Financial planning: the effect of withdrawals versus savings in down markets

August 18, 2023

Financial planning and investing are dance partners of sorts. At times they come together in important ways, and I want to point one out here.

If you're planning on retiring and trying to figure out how your savings will endure, a lot of the answer depends on the direction of the market. The effect of a drawdown from your portfolio in a down market is non-trivial.

In the chart below, diagrammed by the dotted line: Say you start with $100,000. Over six years you withdraw $4,000 per year for discretionary expenses. The market bottoms out at a 25% loss after three years. It will take a 78% return (stock prices plus dividends) over the next three years for you to get back to break even. And this analysis does not include inflation - it could need even more return if inflation were considered.

Whoa, whoa, whoa, you're saying. Do I really need to cancel that ice bath I had in mind for the back patio for retirement? Are you telling me I actually have to look to see how many video services I'm subscribed to, and spend the next week trying to find the cancel links?

Perhaps. A 78% three-year portfolio return would be unusual. Your risk is growing. The ice bath might have to become an ice bucket.

On the other hand, in the same scenario, if you were in a position to save $4,000 a year over the six years, the market would only have to return 3% from the bottom for you to be back to break even! And you'd have a good savings habit to boot, so the future would look bright.

That's a stark difference and shows the power of selling versus buying shares when they are discounted in bad markets.

Here are two other thoughts:

1. There is potentially a bigger risk if you are working and your job is influenced by the market. There are a series of compounding effects that could happen: your expenses may be higher supporting kids, the market drops, you lose your job because it was related either to the market or the health of the economy. You then have to pull substantial amounts from your portfolio, relatively early in life, at the most inopportune time. We are watching for this with clients. This type of correlation can hide quietly.

2. One reason people don't buy into down markets is that it's terrifying. You have to buy the down slope of an asset class, and this is difficult and uncomfortable. As you buy in and the asset class continues to slide, you are actually compounding your loss, because now you have more capital and it's sliding. (This can end up very badly in an individual stock. See more here.) In an index fund it tends to be painful for a while and then quite magical in the medium to long term. Properly constructed index funds don't go to zero.

Dan Cunningham