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 firstname.lastname@example.org.