Handling A Market Downturn

The masses are very skeptical about early retirement. They are insecure, their own choices reflect financial servitude, and they believe a life of forty-hour work weeks for forty years is predetermined for them.

When you run around with these mental blinders on it's easier to condemn financial freedom than make the changes in your life that open up early retirement for you.

Many people are critical of early retirement by pointing out failure with two main questions:

  • What would you do all day? and
  • How will you handle a scary market downturn?

The first question assumes that you will turn into a deviant or a useless blob if you don't have an outside commitment of forty hours a week to keep you in line. We talked about that here.

Dealing With the Markets

We all know that stock markets go up and down. Market movements often dominate media. Financial media is a narrative between market optimists and pessimists. The talking heads and the predictors who strive to provide entertainment value.

Depending on where you go and what you read, the talking heads predict roaring bull markets that will go straight up and make everyone rich. Or they make your fear investing because markets are on the edge of a collapse.

Truth is they don't know. I don't either. In the last 100 years, the U.S. stock market had four occasions where stocks crashed 50% or more (inflation adjusted). It will likely happen again at some point.

A net worth that moves like this freaks people out!

S&P500 1995-2011. Source: Yahoo! Finance

The fear of losing half your money is enough to make most people just avoid the markets all together. They huddle together and put their money in "safe" GICs, bonds, and real estate. They try pay off their mortgage.

Many don't save at all and wait for the government to spoon feed them a promised stipend sometime in the future.

Rational thinkers who pursue independent thought and understand risk know there are strategies to help deal with these massive, and generally temporary, downturns. A little bit of risk acceptance can go a long way towards better, more profitable investing.

Saving Enough

You can't retire early if you don't have enough money. Not having enough money and hoping for outsized returns or perfect market conditions is a recipe for disaster. Accumulation of investable net worth matters.

If you have 30x your annual spending needs invested in productive assets, you will virtually never fail financially in retirement. You can increase your spending with inflation every year, you can maintain various asset allocations, you can "set and forget". The margin of safety at this level is immense.

Even if you have 25x your annual spending invested in productive assets, you are very likely to avoid a financial catastrophe. But you must be broadly invested, follow a sound strategy, and watch your spending. You would theoretically be far more likely to die before running out of money.

Diversify

The next easiest guard is diversification. Successful investors reduce exposure to any single market.

Way too many people have too much of their portfolio permanently in one broad asset class. It might be U.S. stocks and bonds, it could be Canadian dividend stocks, it could be rental houses. Concentration is dangerous.

Simply put, you don't want to be an infallible Japanese early retiree in 1989 fully invested in the roaring, never-goes-down Japanese stock market.

In the next two decades, you would see your portfolio fall off a cliff and plunge into the depths of the Pacific. This epic market crash might never come back; nearly three decades later, Japanese stocks are still at around half their peak level.

Nikkei225 1989-2009. Source: Yahoo! Finance

If the same Japanese retiree would have invested in a global stock portfolio, their investment account would have chugged along averaging 7% per year since 1989 (in Japanese yen terms).

While others sweat a salary job and jump off buildings because they're bankrupt, the diversified retiree would be tending to their bonsai and calligraphy with nary an ulcer.

You can diversify across countries, currencies, asset classes, and strategies to guard yourself from financial failure.

Strategies

Proper use of investment strategies is very helpful in preventing a market downturn catastrophe. Some strategies are complementary while others are correlated.

Buy-and-hold 100% in a stock index is probably among the most dangerous in early retirement because you can't dollar cost average into a falling price scenario. You're basically rolling the dice that you don't retire just before a market crash or high inflation period.

If you are withdrawing money from a falling asset, the effects of the fall are exacerbated. This is known as sequence of returns risk. To limit sequence of returns risk, you can hold a cash cushion, invest in complementary assets, or you can follow a disciplined timing strategy.

Cash cushions are effective in their purpose of limiting withdrawals in a drawdown environment, but they also reduce overall returns. Depending on your investment strategy, large bond allocations can actually reduce your financial success rate.

Complementary assets allocations, such as mixing a hedged strategy (like long/short or managed futures) with a stock strategy, can reduce the full effect of a stock market crash. Hedged strategies tend to do well in market downturns while holding their own in bull markets. However, the best of these are often only accessible to larger investors.

I invest in a disciplined timing strategy. I'm always trying to simply, simplify, simplify while maintaining an edge. So far it has worked out well. In the future I believe the lessons learned will mean better discipline, fewer mistakes, and better results.

Confidence in Strategy

The biggest advantage going into early retirement is having complete confidence in your chosen strategy. I don't mean blind confidence because you read a few good books and read an amateur blog or two.

Rather, I mean having experience and controlling your emotions. Ignoring market swings and sticking to a sound process is how you win the long game.

This is why I'm a huge fan of managing your own money instead of hiring a financial advisor—especially if you are young. Nothing is better than making your own mistakes when you are young, learning from each experience, and forging your own confidence going forward.

An honest, fee-only financial advisor can do a great job of steering your investments and helping you avoid big mistakes. But they can't outperform broad markets over the long term and they can't prevent you from overriding their advice. They're basically just there to help you make good money decisions, promote tax efficiency, and manage your investments using basic models.

It's easier to have true confidence in yourself than to rely on confidence in others.

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