You may have noticed, we seem to be at the beginning, end or middle of an especially rocky ride in global equity (stock) markets. If you’re wondering whether current volatility will continue or dissipate, the evidence suggests we can expect both: plenty of near-term volatility, but relatively dependable long-term growth.
Don’t believe me? Here’s an illustration. The gray, dotted line running horizontally across the chart depicts an 8.27% average premium delivered by US stocks from 1928–2017. As a reminder, “premium” in this case is actually the “equity premium”, which is the amount that stocks have out-performed a risk-free investment. In this case, the “risk-free” asset is 30-day US Government T-bills.
The good news is that 8.27% is extremely attractive. The bad news is that the four, short black vertical bars toward the middle are the only four years U.S. markets delivered anything close to this long-term average. In all other years, the annual premium was either much higher or much lower than average. In other words, lots of annual volatility, eventually delivering satisfying long-term returns.
So, not much we can do about ongoing volatility. But there is an important action you can take now … actually you should take well before any rough patches in the financial markets. It’ll not only help you take your mind off the breaking news, but it can strengthen your ability to ride out any downturns we’ve got in store.
Some call it a liquidity reserve, or less formally, a “rainy-day fund.” I prefer the term lifestyle reserve. Call it what you will … it is extremely important to have one. Your lifestyle reserve consists of high-quality short-term bonds, or similarly dependable, but low-returning assets. They should be in sufficient quantity to carry you through almost any challenging market – without having to cash out of depressed equity markets to free up essential spending money.
Lifestyle reserve while you are working
If you’re years away from retirement with a stable income stream (and solid disability insurance to protect your human capital), then your lifestyle reserve is really a “rainy day fund”. The purpose of this reserve is to cover any unforeseen expenses, and in a worse case cover short-term living expenses if you were to lose your job. While no one size fits all, generally this reserve can be relatively modest, like 3 months’ worth of living expenses. However, if you are starting a new business or are self-employed, then a larger reserve is more appropriate, perhaps 1 to 2 years of living expenses.
Lifestyle reserve in retirement
For those in retirement or similar circumstances, I typically recommend having closer to two to three years of required annual lifestyle needs set aside (even up to five years if that makes you feel more comfortable). For example, if you need $100,000 annually to maintain your lifestyle, then you should have $200,000–$300,000 in a reserve, preferably in an accessible, taxable (non-registered) account.
This may seem like a lot of money to have sitting in low-rate holdings. But there are a couple of reasons this strategy can make a great deal of sense.
(1) Having a generous, if lower-yielding lifestyle reserve would leave you much better off than if you end up making “the big mistake” of panic-selling your riskier holdings at a deep loss during scary markets (and ending up in cash anyway).
(2) Two to three years of lifestyle needs should provide enough time to allow the equity markets to recover. Once they do, you can re-start your systematic selling strategy … at higher prices. This is all provided that you don’t panic and sell, as described in #1.
Whether out of fear or necessity, you don’t want to end up selling your riskier assets when prices are down. You’ll be selling off when their future expected returns are higher too. What do I mean by that? Stay tuned, and I’ll explore it in a future post.
For now remember that having a sturdy lifestyle reserve can be an essential way to keep you anchored during rough markets.