Duration has a special meaning in the investment world. It is a measure of interest rate sensitivity in bond portfolios. You can calculate the duration for an individual bond or for a portfolio of individual bonds and you can derive an average duration. Why is this important? Because in a rising rate environment, like the one we are just entering, the duration will give you an idea of how much your principle will decline for a given increase in interest rates.
If your bond portfolio or your bond fund has an average duration of 6 years then you can expect the value of the portfolio to drop by about 6% for every 1% increase in interest rates. The Pimco Total Return Bond Fund with assets of around $246 billion dollars is one of the largest bond mutual funds in the United States. With an average duration of 5.26 years you could expect about a 5% drop in the funds value if interest rates rose by 1 percentage point. Or you could expect a 1.25% drop in value if interest rates rose by just 0.25%.
Given that most bond funds have a yield of around 3% you can see that even small changes in interest rates can wipe out months of dividend income. So you should be aware of the duration of any bonds or bond mutual funds you own.
Then ask yourself if the risk is worth the reward at this point
CNBC was on in the background, I wasn’t really paying attention, but then I heard it.
“No bear market has ever occurred in the US stock market without a recession”
There it was a blinding insight into the obvious. Who was that masked man? I may never know. He was gone before I could focus my attention, but he left behind something so true it forced me to rethink all the fears that market corrections cause.
If you want proof then you can follow this link to a chart that is easy to understand. There has been one exception: October of 1987’s infamous Black Monday when the Dow plunged 22% in one day.
Could we have another day like that? Maybe, but remember the Dow closed that day at 1,738.74. The Dow closed at 16,102.38 on 9/4/2015.
The moral of this story is sometimes we get so caught up in the day to day worries of markets and headlines that the obvious is often overlooked.
It’s obvious that equity markets go down. It’s obvious that markets don’t stay down.
It’s obvious we are fearful and it’s obvious we should be bold.
It’s obvious we should have a long term view of our investments yet it’s obvious we succumb to short term fears.
How much money you can take out of your investments without running out of money is a critical question when building any financial plan. As a member of the Financial Planning Association I hear from other members and read in the financial press many theories on how to calculate a safe withdrawal rate. Some of the ideas put forth are elegant, some are complicated, and all ultimately fail because they attempt to do the impossible, which is to predict a future event. The future is unknowable, so having any degree of confidence in any method of projecting historic calculations on future events is dubious at best. There is a reason the SEC requires the disclaimer that past results are not indicative of future returns.
The uncertainty of safe withdrawal rates is one of the reasons I advise clients to try to be debt free when they reach retirement age. If your house is paid for and you have no consumer debt, your living expenses can be managed much more easily. You can adjust your lifestyle without too much pain to cope with unexpected events, and adjust withdrawal rates to protect your nest egg.
That said, I do believe having a financial plan gives you a much greater chance of success than not having a plan, and you must select some withdrawal rate that you believe (or maybe hope) to be safe to complete any retirement planning calculations. So here I go with what I believe is as good a way of calculating your safe withdrawal rate as any.
If you've been reading this blog a while you know about estimating your rate of return for a diversified portfolio, and you know how to calculate your real rate of return. My simple if imperfect suggestion for calculating your personal safe withdrawal rate is to use the expected real rate of return of your portfolio. This amount is already adjusted for inflation and you will probably have to make some adjustments along the way anyway. If you can afford to take less, great! Your odds of success are probably improved. Oh, and one other thing, when you reach retirement try to keep one years living expenses allocated to cash, this will help if things get really dismal. Having a large cash reserve will preclude you from having to sell other securities at in opportune times. At least for a year.