Sell everything? Or hold on?

The market drama is gripping the financial markets this week. The age old question is should you sell everything and go to cash or should you hold on for the inevitable bounce?

To answer that question I wanted to step back a bit. It would be meaningless to answer without some context on our savings goals. The conventional wisdom is to hold on and don’t sell. I wanted to see if that was true.  Let’s assume someone wants to retire at 65 years. They have 31 more years before they retire. This person wants to retire with 50,000 annual income. We will ignore any money they get from pension plans or government transfer payments just to keep things simple. 

Our hypothetical investor is very conservative, they never want to touch their principal and will live off their gains. Let’s call this person Average Jane. Average Jane expects to earn 2% on her funds after retirement. How much will she need? 50,000 / 2% gives us 2.5 million dollars. This is not an unreasonable sum. Furthermore, Average Jane doesn’t trust any investment. She prefers cold hard cash, thank you very much. 2.5 million divided by  31 years gives us an annual savings rate of 80,645 a year, assuming she saves everything in cash bills. Average Jane gulps, that might be next to impossible, she would need to earn much more than that to cover savings, taxes, and living expenses. Forget about storage and security of the cash. 

She resigns herself to having to take on some risk to gain a higher return. 

Before we begin here’s how much Average Jane would need if she earned a higher return in retirement for every year she was alive. 

@0-2% – 2.5 million

@4% – 1.25 million

@6% – 833,333

@8%  – 625,000

@10% – 500,000

@12% – 416,667

@14% – 357,143

All would give her the 50,000 she wants in retirement. 

Lesson 1: the amount you need to retire is proportional to your actual return after retirement and the lifestyle you want to have in retirement. 

How much would she need to save per year at various interest rates? Let’s assume Average Jane contributes money at the beginning of each year and earns the same return every year. This is totally unrealistic, I am trying to lay the foundation to test my hypothesis if it is better to hold on or sell.

@2% earned per year while working – she needs 57,834 a year in contributions to have 2.5 million in retirement 

@4% earned per year – the total drops to 20,258 / year for 1.25 million at retirement 

@6% earned per year – 9,270 / yr

@8% earned per year – 4,691 / yr

@10% earned per year – 2,498 / yr

@12% earned per year – 1,371 / yr

@14% earned per year – just 767 for the whole year to have 357,143 at retirement. 

Ahh, the magic of compound investing. We can’t use a simple compound formula to calculate how much we need to contribute, as every year we are adding funds, and those funds continue to compound as well. For this we need a growing annuity calculation. My numbers should match the growing annuity formula, given a certain savings amount, return, and 31 years of investing. 

Lesson 2: for every sustained 2% increase in return the annual amount necessary to save towards a retirement 30 years away goes down roughly by half. 

Let’s say in year 15 Average Jane’s investments go down 25%. And she is patient and the same investments rebound by 33.3% in year 16. This causes her to be exactly where she was two years earlier. What happens to her retirement fund contributions if she earns the same return as before the crisis hit?

@0% – 77,319 vs. 78,125 previously

@2% – 57,197 vs. 56,526 ”

@4% – 20,734 vs. 19,935 ”

@6% – 9,844 vs 9,168 ”

@8% – 5,178 vs. 4,656 ”

@10% – 2,868 vs 2,485 ”

@12% – 1,639 vs. 1,366 ”

@14% – 956 vs 766 ”

At 0%, the shock of earning 33.3% on our money one extra year reduces the payments we need the other years. This doesn’t hold true for rates higher than 0%. This financial shock does major damage, causing us to increase payments any where from 190 a year to 670 a year. The reason is simple, we have lost time. And to make up for lost time we need to increase our payments. 

The more shocks that happen, the longer it takes for our investments to bounce back, the more we need to increase our payments to make up for the time lost. This flies in the face of conventional wisdom to stick things out, to buy and hold, to not be a market timer. The other alternative is to seek a higher interest rate. That has its own risks. The savings shortfall risk increases dramatically if we have less time to retire or require a higher amount of income or have a family to support. Multiple shocks over a working lifetime can completely derail the ability to even retire. We can not expect all shocks to return our money quickly. Some shocks will continue to go down, others will tend to go sideways, others will be a combination of down and sideways. It is prudent to be prepared and repeatedly take stock of where you are. 

Lesson 3: People are always told you should hold onto your investments in a sustained downtrend and wait for them to bounce back. That is certainly one strategy. The risk is higher sustained savings or a higher sustained return may be necessary to get you back on track for retirement. That risk is rarely mentioned by the media. 

Given the above and given my understanding that a deeper correction may have a good chance of materializing I have sold all my financial investments. Most of these are in tax-deferred accounts. 

The media also never mentions you can undertake other alternatives, such as hedging your stocks with covered calls, buying puts as insurance, and buying investments that perform well when the market doesn’t such as inverse etf’s. And that’s a shame. 

Good luck to all of us and be financially well.

Vijay @ smilingdad

Appendix: 

Present Value of a Growing Annuity