As I’m writing this the S&P 500 just passed the 3000 mark. It only took five years for the index to reach this new high from the 2000 point milestone in 2014. In contrast, the rise from 1000 to 2000 required more than 16 years.
I like to think of myself as an optimist. So, I’m always confident that the market will go up over time. I just get a bit concerned when I see politicians taking credit for market gains and large companies using federal tax giveaways to buy back shares, propping up share prices.
All this while the US deficit is moving up in hockey stick fashion. Trade wars also pushed market volatility to new highs in 2018. It’s always easy to find bad news from good sources if you’re looking for it.
The case for optimism
On the other hand, experts have been predicting the next market crash since about 2012. Currently, we are 10 years into a record long bull run in the US stock markets. The point here is that no one can predict the direction of the markets. As much as governments may try, they even have trouble disrupting forward progress. Time marches on, things do eventually get better over time. Stay optimistic. When the next bear market or correction comes along, hang on tight and tell yourself this too shall pass.
Expect the best, plan for the worst
Optimism definitely has its place. For those of us that retired early, are financially independent, nearing retirement, or just hanging out on a beach somewhere, now is the perfect time to be a bit of a pessimist. Over the past two years, as this bull current bull market has gotten a bit long in the tooth, I’ve found myself looking at how specific investments performed during the 2001 and 2008 bear markets and recessions.
If we were to have another major bear market, how would my portfolio perform and what should my asset allocation be before it comes? I look at this as sort of conducting your own financial stress test, similar to what the Fed asks banks to do.
If you’re retired or financially independent and source part of your income from dividends and capital gains, ask this question: What could you do now that would enable you to get through the next recession and bull market without having to sell dividend producing stocks or stock market index funds while prices are dropping?
During a major market decline or correction, stocks are technically “on sale.” If you’re still working, do you have enough cash and working capital set aside that you’ll be able to purchase stocks during a downturn?
Building a bond bridge
My personal solution has been to buy 4 low fee bond index funds (Total US Bond Market Index, Corporate Bond Index, International Bond Index, and Municipal Bond Fund). I use them to build what I call a bond bridge. Over time, bonds have proven to be a very good way to preserve part of your principal during difficult times. During good times, bonds are nice alternative to savings accounts that are often low yielding and don’t keep up with inflation.
Preparing for a market downturn with lots of room for upside
In the news we often hear about investors “fleeing to safety” when the market has a correction, like we had this past December. The S&P 500 dropped about 18% from its high just shy of bear market territory. “Fleeing to safety” means that investors large and small start selling off shares and moving the money to fixed income and bonds during a downturn. This helps bonds to move in a different direction than stocks.
As an investor, especially one that relies on dividends and capital gains to supplement my income in early retirement, the very last thing I want to be doing during a downturn in the market is selling off stocks and stock index funds at a discount.
Bull Market Behavior
The time to take some gains off the table and move those gains into bond funds is during a bull market. You may say: well if I sell my stocks now I’ll miss out on these fantastic gains in the stock market everyone’s talking about.
The goal of building a bond bridge is to preserve capital during a downturn so that you’ll be able to buy stocks and stock index funds again when they’re being sold at a discount like during a bear market. I’m not talking about selling all of your stocks. I’m moving small percentages to bonds only when the market hits new highs.
If you’re selling some stocks to lock in gains and buying bonds, ideally you want most of this activity to be in your tax-advantaged retirement accounts like IRAs and 401Ks. This allows you to defer taxes on gains and also reinvest bond dividends tax-free.
I also like to have a high quality tax free municipal bond fund in my taxable brokerage account that equal at least one year of expenses during retirement or periods with limited income. During a downturn, I would sell these off first and replenish them later when I rebuild my bridge after the market recovers.
These bonds combined with the total market bond index funds and corporate bond index fund are my bond bridge. Meaning they can support me during difficult times in the market and allow me to avoid locking in any losses by selling stocks.
Bear Market Behavior
Here is how my core bond fund holding FXNAX performed during the December 2018 correction. You don’t want to be selling stocks during a correction or bear market. Start building your bridge.
Six steps to build a bond bridge
- Look at all of your taxable and tax-advantaged accounts like 401(k)s in a holistic manner to get a good understanding of what your total bond allocation really is.
- Use a free online tool like Personal Capital or Mint to track your holdings and total allocation across all of your accounts.
- Determine your ideal bond allocation. I’ve used the 2008 recession as a guideline. If that were to happen again, I’d like to have enough bonds on hand to cover at least two years of expenses and be able to keep my total allocation above 20% after selling off any bonds during a long recession.
- Create an emergency fund that includes at least one year of expenses. This should include cash in high-yielding savings accounts as well as high-quality municipal bond index funds. Ideally this smaller portion of your bond holdings is in a taxable brokerage account.
- Choose high quality bond index funds or Bond ETF’s with very low fees. I use Fidelity and Vanguard for lean low fee investing.
- Create your own investment policy and write it down. What you’re reading here is mine. You should speak to a professional investment advisor and build one based on your own needs that includes an emergency fund and bond index fund allocation. .
Over the past 5 years, I’ve sold stocks and purchased bonds to take my total allocation in bonds from 10% to over 30%. Instead of rebalancing large chunks of my portfolio once per year, I’ve held onto more of my stock market gains. As stocks added to gains, I’ve simply slowly increased my percentage of bond holdings.
I’ve done this very slowly, moving about 1% of my portfolio whenever the S&P 500 hits a new high.
So far I’ve gotten to about 30% and I will continue moving 1% with each new high until I’m close to 35%. This is different than rebalancing which simply keeps your bonds at a set percentage based on market gains and losses.
If the market goes into a correction or bear market, I simply pause any stock sales and make any necessary withdrawals from bond funds, while also taking advantage of dividends to supplement income.
This is the primary reason I am pushing the bond percentage towards 35%. I’m planning that I’ll have some left over working capital to buy stocks in the event of a recession. At the end of a recession or after buying stocks on sale my bond allocation would be closer to 20%. I’d then start the long process of building my bond bridge again.
The charts in this post are from an excellent Pimco research site that includes some compelling data to make the case for bonds.
I’d love to hear your experience in simplifying your investments. A quick disclaimer — Any concepts presented on this blog are simply opinions and should not be considered as professional investment advice. As with most other things in life, you are solely responsible for your own choices, make them thoughtfully.