The markets are off to the worst start since 1939!
Given that, I’m answering three (3) BIG questions from listeners today:
- Why are stocks AND high-quality bonds down at the same time and what should conservative investors be doing right now to protect their portfolio?”
- How can we improve our mindset and gain optimism in the face of all the negative economic outlooks?
- What is the correct order of operations when withdrawing money in retirement?
If you’re asking similar questions and concerned about the current state of the markets, you’re going to love this episode.
How to Listen to Today’s Episode
- Do You Need Retirement, Investing, and Tax Planning Help?
- Financial Myth: Bonds Lose Money if Interest Rates Rise [Stay Wealthy]
- The Worst Bond Market Since 1842 [WSJ]
- The Daily Stoic Book [Ryan Holiday]
- Roth Conversion Series:
Bonds, Recessions, and Withdrawing Money in Retirement
Taylor Schulte: Welcome to the Stay Wealthy podcast! I’m your host Taylor Schulte and today I’m answering three BIG questions from listeners:
Number one, why are stocks AND high-quality bonds down at the same time and what should conservative investors be doing right now to protect their portfolio?”
Number two, how can we improve our mindset and gain optimism in the face of all the negative economic outlooks?
Number three, what is the correct order of operations when withdrawing money in retirement?
For all the links and resources mentioned today, head over to youstaywealthy.com/152.
A quick reminder for everyone before we get started. If you ever have a retirement, investing, or tax planning question, or you’re faced with a retirement challenge that’s keeping you up at night, send me an email at firstname.lastname@example.org. Your questions and comments are largely what drives the content for this show. So, help me help you. Again, that’s email@example.com.
Ok, let’s dive in.
The first question comes from stay wealthy listener Susan H. and she’s curious about the bond market. She asks:
“Why are bonds going down along with the stock market right now? I thought bonds were supposed to protect my portfolio when stocks crash. If interest rates continue to rise, does that mean bonds will continue to lose money? What should conservative investors be doing right now to protect their portfolio?”
Great question and a big thank you to Susan for reaching out and asking something that I think is on everyone's mind right now. There are a handful of things to unpack here.
First, a reminder to everyone that, like stocks, not all bonds are equal. There are risky bonds, safe bonds, and everything in between. The risk profile of a bond or bond fund largely rests on the credit quality of the bonds and/or the duration.
To put some numbers to this, here in 2022, year to date, the vanguard short-term treasury ETF (VGSH) is down about 3% and the vanguard long-term treasury ETF (VGLT) is down about 20%.
Longer-term bonds are riskier and more sensitive to interest rate risk, so they are, not so surprisingly, experiencing larger losses at the moment. Over the long term though, you would expect the riskier, longer-term bonds to outperform the shorter-term bonds. Risk and reward go hand in hand.
As mentioned, we can also look at the credit quality of bonds to determine the level of risk. Corporate bonds are lower-rated and riskier than treasury bonds and we’re seeing that in the current performance as well. Intermediate treasury bonds (the highest quality bonds you can own) are down about 7.5% so far this year. However, intermediate corporate bonds (lower credit quality bonds) are down almost double that amount, close to a 13% YTD decline.
I’m sharing all of this because it’s an important first step when talking about bonds to acknowledge that not all bonds are equal. It’s also important to understand what kind of bonds you own and why you own them before racing to conclusions or rushing out to make investment changes.
With that understanding, let’s talk more about why stocks and bonds are down at the same time when, as Susan noted, bonds are supposed to be safe and provide protection in the portfolio.
So, first, let’s talk about U.S. stocks which are down about 17% here in 2022. While a negative 17% return is not enjoyable to see, it’s actually quite normal. The stock market experiences this type of correction or drawdown every couple of years, on average. Most investors know that stocks are risky and accept significant downturns from time to time in order to reap the long-term reward.
Bonds, on the other hand, are not acting normally. The last time we saw bonds suffer this kind of intra-year drop was 1842, according to the wall street journal. In other words, we could call this one of the worst bond bear markets in history.
In addition to it being rare that bonds are down this significantly, it’s also rare that stocks and high-quality bonds are down at the same time. The data we do have access to concludes that stocks and bonds both experience negative returns in a single quarter about 8% of the time. In other words, while it’s not necessarily QUOTE “normal”, there are definitely periods of time where both asset classes are negative at the same time, and this is one of those periods.
And these unique time periods support why cash management is so important. If you’re in the withdrawal phase of retirement and you have a strange quarter where everything in your portfolio is in the red, hopefully you have a strong war chest of cash to lean on. Hopefully, you have your emergency savings + one year of living expenses in cash.
While you would typically replenish your living expense cash bucket by selling some investments each quarter, when you go through unique times like we’re in right now, you might consider holding off on tapping your investments. Perhaps you wait until next quarter and spend down more cash. It’s certainly not ideal, but this is why we have a healthy amount in cash. It provides flexibility when it’s truly needed. It allows us to weather unforeseen storms without disrupting our plan.
Before we tackle the last part of Susan’s question, it’s important to remind everyone that high-quality bonds, historically, provide the protection that some might be expecting right now during catastrophic time periods. While things certainly feel bad right now, this is not what we would refer to as catastrophic.
The covid crash in 2020 was catastrophic. 2008/2009 was catastrophic. The tech bubble collapse followed by 9/11 was catastrophic. During those catastrophic events – and others if you continue going back through history – we saw US treasury bonds doing their job and moving in the opposite direction of stocks.
For example, from 2000 - 2002, U.S. stocks were down about 40%. On the other hand, US treasury bonds were up close to 35%. While things could get worse from here, we haven’t quite reached a level where there is a mad dash to safety.
Which leads nicely into the last part of Susan's question where she asks about what conservative retirement investors should be doing right now. While I might have already addressed it through my other answers, it reminded me of some other comments I’ve seen flying around suggesting that diversified portfolios aren’t doing their jobs because everything seems to be in negative territory.
I have two responses to this:
First, a 50/50 stock/bond portfolio is down about 13% this year with a standard deviation of 12. On the other hand, a 100% stock portfolio is down about 17% with a standard deviation of 24. The less risky, less volatile portfolio had smaller losses. Diversification most certainly did its job.
Second, one of the most interesting aspects of this current sell of is the difference in performance between growth stocks and value stocks. As long-time listeners know, I’m an advocate of evidence-based investing which leads to underweighting growth and overweighting value. And I am thankful for that philosophy this year.
I’m not sure if you’re following, but growth stocks are down about 25% in 2022. Value stocks, on the other hand, are only down around 7%. If you had an academically sound portfolio coming into 2022, you’re likely feeling pretty good. Again, diversification – proper diversification – has definitely done its job.
While I don’t have a crystal ball, my informed and educated opinion is that the bond market will likely begin to settle down from here. But even if rates do continue to rise, don’t forget about the myth of rising rates causing permanent losses in bonds. I’ve talked about this a few times on the podcast, but even in an aggressive rising rate environment, high-quality bonds and bond funds weather the storm quite well due to the increased interest payments.
Instead of going through it again, I’ll link to the episode in the show notes if you want to check it out and get a refresher. Just remember, that intermediate-term treasury bonds are not short-term cash alternatives. They aren’t guaranteed to have positive returns every day or even every year. These are 6-8 year instruments that will experience short-term fluctuations and sometimes uncomfortable losses.
We have to be sure to acknowledge their time horizon and be honest about their longer-term role in our portfolio. If you don’t have a long time horizon or you’re uncomfortable with short-term losses and fluctuations, then you may need to consider taking less risk, which in turn means you would need to expect and be ok with a lower rate of return.
You can do this by holding more cash, shortening the duration of your bonds (i.e., holding short-term bonds vs intermediate), or by leveraging insurance-based solutions to share the risk.
Again, you can’t have your cake and it too, whether you reduce the risk yourself or transfer some of it to an insurance product, you’ll still need to expect a lower rate of return.
Ok, our next question comes from Lori G. and she sent me the following email:
“Everything I’m reading and watching is negative and pessimistic. I’m finding myself more panicked than usual and I know that feeling this way isn’t helpful for my long-term plan (or my sleep). What tips do you have for gaining optimism and changing our mindset with everyone calling for the next recession?”
While I love nerdy financial and tax planning, I’m also fascinated by the psychology of money and investing. If you’re listening to this podcast, chances are you are very familiar with the keys to investing success. Diversify, keep costs low, and be patient. Pretty simple. Except it’s not that simple.
We are our own worst enemies and we let our emotions get in the middle of these simple keys to success. Even if we don’t panic and stuff our money under the mattress and destroy our thoughtful, long-term plan we put into place when we were clear-headed, many of us suffer in other ways…anxiety, stress, sleepless nights, relationship struggles, etc.
One simple solution is to, of course, ignore the noise. Turn the TV off, stop listening to talk radio, put away the newspapers. But that’s easier said than done, too. Especially in today’s day in age where clickbaity headlines follow us around everywhere. And if it’s not a headline, it’s your friend or neighbor or family member expressing their concerns and pessimistic outlook. It’s hard to get away from. So when all else fails, I personally do two things:
One, I go through a mental exercise where I imagine the worst-case scenario – the absolute worst-case scenario – and then come up with 5 solutions to overcoming that worst-case scenario. And then I come up with 5 more. Because the first 5 are easy. The second 5 is where the magic happens.
As the stoics suggest, while it may be an unpleasant exercise, it can help you come to grips with the fact that the worst-case scenario is likely something you would be able to cope with.
In fact, stoic philosophers like Seneca referred to this exercise as a premeditation of evils. IT allowed him to be prepared for disruption. He was prepared for defeat or victory. In some cases – and I’m sure we can all imagine some of these as it pertains to money and investing – there are no solutions, nothing can be done. It’s something outside of our control that we have to suffer the consequences of.
In those cases, we just have to be comfortable saying, “it’s going to suck, but we will be okay.’
As Ryan Holiday put it,
“the only guarantee, ever, is that things will go wrong. The only thing we can use to mitigate this is anticipation because the only variable we control completely is ourselves.”
In addition to a mental exercise, you can also – and should also – go through an actual planning exercise. A retirement planning exercise. Where you explore what we call “what if” scenarios and devise solutions that you have control over to recover from them.
What if my diversified portfolio of stocks AND bonds somehow some way, even though it’s never happened before, drops by 50%?
What if stock market returns are cut in half for the next 20 years and we are in an extended low-return environment?
What if I retire tomorrow and we immediately go into a recession?
The questions are endless. But going through them and then modeling solutions to combat them can be a very comforting exercise.
The other thing I like to do when we’re going through challenging marketing environments is to zoom out. By zoom out, I mean remove ourselves from the short-term noise, from the short-term predictions and events, and look at things with a slightly longer-term perspective. What you typically find is that you don’t have to zoom out very far to find optimism.
For example, since January 1st, 2020, the U.S. stock market is up about 25%.
A global pandemic
The fastest 30% drop in stocks EVER (22 days)
An overseas war
Multiple interest rate hikes
...U.S. stocks have returned a positive 25%.
The S&P 500 is off to its worst start since 1939. But you’re still buying stocks at a higher price today than 18 months ago.
Again, you don’t have to zoom out very far to find some optimism.
It’s easy to get caught up in the short-term fluctuations, the headlines, the predictions, the dire outlooks. But they aren’t constructive. We don’t take our money out from underneath the mattress to invest it for 6 months. Or 24 months. Even for those who are in retirement, we’re investing for the next 20/30/or even 40 years.
By the way, if you don’t know who Ryan Holiday is and you haven’t checked out the book, “The Daily Stoic”, I highly recommend it. It’s meant to be read one day at a time and has a very unique way of just making you feel better about the uncertainty that we’re constantly faced with. Nothing to do with investing, but also everything to do with investing. I’ll link to it in the show notes if interested.
Ok, the last question comes from Gary H. who asked the following question:
If I’m focused on optimizing for taxes, in what order should I tap into my different accounts in retirement to create income? Should I spend my after-tax brokerage accounts first, then Traditional IRA, Social Security, and finally Roth IRA?
This is a great question, and while the real answer is “it depends”, there are some important things to take into consideration when thinking about where to pull money from first, second, third, and so on.
First, contrary to what most people think, I personally like to target Traditional IRA dollars first. And that’s because I want to be sure we’re taking advantage of opportunities to get money out of a Traditional IRA at a favorable rate before tapping into any other account.
If you listened to my 2-part series on Roth conversions last month, you might remember me saying that what is favorable today depends on what your future tax rate is expected to be at age 72 when Required Minimum Distributions collide with Social Security and any other income you might have.
For example, if you determine that you will likely be in the 35% federal tax bracket at age 72, then you might consider taking money out of your Traditional IRA up to the 22% or even the 24% bracket in earlier years. Heck, even if you expect to be in the 22% bracket at age 72, you might still consider withdrawing money from your Traditional IRA in earlier years to fill up your 22% bracket and stop the tax liability in your IRA from growing. (i.e., as the investments in your Traditional IRA grow between now and age 72, so does the amount you have to pay the IRS.)
Again, targeting your Traditional IRA first seems a bit backward and contradicts what most people think is the starting point for retirement withdrawals. It makes sense that people think that and be drawn to tap their after-tax brokerage accounts first\ because the tax impact of that approach is usually zero or very low.
And while avoiding a tax consequence might feel like the right move, we have to be careful about looking at taxes in a vacuum and making tax decisions year by year. By creating a longer-term tax plan, and looking at the long-term consequences of your withdrawal decisions, you can create a more stable, predictable tax bill throughout retirement. You might also be able to significantly lower the amount you pay the IRS between now and end of life.
Now, as you might already be thinking, we can get money out of our Traditional IRA at a favorable tax rate two different ways. One way is to simply take a withdrawal (or multiple withdrawals) up the top of the tax bracket we have deemed to be favorable and then use that withdrawal to pay for (or supplement) our living expenses. The other way is to convert the money to a Roth IRA through a Roth conversion.
If you’re actively pursuing Roth conversions each year, and filling up your favorable tax bracket through that strategy, then you won’t have any room left in the tax bracket you’re targeting to take additional, taxable withdrawals from your Traditional IRA. In that case, you’ll have to look at a different account to pull from to create your retirement paycheck. Which leads us to the next account type to target…and that would be your after-tax brokerage accounts.
Before I share more details, I want to highlight that one common mistake I see here is people spending from cash instead of tapping their investments in their after-tax brokerage account. And while it might be more tax-friendly to do that – and it might seem more rational because it allows your investments to grow for a longer period of time – it usually signals to me that the person doesn’t have a good cash management plan in place.
That, either they have too much cash (which can be a drag on your long-term returns) or they just wrongfully assumed spending down all of their cash first and letting their investments grow was most prudent.
In short, my rule of thumb for those who are retired and living off their investments in retirement is to have 3-6 months of cash in an emergency account and then have one year of cash in a living expense account for the next 12 months of spending. As you spend down cash each quarter from your living expense account, investments should be sold and used to replenish that living expense bucket through a dynamic sustainable withdrawal strategy.
In case you missed it, I did an entire retirement income series last year and dove deep into sustainable withdrawal strategies. I’ll link to it in the show notes which again you can find by going to youstaywealthy.com/152
So we want to replenish our living expense cash account every quarter because the last thing you want to happen is to spend down all of your cash, go to tap your investment account for your next withdrawal, only to realize we’re in the middle of a market meltdown and you would be forced to sell investments at a sizable loss to pay for living expenses. We never want to be in that position.
So, as I’ve said numerous times here on the show, it’s critical to have a good cash management plan in place when it comes to producing your retirement paycheck. Oh, and I should mention that having a third cash bucket for next year's projected tax bill is important as well.
For example, if you did a Roth conversion this year or plan to do one, put the projected tax bill money in a cash account earmarked for next year's tax bill. Since you know that money is going to the IRS within the next 12 months, it should not be invested.
Ok, with that, let’s go back to tapping your after-tax brokerage account as the second place to withdraw from after your Traditional IRA. In most cases, when tapping your after-tax brokerage account, you’ll be forced to liquidate securities in order to take the withdrawal. Given that, you’ll want to be sure you’re targeting investments that you’ve held longer than one year so that you get long-term capital gains treatment on that sale.
If that’s the case – if you do need to sell long-term appreciated securities to take a withdrawal – you might also look to see if you have any positions with long-term losses that can be sold and realized to offset some or all of the gains.
To be sure everyone is following, let’s look at a quick example.
Let’s say I bought $10,000 of SPY (S&p 500 ETF) 5 years ago and it’s grown to $20,000. If I sell that position today, I will have to pay long-term capital gains tax on the $10,000 gain, the difference between what I bought it for and what I sold it for.
But say I also bought $20,000 of a growth and technology ETF 18 months ago and that investment has been cut in half and is now only worth $10,000. Perhaps I’m still bullish on growth and technology, so I sell that ETF and realize a $10,000 loss to offset the gain from my S&P 500 ETF sale.
Now I can’t buy back the same growth and technology ETF I owned because that would trigger the wash sale rule, but most agree that you can by a similar growth and tech ETF that tracks a different index, allowing you to use the losses from the previous sale but also maintain your position in that asset class.
To summarize, if done correctly, you were able to withdraw $20,000 from your brokerage account without a tax consequence.
So, we’ve targeted our Traditional IRA first to ensure we’re getting money out of there at a favorable rate. Then we’re moving to our after-tax brokerage account. And when and if that after-tax brokerage account is exhausted, we would finally target our Roth IRA dollars. We want our Roth IRA to grow for as long as possible because that money has already been taxed and it’s growing tax-free.
It’s also much easier for heirs to inherit a Roth, so most would prefer for that account to have the most dollars in it at end of life if legacy planning is important.
Lastly, I should note that other income sources certainly play into all of this as well. For example, social security, pensions, real estate, and so on. The amount and timing of these other income sources will factor into the prioritization of retirement withdrawals, so be sure to take everything into consideration.
Once again, if you have any retirement, investing, or tax planning questions, send them my way at firstname.lastname@example.org.
To grab the links and resources from today's episode, head over to youstaywealthy.com/152.
Thank you, as always, for listening and I will see you back here next week.
Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.