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Post #16 – How the Financial Crisis Moved Our Retirement Date Forward by 2 Years

My last post discussed the importance of periodically “Re-balancing” your portfolio as a practice that everyone should incorporate into the management of their retirement assets. I practiced this method throughout the recent financial crisis and the results worked out so well that we moved our retirement date forward by 2 years. In this post I will share with you the exact “Re-balancing” moves I made during the 2008-2009 financial crisis and my thought process when making those moves.

Some Advantages that I had over the Average Investor

But first, I’d like to briefly discuss some things that benefited my decision making during the financial crisis.

One of the things that benefited me most was just paying attention to what was happening in the economy. If you pay attention to the economy, you will notice that there are usually “macro” signals about the direction of the economy which will in turn affect the markets. For example, in 2005 to 2007, there were red flags everywhere regarding real estate being wildly overvalued (e.g., when owning a property costs 4 times as much as renting the same property). I do not understand how most people (including the Federal Reserve members) could have missed these obvious signs. It was clear (to me at least) that, when incomes are mostly stagnant, residential real estate prices cannot continue to increase at 15% to 20% per year. Also, when lenders are approving residential mortgage loans for anyone who can sign their name, it is obvious that, at some point, the holders of all these “Sub-prime” residential mortgages would be in trouble. I don’t know how everyone thought that this could continue. You did not need any inside information to see what was coming, you only needed to use your common sense to know to stay clear of real estate.

A second area where I benefited was I did not invest in any bonds (or bond funds). During the 2008-2009 financial crisis, bond prices dropped significantly along with stock prices. In a typical business recession, bond prices do not drop. What made the 2008-2009 recession different was that it was not a business slowdown, but a credit crisis originating from the real estate mortgage defaults that subsequently spread to all types of private lending. When all private lending stopped, businesses were unable to obtain credit. This caused a liquidity crisis which caused bond prices to drop precipitously.

Part of being a good investor is in knowing the limits of your abilities. Bond investing is very difficult even for the professionals. I know that with the limited time I have available to manage my investments, I cannot hope to do proper bond investing, so I don’t even try. With the exception of a fairly large cash position, all my fixed income assets during the financial crisis were invested in bank Certificate of Deposits (CDs). I was fortunate that, in 2007, I locked up significant assets in CDs at 5%, 6%, and 7% for several years. Because of this, I did not suffer any fixed income losses during the crisis.

Finally, I subscribe to half dozen investment “subscriber pay only” newsletters that provide objective investment advice. These newsletters are not always correct in their specific recommendations, but their general guidance is usually on the mark. The information provided in these newsletters gave me the confidence, in a very difficult environment, to proceed with my re-balancing moves.

The table below shows the actual equity allocation changes I made during the 2008-2009 financial crisis. I have removed the annual contributions I made during the 2008 to 2010 period so you can see the impact of just my re-balancing moves on my asset totals. For simplicity, I have used a $100,000 portfolio value as a proxy for my entire retirement financial portfolio.  However, the dates, asset allocations, relative values, and re-balancing moves represent the actual changes to my portfolio during this period.

Keeping your Cool When the Chips are Down

I will never forget that day in March 2008 when I picked up the Wall Street Journal and saw the headlines about Bear Stearns on the verge of collapse. As I stated earlier, I knew that the bond investors who bought mortgage-backed securities were going to take big losses at some point. I also knew that real estate values would fall, but I believed that the impact of these events would be mostly restricted to real estate related assets. But when I read that Bear Stearns was on the verge of collapse and that JP Morgan had agreed to buy them out at $2 per share, I immediately knew something was very seriously wrong. I could not believe that Bears Stearns, one of the biggest investment banking firms on Wall Street, was going bust. The mortgage-backed security “problem” was obviously much bigger than I had realized. If big Wall Street firms were being impacted to this magnitude, the coming crisis would involve more than just real estate.

The collapse of Bear Stearns really spooked me. In March 2008, when the S&P500 index was about 1,330, I had an equity allocation of 50%. As the table shows below, I changed my equity allocation to 40% (Move A). This was purely a defensive move outside of my normal re-balancing I do every January. But I thought the Bear Stearns collapse was a big enough market signal to warrant it.

I remember the markets moving along without too much volatility from March 2008 into that summer, and I remember thinking perhaps I had overreacted to the Bear Stearns collapse. But in late June 2008, it became obvious that Fannie Mae and Freddie Mac were going belly up. This is when I knew we had a big problem. I contemplated lowering my equity allocation even more which, in retrospect, would have been the right move, but I felt I had a large enough fixed income position. And, of course, you never know what the market is going to do. What if July 2008 turned out to be the market bottom? You shouldn’t stray too far off your target equity allocation, because at some point you have to move back to it. You don’t want to become a “market timer.” Market timing is a good way to quickly suffer what investors call “a permanent loss of capital.”

The market meltdown finally occurred when Lehman Brothers, another venerable Wall Street firm, went bankrupt in September 2008. The S&P 500 Index lost about 25% to 30% of its market value in just a couple of weeks. At this point, everyone was selling everything. No one was buying for fear that the market would fall even further. I remember thinking in October 2008 that it was one of those rare times when, “it is probably too late to sell and too early to buy back in.” At 53 years old my plan called for 4 more years before retirement, I had a large income position, so I did not make any more portfolio moves until my January 2009 annual portfolio re-balancing review.

One thing to keep in mind, I, like everyone else, was concerned about my retirement accounts. But if you look at “Move B” (January 2009) in the table, even after the markets (both equity and bond markets) had been in a free-fall, my portfolio had only decreased by 13% from March 2008. Of course I was not happy about this, but I was not about to do any panic selling. Again, let me reiterate a theme from the last few posts about why I did not panic. I had already selected an equity allocation that I believed was suitable for my risk tolerance. I knew that I would maintain my calm if the markets went through a meltdown. The markets certainly did go through a meltdown and I did maintain my cool throughout, so my chosen equity allocation was obviously correct for me.

By January 2009 it was time for me to re-balance as my equity percentage had fallen to 29%.  My target equity allocation had been 50% before March 2008 and this is where I ultimately wanted to go but the markets were still falling. When all the financial market pundits are talking about how the sky is falling and recommending you stay away from equities (the ones I told you in an earlier post to ignore), this is when you really have to have the courage of your convictions. And this is where the investment newsletters really helped. Almost all of my investment newsletters were recommending that it was time to buy back into equities. I remember thinking at the time, “These guys (the newsletter editors) are experts without any bias, if I do not take their advice now, then I might as well stop paying them for it.” I also remember thinking, that even after re-balancing, I will still have 50% in fixed income assets. This amount was enough to last us a decade into retirement, in the event the equity markets do not come back right away. So, I was able to muster the courage to re-balance back to 50% equity.

But at 29% equity allocation I would have to make a 21% increase in my equity allocation when the markets were still dropping. So, being a cautious person by nature, I decided to perform my January 2009 re-balancing in 2 steps. As the table shows in “Move B” I re-balanced back to 40% allocation when the S&P 500 index was around 850. Then in mid-March 2009 when the S&P 500 index had dropped another 10% and stood at about 770, I re-balanced again to a 50% equity allocation as shown in “Move C.” In March of 2009 my retirement portfolio was at its lowest point—a 16% loss in value from March 2008. This 2 step move turned out to be a good approach as the S&P 500 index bottomed, I think, at around 680 in early March 2009. Of course, I had no way of knowing this. The 2 step move was purely one more defensive maneuver I took during a very tumultuous period in the markets.

As they say, the rest is history. I was really surprised by the speed of the market recovery. This was not something I was expecting. By January 2010 the S&P 500 index was back up to about 1,150 and my equity allocation had increased to 59%. Re-balancing back to a 50% equity allocation in “Move D” in the table was an easy decision. Yes, the markets did keep going up and I would have made more money if I had not re-balanced in January 2010. But investing is mostly about risk management, and having the discipline to re-balance your portfolio periodically is one of the best practices to assist in risk management.

As you can see in the table by January 2010 my retirement portfolio was 6% above where it was in March 2008 (before the financial crisis) and in January 2011 it was 13% higher than March 2008. Since I can only withdraw 4% of our retirement balance annually to fund expenses in retirement, this increase in value by January 2011 allowed for about 2 years of retirement withdrawals (after inflation). This fact, along with the retirement contributions we made during this time period (which amounted to another 7% of our retirement account balances) was enough for us to move up our planned retirement date from January 2013 to January 2011.

Although these portfolio moves helped increase my retirement assets, I should point out that even if you had done absolutely nothing during the entire period from early 2008 to the first quarter of 2011, and you were still making annual retirement contributions, your retirement account balances should be just about back to where they were in early 2008. That is, the financial crisis should have been nothing more than a bad dream that you have finally woken up from. If your retirement account balances are still way down, this means you made some untimely moves like selling low and/or buying high. Disciplined portfolio re-balancing avoids this problem.

One last point– I have included my January 2011 re-balancing in the table (Move E). As you can see in January 2011 before re-balancing, my equity allocation was 52%. Normally, if I were maintaining a 50% equity allocation, I would not make any adjustments for a 2% difference. However, by January 2011 the markets, in my opinion (and the opinion of my investment newsletters), had again become over-valued. This opinion combined with the fact that I am now actually retired, I decided to reduce my equity allocation target to 40%.

My wife and I are still in our mid-50s and many financial advisors, I am sure, would say that a 40% equity allocation is too conservative for people our age. Well, perhaps it is for some people. But, let me ask one question, how well did those people do in the 2008-2009 financial crisis? Most people I know in their 50s and 60s have had to delay their retirement by a few years.

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