path strategy that is so widely advocated for in the financial industry. Sure, there are reasons to hold bonds—particularly if their yield is attractive to generate income, but for many investors, constructing a portfolio of equities and cash will result in better long-term outcomes.
Implement a Strategic (and Realistic) Withdrawal Strategy
There are three things you can do to adjust to a more stocks-heavy investment strategy—the good news is they are all within your control.
Choose a conservative withdrawal rate. There is no way to protect yourself against irresponsible and unsustainable withdrawals from your investments. Rule of thumb, if you withdraw more than 5% annually from your investments—you are not going to make it. If you can stick to a 4% withdrawal—even better.
When you project your withdrawal scenarios on your financial plan, review how much of your total portfolio you are requiring each year to sustain your desired lifestyle. It should be lower in the early retirement years as you have a larger portfolio; withdrawals as a percentage of your total portfolio are likely to increase as you approach life expectancy. However, for the majority of your withdrawals, keep it under 5% to be safe. For example, if you have $1,000,000 in one year, you should not withdraw any more than $50,000, and ideally, if you are early on in your retirement, it should be closer to 4% (or $40,000).
It’s important to note that continuing investment growth in your retirement plays a vital role; the longer your withdrawal rate remains below your average investment returns, the more likely your success. If your initial investment does not continue to grow at a pace above your withdrawal rate, you will eventually begin dipping into principal—and this does not even consider the impact inflation may have on your total picture. This is another reason equities are invaluable during retirement, over these decades your earnings are more likely to remain higher than your (responsible) withdrawal rate.
Have a variable spending plan in retirement.
I recommend people have flexibility when it comes to their cost of living in retirement. One should have two retirement spending plans; a “no-frills” and a “desired” budget. No frills means your covering all your needs—food, clothing, shelter, basic enjoyments. The desired cost of living would include the vacations, increased spending on hobbies, and other discretionary desires. Having a flexible spending approach allows you to tailor your cost of living to the current market conditions; reducing withdrawals during market downturns and potentially increasing spending during strong markets.
For example, perhaps your “no frills” budget in retirement costs $50,000; this annual amount includes all the things you need to keep the lights on but you will forgo the annual cruise and the golf membership that year. However, in better market conditions, perhaps you plan on spending $20,000 on travel and other lifestyle upgrades and increase your desired annual spending to $70,000.
In moderate or excellent market conditions you continue to spend $70,000/year; likely selling equities regularly to sustain your lifestyle. However, during a downturn you reduce your spending and halt any equity selling. At this time, you turn to the 1-3 years’ worth of cash you have stashed for this purpose (cash reserve strategy discussed in detail below). Burn your cash to sustain your no frills lifestyle for the year or two while the market returns to positive returns.
Important note: when you are saving for retirement, make sure you are saving to sustain your desired lifestyle costs—not your no-frills budget. This will also build in a cushion to sustain your retirement during the ups and downs of the market.
Be realistic in your retirement income and lifestyle expectations.
Most of the failures in retirement planning stem from people not wanting to admit how much their retirement will cost, and as a result fail to save enough to sustain it. Ultimately, a retirement plan that relies on unrealistic market performance or spending patterns will fail
Before you worry too much about withdrawal planning be sure you’ve saved enough—that you have something to withdraw from! If you are starting out on your retirement planning, plan to save at least 15% of your gross household income.
As you get closer to retirement you need to get serious about how much your cost of living really is and make sure the lump sum you are building can truly support that at a 4-5% withdrawal rate. For example, if you know you need $60,000/year to live on for a retirement period you expect to last 30 years, use that number to figure out exactly how big a nest egg you’ll need. In this example if you need $60,000 annually and you're using a 4% withdrawal rate, you'll need a portfolio of about $1.5 million. (If you want more help looking at different target numbers for retirement, check out my video 3 Numbers You MUST Know Before You Retire.)
The key here is being brutally honest with yourself. Don't build a retirement plan on best-case scenarios or overly optimistic market returns. Build it on real numbers, real spending patterns, and real life. Because at the end of the day, a retirement plan is only as good as the numbers it's built on.
Use A Cash Reserve Strategy for Retirement Withdrawals
The biggest threat to your retirement is not that the market will have a downturn during your golden years (it will, and possibly several times); it’s that you will be forced to compound a down market by selling equities at their lows to sustain your lifestyle.
Using a cash reserve strategy for retirement hedges against this sequence of returns by earmarking a cash position to be withdrawn to support your lifestyle needs when the market has performed poorly and you want to wait for a recovery of your investments before you resume selling positions.
Here is how to implement a cash reserve strategy:
Maintain a 2-3 year "safety bucket" of living expenses in cash/cash equivalents. Ideally, it is three years, but in reality, many people do not have portfolios large enough to keep three years’ worth of living expenses in cash during positive market years. Adjust this recommendation for your needs and situation considering things like your “no frills” budget, your pension and Social Security income, your overall portfolio size, your risk tolerance, and your health status. Those with guaranteed income streams covering most basic expenses might be comfortable with a smaller safety bucket, while those with variable income or health concerns might want to maintain a larger cash cushion. The key is finding the right balance between having enough readily available cash to avoid selling investments in down markets while not keeping so much in cash that it significantly drags down your portfolio's long-term growth potential.
During bear markets (falling markets), draw from your safety bucket for living expenses rather than selling depreciated investments. This gives your portfolio time to recover and prevents the permanent loss of capital that comes from selling investments at low points.
During bull markets (rising markets), systematically replenish your safety bucket by harvesting gains from your growth investments. When your stock positions have appreciated significantly, sell a portion to top off your cash reserves back to your target level. This "sell high" discipline helps lock in gains and ensures your safety bucket remains fully funded without having to sell investments during market downturns.
Navigating your withdrawals in retirement is the cornerstone of your success, so make sure you have a reasonable withdrawal strategy—one that favors flexibility and sustainability. Combining feasible withdrawals and a cash reserve strategy helps insulate you emotionally and financially from market downturns because you have a strategy already in place for tough market conditions. And by avoiding selling in down markets and replenishing your cash in up markets you are implementing the core principle of "buy low, sell high" while protecting your long-term financial security.