Liquidity risk can be a major threat to financial security and peace of mind during retirement—which is why it should be on all retirees’ radar screens.

In its simplest form, liquidity describes how quickly an asset—such as a stock, a mutual fund or even a house—can be converted into cold hard cash. If an asset takes a long time to liquidate (sell) or incurs a large loss in its value when selling it quickly, it can be said to have significant liquidity risk.

During retirement, having access to liquid funds is vital to meeting current expenses. If an investor’s retirement savings are tied up in assets that take a long time to sell or that require a substantial markdown in value to be converted to cash, it can impact the ability to pay for regular living expenses, that vacation of a lifetime or an unfortunate healthcare emergency.

In a previous blog post, we discussed our approach to retirement income as an alternative to annuities, a common, but illiquid, type of retirement illiquid investment. This time, we will examine how to combat liquidity risks that stem from a poor sequence of returns—for example, suffering a major loss of value in a portfolio at a time when liquid assets are needed to fund expenses.

A poor sequence of returns can cause a large loss in principal for investors who rely on invested assets to meet spending needs. We advocate using two simple and intuitive rules to mitigate this form of liquidity risk:

1. Keep enough liquid assets on hand to weather a bad market.
2. To minimize locking in losses, seek to replenish liquid assets when there are gains in the portfolio.

Getting through bad markets

In our previous blog on fighting longevity risk, we advocated allocating more money to stocks than traditional fixed income-heavy retirement solutions generally do, to stretch savings across what may be a long retirement.

That said, a stock-heavy portfolio is likely to experience more significant gains and losses over the short term than will a bond-focused portfolio—and naturally it’s those losses during bad markets that get retirees nervous about holding equities.

But just how long might we expect stock losses to hold a portfolio underwater?

First, it is helpful to understand what we mean by “underwater.” We define underwater as the period of time when a portfolio’s value is less than its previous high. As seen in Figure 1, this period of time includes both the drawdown, or loss of principal, and the recovery back to where the portfolio was before it began to lose money.

Figure 1: Growth of $100,000 of the S&P 500 index. The red arrow indicates the period of time “underwater”

Source: S&P 500 total return data, Ibbotson SBBI database.

Figure 2 below shows the maximum number of quarters that three hypothetical portfolios remained underwater during the 50 years through 2016. While the all-stock portfolio’s maximum underwater period was large—26 quarters, or more than six years—the balanced portfolio of 50% stocks and 50% bonds had a maximum underwater period of less than 3 years.

Figure 2: Maximum number of quarters a hypothetical portfolio was “underwater” in the last 50 years

Source: Stocks is the S&P 500 total return index and bonds is intermediate term government bonds, both from the SBBI Ibbotson database. 80 / 20=an 80% stock and 20% bond portfolio, 50 / 50=a 50% stock and 50% bond portfolio.

Retirees are also often fearful of stocks during crisis times such as the global stock market crash of the early 1970s, Black Monday in 1987 and the 2008 financial crisis.

At times like these, it’s not uncommon for markets to plummet 30% or more. For retirees with no incomes, the prospect of losing 30% is often too much to bear— causing many to shy away from stocks to avoid such catastrophic outcomes.

But our belief is that many investors incur major long-term losses in savings during these catastrophic drawdowns because they sell their portfolio holdings at the bottom and take all of their money out of the market.

We also believe it is crucial to take note of the trends of these underwater periods following market meltdowns, which have historically tended to be relatively short. For example, Figure 3 shows that during the worst market crashes of the last fifty years, various types of portfolios recovered rather quickly.

Figure 3: Number of quarters underwater for three hypothetical portfolios during three of the worst market crashes in the last fifty years

Source: Stocks is the S&P 500 total return index and bonds is intermediate term government bonds both from the SBBI Ibbotson database. The time periods included at least one quarter from 2008, 1987, or 1973.

The takeaway: liquid assets to cover spending needs for a few years can help to weather the kinds of drawdowns we’ve seen in the last fifty years.

Building up liquid assets in a portfolio

So what about our other rule: Only replenish liquid assets when there are gains in a portfolio? To gauge how reasonable this is, let’s look at the largest number of consecutive negative quarters for these same hypothetical portfolios.

For both a 100% stock portfolio and an 80% stock/20% bond portfolio, the largest number of down quarters in a row was six, starting in the late 1960s and then during the most recent financial crisis (see Figure 4). That means an investor following this rule would have had to wait just six quarters in a row, at most, before gains in the portfolio could be used to replenish the pool of liquid assets to meet current needs.

Figure 4: The most number of down quarters in a row for three hypothetical portfolios over the last fifty years

Source: Calculations by Horizon Investments, using SBBI Ibbotson data.

To combat the many risks facing retirees today, we advocate using more equities than the traditional rules of thumb suggest. While equity-centric portfolios are more sensitive to short-term fluctuations than are bond-heavy portfolios, the analysis shows an investor can help navigate these market moves by implementing a few simple and intuitive rules.

Learn more about Real Spend®, our retirement income solution designed to mitigate longevity risks.