Let’s use the market crash of 1987 as an example for this discussion on “What are the odds the market will crash during your retirement years?” from Market Watch. It’s not as famous as the deep dives of the 2008 markets, but it was actually the worst in U.S. stock market history. While some people believe it was not that significant and that government safeguards would have prevented the crash if it was really that bad, those arguments may not be right.
A study released from Harvard and Boston University came up with a formula that predicts the frequency of stock market crashes over extended periods of time, “Institutional Investors and Stock Market Volatility.” If these extremely learned sources are correct, then we should all understand that market crashes are events that will continue to occur, regardless of any other factors.
For this analysis, imagine a person retiring at age 65 with a generous life expectancy of 30 years. Let’s look at the scientists’ formula for the chances of a market crash during that person’s retirement. Note that the bigger the size of the crash, the lower the probability of one occurring. However, the odds of a huge crash are still high enough that we should expect one, and perhaps more than one, during any given person’s retirement.
Consider first a 15% daily drop, which would be a decline of around 4,000 points in the Dow Jones Industrial Average. There’s a 67% chance that this will happen at some point during a 30-year retirement. Note that the formula does not mean that crashes of this size happen like clockwork every so many years. The formula predicts what the average frequency of crashes will be over an extended period of time. You may never see a 15% crash—but your planning is on shaky ground, if you have set your retirement investments up with no consideration for a big crash.
What would such a drop do to retirement finances? The answer is different for everyone, depending on how their equity portfolios are structured, how much cash on hand you have, and if you are able to dramatically change your spending when your portfolio loses value.
However, a bigger impact could be the psychological response to the drop that many people, unfortunately, are quick to make in the face of a crash. Going to all cash is the worst thing that anyone could do, and yet, people do it time and time again.
According to the professor’s formula, we should expect as many as 18 daily drops of at least 5% in the years during our retirement. Over the last thirty years, there actually have been 15 such daily drops. It is slightly slower than the prediction but still remarkably close.
What can you do to prepare for these inevitable events? Be aware that one or more stock crashes will likely occur during the course of your retirement. Don’t panic when they occur and depending upon on your risk aversion, do what you need to in order to position your portfolio so you can sleep at night.
Reference: Market Watch (October 31, 2019) “What are the odds the market will crash during your retirement years?”