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Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte. And today I'm answering three big questions from our listeners. The first, why are stocks and high quality bonds down at the same time? And what should conservative investors be doing right now to protect their portfolio? Number two, how can we improve our mindset and gain optimism in the face of all the negative economic outlooks at the moment?
And then finally, number three, what is the correct order of operations when withdrawing money in retirement? For all the links and resources mentioned today, just head over to youstaywealthy.com forward slash 152.
Okay, a quick reminder for everyone before we get started. If you ever have a retirement, investing, or tax planning question, or you're faced with a retirement challenge that's maybe keeping you up at night, please send me an email at podcast at youstaywealthy.com. Your questions and your comments and your concerns are largely what drive the content for this show. So help me help you. Again, send me an email at podcast at youstaywealthy.com.
Okay, let's dive in. The first question for today comes from Stay Wealthy listener Susan H. And Susan is curious about the bond market. She asks, why are bonds going down along with the stock market right now? I thought bonds were supposed to protect my portfolio when stocks crash. Also, what should conservative investors like myself be doing right now to protect their portfolio?
So great question and a big thank you to Susan for reaching out and asking something that I think is on a lot of people's minds right now. There are a handful of things to unpack here. So first, a reminder to everyone that like stocks, not all bonds are equal. There are risky bonds, there are safe bonds, and there's everything in between. The risk profile of a bond or a bond fund largely hinges on the credit quality of the underlying bonds and or the duration or maturity.
To put some numbers to this, here in 2022, year to date, the Vanguard short-term treasury bond ETF is down about 3%. On the other hand, the Vanguard long-term treasury ETF is down about 20%. Longer-term bonds, as I noted, are riskier and they're more sensitive to interest rate risk. So they are, not so surprisingly, experiencing larger losses at the moment.
Over the long term, though, you would expect the riskier, longer-term bonds to outperform the shorter-term bonds. Risk and reward go hand in hand, and the bond asset class is no different here.
As mentioned, we can also look at the credit quality of bonds to determine the level of risk we might be taking. Corporate bonds are lower rated and riskier than treasury bonds. And we're seeing that play out right now in the current performance as well. Intermediate treasury bonds, the highest quality bonds you can own, are down about 7.5% so far this year. However, intermediate corporate bonds, lower credit quality bonds, are
are down almost double that amount, close to a 13% year-to-date decline.
Now, I'm sharing all this because it's an important first step when talking about bonds to acknowledge that not all bonds are equal. It's also important to understand what kind of bonds we own and why we own them before racing to conclusions or rushing out to make investment changes. So with that understanding, let's talk more about why stocks and bonds are down at the same time when, as Susan noted, bonds are supposed to be safe and provide protection in a portfolio.
So first, let's talk about U.S. stocks, which are down about 17% here in 2022. A negative 17% return is not enjoyable to see, but it's actually quite normal. The stock market experiences this type of correction or drawdown every couple of years on average. Most investors know that stocks are risky and they accept significant downturns from time to time in order to reap the long-term reward.
Now, bonds, on the other hand, are not acting normally. The last time we saw bonds suffer this kind of intra-year drop was back in the 1800s, according to the Wall Street Journal. In other words, we could call this one of the worst bond bear markets in history.
In addition to it being rare that bonds are down this quickly and this significantly, it's also rare that stocks and high quality bonds are down at the same time. The data that we have access to concludes that stocks and bonds both experience negative returns in a single quarter about 8% of the time, 8% of the time. In other words,
While it's not necessarily, quote, normal, there are definitely periods of time where both of these asset classes are negative at the same time. And this is just one of those periods.
And these unique time periods support why cash management is so important. If you're in the withdrawal phase of retirement and you have a strange quarter where everything in your portfolio is down, well, hopefully you have a strong war chest of cash that you can lean on. Hopefully you have your emergency savings account plus one year of living expenses in cash. And while you would typically replenish your living expense cash bucket by selling some investments every single quarter, you
When and if we go through a unique time like we're in right now, well, you might consider maybe holding off on tapping your investments. Maybe you wait until next quarter and you spend down a little bit more of your cash. It's certainly not ideal, but this is why we have to have a healthy amount of cash. It provides flexibility when it's truly needed. It allows us to weather these unforeseen storms without disrupting our long-term plan.
Now, before we tackle the last part of Susan's question, it's important to remind everyone that high quality bonds historically provide the protection that some, maybe Susan, that Susan might be expecting right now during what we call catastrophic time periods. While things certainly feel bad right now, this is not what we would refer to as catastrophic necessarily. The COVID crash in 2020 was catastrophic. 08, 09 was catastrophic.
The tech bubble collapse followed by 9-11, that was catastrophic. And during those catastrophic events and others, if you continue to go back through history, during those catastrophic events, we saw U.S. treasury bonds, those high quality bonds, doing their job and providing the protection that most investors need. For example, from 2000 to 2002, U.S. stocks were down about 40%. On the other hand, U.S. treasury bonds were up close to 35%.
While things could certainly get worse from here, we haven't quite reached a level where there's this mad dash to safety and we would expect bonds to perform like they have in previous catastrophic events.
Which leads nicely into the last part of Susan's question, where she asks about what conservative retirement investors should be doing right now. And while I might have already addressed it through my other answers here, it reminded me of some other comments that I've seen flying around lately, suggesting that diversified portfolios are not doing their jobs right now because everything seems to be in negative territory. And I have two responses to this.
First, a 50-50 stock bond portfolio is down about 13% with a standard deviation of 12 so far in 2020. On the other hand, a 100% stock portfolio is down closer to 17% with a standard deviation of 24%.
The less risky, less volatile portfolio had smaller losses. So diversification most certainly did its job. Second, one of the most interesting aspects of this current sell-off is the difference in performance between some different asset classes. For example, growth stocks and value stocks.
As longtime listeners know, I'm an advocate of evidence-based investing, which leads to underweighting growth-oriented companies and overweighting value stocks. And I'm thankful for that philosophy this year. I'm not sure if you're following, but growth stocks this year so far in 2022 are down about 25%, with some of these growth stocks individually being down 60%, 70%, 80%, 90%.
Value stocks, on the other hand, are only down about 7% so far this year. So if you had an evidence-based, academically sound portfolio coming into 2022, you're likely feeling pretty good. Again, diversification, proper diversification has definitely done its job.
While I don't have a crystal ball, my informed and educated opinion is that the bond market will likely begin to settle down from here. But even if rates do continue to rise, don't forget about the myth of rising interest rates causing permanent losses in bonds.
I've talked about this a few times on the podcast, but even in an aggressive rising rate environment, high quality bonds and high quality bond funds weather the storm quite well due to the increase in interest payments. And instead of going through it all over again, I'll link to the episode in the show notes if you want to check it out and get a refresher. Just remember that
Intermediate-term treasury bonds are not short-term cash alternatives. They are not guaranteed to have positive returns every day or every quarter or even every year. These are six- to eight-year instruments that will experience short-term fluctuations and sometimes some uncomfortable losses in the short term. We have to be sure to acknowledge their time horizon and be honest about their longer-term role in our diversified portfolio.
If you don't have a long time horizon or you're uncomfortable with short-term losses and fluctuations, then you may need to consider taking less risk, which in turn means you would need to expect and be okay with a lower rate of return.
You could do this by holding more cash, by shortening the duration of your bonds, i.e. holding short-term bonds versus intermediate or long-term bonds, or maybe by leveraging insurance-based solutions to help share that risk. Again, you can't have your cake and eat it too. Whether you reduce the risk yourself or transfer it to some insurance company or insurance product, you're still going to need to expect a lower rate of return.
So thanks again, Susan. I hope that was helpful. If you have any follow-up questions, let me know. Okay. Our next question comes from Lori G and she sent me the following email. Everything I'm reading and watching right now is negative and pessimistic. I'm finding myself more panicked than usual. And I know that feeling this way is not helpful for my long-term plan or my sleep. What tips do you have for gaining optimism and changing our mindset with everyone calling for the next recession?
So great question here. And while I love nerdy financial and tax planning, I'm also fascinated by the psychology of money and investing.
If you're listening to this podcast, chances are you are very familiar with the keys to investing success. Diversify, keep costs low, and be patient. Pretty simple, except it's not that simple. We are our own worst enemy, and we let our emotions get in the middle of these very simple keys to success. Even if we don't panic, even if we don't stuff our money into the mattress, even if we don't destroy our long-term plans that we put into place when we were clear-headed, maybe
Many of us still suffer in other ways, anxiety, stress, sleepless nights, relationship struggles. One simple solution to all of it is to, of course, ignore the noise. You've probably heard me say this before. Ignore the noise. Turn the TV off. Stop listening to the radio. Put away the newspapers. But that's all easier said than done, especially in today's day and age where these clickbaity headlines follow us around everywhere.
And if it's not these headlines, it's your friend or your neighbor or family member expressing their concerns and sharing their pessimistic outlooks.
It's hard to get away from sometimes. So when all else fails, when things are scary and I'm not sure what to do, I personally revert to doing two things. The first is I go through a mental exercise where I imagine the worst case scenario, the absolute worst case scenario. And then I come up with five solutions to overcoming that scenario. But I don't stop there. I then come up with five more because the first five are easy. The second five is usually where the magic happens.
As the Stoics suggest, it may be an unpleasant exercise, but it can really help you come to grips with the fact that the worst case scenario is likely something that you're able to cope with. In fact, Stoic philosophers like Seneca referred to this exercise as a premeditation of evils.
It allowed him to be prepared for disruption. He was prepared for defeat or victory in some cases. And I'm sure we can all imagine some of these as it pertains to money and investing. In some cases, there are no solutions. Nothing can be done. It's something outside of our control that we just have to suffer the consequences of. In those cases, we might just have to be comfortable saying it's going to suck, but we will be okay.
As Ryan Holiday put it, the only guarantee ever is that things will go wrong. The only thing we can use to mitigate this is anticipation because the only variable we control completely is ourselves. I'll say that again. The only guarantee ever is that things will go wrong. The only thing we can use to mitigate this is anticipation because the only variable we control completely is ourselves.
In addition to a mental exercise, you can also, and you should also, go through an actual planning exercise, a retirement planning exercise, where you explore what we call what-if scenarios and devise solutions that you have control over to help you recover from these what-if scenarios. What if my diversified portfolio of stocks and bonds somehow, someway, even though it's never happened, drops by 50%?
What if the stock market returns are cut in half for the next 20 years and we're in this extended low return environment? What if I retire tomorrow and we immediately go into a recession? The what if questions are endless, but going through them and then modeling solutions to combat them can be a very comforting exercise.
The other thing I like to do when we're going through challenging market environments is to zoom out. By zoom out, I mean remove ourselves from the short-term events, from the short-term predictions, and look at things with a slightly longer perspective. What you typically find is that you don't have to zoom out very far to find optimism. For example...
Since January 1st of 2020, the U.S. stock market is up about 25%. So despite a global pandemic, the fastest 30% drop in stocks ever is 22 days. Despite 8% inflation, despite an overseas war, despite multiple interest rate hikes, U.S. stocks have returned a positive 25% since the start of 2020.
The S&P 500 right now is off to its worst start since 1939, but you're still buying stocks at a higher price today than 18 months ago. Again, you don't have to zoom out very far to find some optimism. It's easy to get caught up in the short-term fluctuations, the short-term headlines and predictions, the dire outlooks, but they aren't constructive as Lori suggested. We don't take our money out from underneath the mattress to invest it for six months or 24 months.
Even for those who are in retirement, we're investing for the next 20, 30, or even 40 years. By the way, if you don't know who Ryan Holiday is and you have not checked out the book, The Daily Stoic, I highly recommend it. It's meant to be read one day at a time and has a very unique way of just making you feel better about the uncertainty that we are constantly faced with. Nothing to do with investing, but also everything to do with investing. So if you're interested, I'll link to it in the show notes and you can check it out.
Okay. The last question for today comes from Gary H who asked the following question. If I'm focused on optimizing for taxes, in what order should I tap into my different accounts in retirement to create income? Should I spend my after-tax brokerage accounts first, then my traditional IRA, then leverage social security income, and then finally touch my Roth IRA last? What is the best order?
Okay, so this is a great question. And while the real answer is it depends, there are some important things to take into consideration when thinking about where to pull money from first, second, third, and so on when we're creating our retirement paycheck.
First, contrary to what most people think, I personally like to target traditional IRA dollars first. And that's because I want to be sure that we're taking advantage of opportunities to get money out of our traditional IRA at a favorable rate before tapping into any other account.
If you listen to my two-part series on Roth conversions last month, you might remember me saying that what is favorable today depends on what your future tax rate is expected to be at age 72 when required minimum distributions collide with Social Security and any other income that you might have.
For example, if you determine that you will likely be in the 35% federal tax bracket at age 72, then you might consider taking money out of your traditional IRA up to the 22% or even the 24% bracket in your earlier years.
Heck, even if you expect to be in the 22% bracket at age 72, you might still consider withdrawing money from your traditional IRA in earlier years to fill up your 22% bracket and stop that tax liability in your IRA from growing. I.e., as the investments in your traditional IRA grow between now and age 72, so does the amount that you have to pay the IRS. Again, talk
targeting your traditional IRA first seems a little bit backwards and maybe contradicts what most people think is the starting point for retirement withdrawals. It makes sense that people think that they want to tap into their after-tax brokerage accounts first because the tax impact of that approach is usually zero or very low.
And while avoiding a tax consequence might feel like the right move, we have to be careful about looking at taxes in a vacuum and making tax decisions in a single year. By creating a longer-term tax plan and looking at the long-term consequences of your withdrawal decisions, you can create a more stable, a more predictable tax bill throughout retirement. You might also be able to significantly lower the amount that you pay the IRS between now and end of life.
Now, as you might already be thinking, we can get money out of our traditional IRA at a favorable rate two different ways. One way is to simply take a withdrawal or multiple withdrawals up to the top of the tax bracket that we have deemed to be favorable and then use that withdrawal to pay for or supplement our living expenses. The other way is to convert the money to a Roth IRA through a Roth conversion.
If you're actively pursuing Roth conversions each year and you're filling up your favorable tax bracket through that strategy, well, then you won't have any room left in that tax bracket you're targeting to take additional taxable withdrawals from your traditional IRA. In that case, you'll have to look at a different type of account to pull from to create your retirement paycheck, which leads us to the next type of account to target. And that would be your after-tax brokerage accounts.
Before I share more details, I want to highlight that one common mistake I see here is people spending from cash instead of tapping their investments in their after-tax brokerage account. And while it might be more tax-friendly to do that, and it might seem more rational because it allows your investments to grow for a longer period of time, it usually signals to me that the person doesn't have a good cash management plan in place. That either they have too much cash, which can be a drag on your long-term returns, or
Or they just wrongfully assume that spending down all of their cash first and letting their investments grow was most prudent. In short, my rule of thumb for those who are retired and living off their investments in retirement is to have three to six months of cash in an emergency account and then also have one year of cash in a living expense account for the next 12 months of spending.
As you spend down cash each quarter from your living expense account, investments should be sold and used to replenish that living expense bucket through a dynamic, sustainable withdrawal strategy. In case you missed it, I did an entire retirement income series last year, and I dove deep into sustainable withdrawal strategies. I'll link to it in the show notes, which again, you can find by going to youstaywealthy.com forward slash 152.
So we want to replenish our living expense cash account every quarter because the last thing you want to happen is to spend down all of your cash, go to tap your investment accounts for your next withdrawal, only to realize that we're in the middle of a market meltdown and you might be forced to sell investments at a sizable loss in order to fund your living expenses.
We never want to be in that position. So as I've said numerous times here on the show, it's critical to have a good cash management plan in place when it comes to producing your retirement paycheck.
Oh, and I should mention that having a third cash bucket for next year's projected tax bill is important as well. For example, if you did a Roth conversion this year or you plan to do one, you should put the projected tax bill money in a separate cash account earmarked for next year's tax bill. Since you know that that money is going to the IRS within the next 12 months, it should not be invested.
Okay, with that, let's go back to tapping your after-tax brokerage account as the second place to withdraw from after your traditional IRA. In most cases, when tapping your after-tax brokerage account, you'll be forced to liquidate securities in order to take the withdrawal. Given that, you'll want to be sure that you're targeting investments that you've held longer than one year so that you get long-term capital gains tax treatment on that sale.
If that's the case, if you do need to sell long-term appreciated securities to take a withdrawal, you might also look to see if you have positions with long-term losses that can be sold and realized to offset some or all of those gains.
To be sure everyone is following here, let's take a look at a quick example. Let's say that I bought $10,000 of SPY. That's the S&P 500 ETF. So let's say I bought $10,000 worth of SPY five years ago, and it's doubled. It's grown to $20,000. Well, if I sell that position today, I'll have to pay long-term capital gains tax on the $10,000 gain, the difference between what I bought it for and what I sold it for.
But let's say that I also bought $20,000 of a growth and technology ETF 18 months ago, and that investment has been cut in half, and it's now only worth $10,000. Perhaps I'm still bullish on growth and technology. So I sell that ETF. I realize a $10,000 loss to offset the gain from my S&P 500 sale.
Now, I can't buy back the same growth and technology ETF I own because that would trigger the wash sale rule. But most people agree and talk to your CPA here. This is not advice, but most agree that you can buy a similar growth and tech ETF that tracks a different index, allowing you to use the losses from the previous sale to offset the gains, but also maintain your position in that asset class.
So to summarize, if this was all done correctly, you would be able to withdraw $20,000 from your brokerage account without a tax consequence.
So we've targeted our traditional IRA first to ensure that we're getting money out at a favorable rate. Then we're moving to our after-tax brokerage account. And when and if that after-tax brokerage account is exhausted, we would finally target our Roth IRA dollars. We want our Roth IRA to grow for as long as possible because that money has already been taxed and it's growing tax-free.
It's also, as I've mentioned before, much easier for your heirs to inherit a Roth. So most would prefer for that account to have the most dollars in it at end of life if legacy planning is important. Lastly, I should note that other income sources certainly play into all of this as well. For example, social security, pensions, real estate, and so on. The amount and timing of these other income sources will factor into the prioritization of retirement withdrawals. So be sure to take those into consideration.
Once again, if you have any retirement, investing, or tax planning questions, please send them my way at podcast at youstaywealthy.com. To grab the links and resources from today's episode, just head over to youstaywealthy.com forward slash 152. Thank you as always for listening, and I will see you back here next week.