MANY OF US HAVE much of our wealth in stocks and bonds—and that raises some nagging questions. How safe is this money? What do I own that I can really count on? If I’m retired, how much of this portfolio can I afford to spend in the year ahead? These concerns grow when markets seem high.
How can we get some perspective on these questions? We might try calculating our “spendable net worth.” What’s that? It’s basically our net worth—our assets, excluding the value of our primary residence, minus all debt—with a discount applied that reflects the market risk involved.
To assess market risk, we need to ask, “How bad could things get?” Fortunately (or unfortunately), we can draw on recent experience. Twice this century, the stock market has fallen by 50%. During recent recessions, investment grade corporate bonds and high-yield junk bonds also got hit hard, albeit to a lesser degree—and those recessions seem to happen at least once a decade.
Looking at performance in recent recessionary periods can help us estimate how bad things could get. We can use these historical price drops for different asset classes to come up with market risk discount rates, and we can then apply these discounts to a portfolio’s various investment categories to come up with spendable net worth.
Suppose we estimate that the worst-case market risk discounts—in other words, the potential price declines—are 50% for stocks, 35% for high-yield bonds and 20% for investment grade bonds. Let’s also assume we have a $1 million portfolio comprised of $500,000 in stocks, $350,000 in investment grade corporate bonds and $150,000 in junk bonds. Applying the market risk discounts to each asset class would give us a consolidated risk discount of $372,500, or 37% of the portfolio’s value. This is the money that’s at risk—and it leaves us with a total spendable net worth, or SNW, of $627,500.
We can think of the $1 million as divided between a $627,500 low-risk segment—the SNW—and a $372,500 high-risk segment that’s equal to the market risk discount. A more conservative portfolio, with less in stocks and junk bonds, would have a lower risk discount. Think of spendable net worth as a kind of acid test. It makes us think hard about our risk tolerance—and whether we’re comfortable with the amount of money that’s at risk.
There are some difficult tradeoffs here. To get the higher return offered by stocks, we need to accept a steeper market discount and hence a lower spendable net worth. If we move $1,000 of cash into stocks, we drop our SNW by $500. A younger investor might make that bet, while an older investor might shy away. But whatever our age, our portfolio’s asset allocation should be driven by the level of SNW with which we feel comfortable—because there’s a risk that the rest of our net worth could be lost in pursuit of higher returns.
Spendable net worth can also help retirees with long-range planning. Retirees want to know how much of their portfolio they can safely spend this year, while leaving enough to cover their remaining years. To find that number, we might divide our current SNW by our estimated life expectancy.
Take the example above, with its spendable net worth of $627,500. If we expect to live 30 more years, the low-risk annual spending amount would be $627,500 divided by 30, or $21,000. That spending amount rises to $33,000 if full net worth is used. Which number should we use? We might pick an annual spending amount somewhere between these two limits, depending on our risk tolerance.
The annual spending calculation assumes that our portfolio’s after-tax return will match our rising living costs, so our spending can climb along with inflation. This is arguably a conservative assumption. What if it’s wrong? If we recalculate our spending budget each year based on remaining life expectancy and current portfolio values, we’ll be compelled to adjust our spending—for better or worse.
If we do spend based on SNW, rather than based on full net worth, it’ll also impact how much we end up bequeathing. Let’s assume a retiree holds annual spending to each year’s SNW budget and lives to his or her full life expectancy. At the time of death, the retiree’s remaining portfolio value would equal the market risk discount that was applied to his or her full net worth. In other words, at the time of death, the unspent market risk discount amount becomes the estate value that’s available to our retiree’s heirs. Throughout retirement, the market risk discount value is, in effect, earmarked for the heirs.
Tom Welsh is a certified management accountant in Raleigh, North Carolina. He has been the chief financial officer at several manufacturing companies and is founder of Value Point Accounting, where he helps businesses manage product and customer profitability. His previous articles were Better Than Nothing, Five Lives and Pay to Play. Tom can be reached at tomgwelsh@valuepointaccounting.com.
Want to receive our weekly newsletter? Sign up now. How about our daily alert about the site's latest posts? Join the list.
This Vanguard model portfolio allocation graphic gives shows you how various stock/bond asset allocations have fared from 1926 to 2020.
For example, a 50/50 allocation:
Average annual return 8.7%
Best year (1982)33.5%
Worst year (1931)–22.5%
Years with a loss 20 of 95
https://investor.vanguard.com/investing/how-to-invest/model-portfolio-allocation
Thanks for your useful analysis. Given that this is a conservative low-risk scenario, I think one should assume that they will live longer than their estimated life expectancy.
These types of articles assume that retirees live by spending down their capital. If you live on the income your capital generates, you will have different concerns. Will my stocks continue to pay dividends? Will the dividends increase over time to keep up with inflation? Do bonds pay so little interest that they are actually losers after inflation?
If you want to live on your income, I would suggest a larger allocation to stocks, but to more conservative stocks that are likely to continue to be able to pay. If you don’t need all of your income to meet your expenses, then you can invest more aggressively, and continue to add to your portfolio.
Correct. I keep 5 years’ expenses as my cash bucket (mainly in I-Bonds). The rest is invested in blue-chip dividend growth stocks. I am laser focused on the income rather than “net worth”. When stocks crash, I go shopping to increase my income. I have rarely had a stalwart company cut its dividend.
Thank you Mr. Welsh. While we have indeed seen a few significant market declines over the past 20 years the Fed has shown us that, aside from its already robust tool box, it is very creative in making new tools as needed to keep any decline short-lived. It’s astonishing. Because of that I do wonder if retirees could simply continue spending at a consistent but moderate rate without calculating any SNW budget. When it’s time to decide our own retirement spending I suspect I’ll use a lower portfolio growth rate due to lower expected future returns while also keeping a few years worth of cash.
Presumably the Fed will eventually run out of tools.
A very interesting perspective. I also apply valuation discounts to account for estimated taxes.
Thanks for sharing a fairly detailed analysis with a representative example.