Nestegg Cycle © How to Stress Test your Portfolio

Posting Date: Mar.05, 2024    By: Fred P Davidson, Founder of
    Rev.A: Mar.19, 2024
    Rev.B: Mar.25, 2024

INTRODUCTION: Concepts, Terms, and Assumptions related to this Stress Tester

To set the scene: It is 9:00AM on Day One of your retirement. Given your particulars ...
IF things were to go sour right now, just how bad could it get for your retirement?
This kind of bad news scenario happens to only about 20% of retirees,
and this calculator makes it simple to explore defensive alternatives.
For the luckier other 80% -- but you don't know beforehand which you'll be --
you would NOT need to deal with this, also known as Sequence of Returns Risk, or SRR.

SHOWING / HIDDEN  Sections of This Posting -- Click to Toggle. Then scroll down to view:

You provide six inputs:
  Portfolio Yield, NET of inflation
  YEARS Money needs to Last
  Annual PAYOUT as PERCENT of your PRINCIPAL, your nestegg
  Post-Crash Haircut (normally "NONE")
  Cash Reserve, and, Reserve Type

The Calculator

  Calculated Stress Test Report: BEST viewed from Desktop or Laptop
  where you can Resize by dragging lower right corner, JUST ABOVE.
  On a PHONE, rotate to LANDSCAPE and use Height/Width buttons below for sizing.

Height: 10% - 20% - 40% - 80%           

Width: 50% - 65% - 80% - 95%           

DISCLAIMERS: This is just math. The calculations know NOTHING ELSE about your situation, other than the inputs requested here. Real-world markets can have unexpected complications. Please share these reports with a trusted financial advisor and do your own due diligence. We are not responsible for the performance of your investments.

We assume that during crash times, you are keeping up with inflation "somehow", possibly by moving the money to a money market fund.
This greatly simplifies the math, but you MUST keep this in mind as you consider these reports.
If you were NOT keeping pace with inflation, the crash results would be more severe than what's shown here.

The decision to DEPLOY these defensive measures, and to what extent, requires decisive action at the start of a crash, based on incomplete information!
This requires real-world wisdom which IS NOT, and CAN NOT, BE PROVIDED IN A CALCULATOR.
You would need to swing into managing your "worst expected scenario", immediately cutting your payouts from crashed equity, in accordance with these calculations, and for the number of years you specified.
This is a relatively RARE event: you may never need to deal with one.

Instructions for the Calculator

SEE ALSO: Main Discussion section, for additional insights; CALCULATOR section for Disclaimers.

We assume, for purposes of the reporting, that your nestegg contains 1 million dollars.
This means that if you specify let's say, a 5.5% payout, the messages will show this as 55000 per year.
If you have for example 500,000, you would need to divide the reported dollar amounts by 2: 55000/2 is 27500.
Percentages and Crash-Points stay as-is.
This keeps your actual balance totally private because it never gets entered.

We have a somewhat specialized definition of a "crash":
 It begins suddenly and completely on the morning of Day One of your retirement.
 It is a synthetic construct, simpler than a real crash. A flat line, there is no jagged-line volatility.
  This simplifies exploration of effects that might occur.
 Our crash minimally means the LOSS of your net YIELD: You stop gaining against inflation.
 This means we can have a "crash to 100%" at which you still have the whole million, but just no interest.
  Indeed, this is the first situation we explore in each report.
 A crash to 80%, for instance, would mean that the million suddenly dropped to 800000 in value, on Day One.
 Our crash recovers suddenly, exactly on a retirement anniversary, by applying the inverse fraction to the remaining balance. So in the case of a crash to 80% (0.80), the balance remaining after payouts at end of the crash, gets multiplied by (1 / 0.80), which is 1.25.
 After that, the portfolio yield (as entered by you) resumes immediately and until the end of the term.

We "crash test" your portfolio for periods of 2, 3, 4, and 5 years and report the outcomes for each crash.
Be aware that there is no "generic crash". Rather, the calculation depends on ALL the values you entered, as well as the duration of each crash, and its DEPTH. The depth of a crash is indicated as a "crash-to" percentage.

In our on-screen report, we show five "Crash To" depths for each crash length: 100%, 80%, 60%, 40% and 20%.
For each "Crash To" depth, we show how much of your payout can come out of crashed equity, how much (if any) needs to come from fixed income RESERVES instead, and the consequences of ignoring this distinction.

  These consequences are shown in the "WHAT_IF1" and "WHAT_IF2" columns of the report.
  Briefly: "WHAT_IF" numbers less than 1.00 tell you the fraction of your payout capacity that would remain.
  Scroll down to the section, "Explaining the Report's Column Headers for each crash".

A Crash To 20% has not been seen since the Great Depression, which began in 1929, and ran through the 1930s.

Long-term Effects:
By this, we mean crash-related effects that spill over to the REST of your retirement,
depleting your nestegg to the point where the initially planned payouts can no longer be sustained through the planned end of your retirement term.

We have devised a measure of your portfolio's crash resistance, called its "crash-point", and by this measure, smaller is better.

Consider what happens if your portfolio's yield drops to zero for some years at the start of retirement, without losing any of its value.
You are retired and expecting to draw your payouts. How much will this affect you in the long run, if any? At low enough payouts, your nestegg may contain more than you actually require, providing some margin of safety. The crash-point tells you, for the particular crash in question, how much your portfolio could drop in value, and for how long, before you begin to suffer long term effects.

A crash-point value of 1.00 means that you are taking the exact maximum payout that will survive the "Crash to 100%" with no ill effects, but that as soon as your portfolio value were to drop at all, or you withdrew one dollar more than the planned annual amount, long term damage would begin. We flag as "BRITTLE", any crash scenario with a crash-point greater than 0.75, meaning that a sustained market drop of 25% leaves you susceptible to long term damage.

A crash-point value of 0.45, or even less, is a lot more desirable: your portfolio would need to crash down to 45% (450K on our hypothetical million, or less) before long term problems would set in.

The ages-old problem of "fear versus greed"!
Everybody would like the payout to be larger, and the risk to be smaller, but the tension is that these pull you in opposite directions, and so you need to experiment with alternative choices until you find something you can live with.

Assuming that your investment yield and time horizon are fixed, or nearly so, your main adjustment levers will be your Payout, your Reserves, and/or your Post-Crash Haircut.

Simplest for basic safety and security, is to reduce the annual payout until the results of a 3, 4, or 5 year crash look acceptable to you. Stay away from the Reserves and the Haircut for a first exploration, at least.

If you see that Reserves are needed at 100% or 80% or 60% crashes for 3 years, you are reaching for more payout than your portfolio can safely provide, and you need to step it down until it looks more reasonable. If you are depending on good crash protection at 4 and 5 years, apply this same screening process to those longer crashes, and yes, it will reduce the payout you can take.

In the following sections, Your RESERVE and Taking a POST-CRASH HAIRCUT
we describe the value proposition of this posting and calculator:
Some techniques you can explore to find more livable compromises between Payout and Crash-Resistance!

If you have other income sources such as a pension or Social Security which already cover your basic expenses, you may be comfortable farther out on the risk spectrum, seeking the better payout.

Your RESERVE -- "Add-On" or "Carve-Out":
We define your RESERVE as an additional pot of money, invested in a stable value account, like a bank account or money market fund, from which you can draw when your portfolio will not support your full payout. IF you are fortunate enough to HAVE such a fund, select "Add-On". The report will detail how much you would need to use it in the various crash scenarios.

IF you are not this fortunate, you will want to explore scenarios in which substantial market crashes will not impact your payouts. Necessarily, this will limit you to lower payouts, but it is vitally important to adhere to these limits if you cannot risk the shortfalls.

A new alternative: you can select the "Carve-Out" type of reserve.
This works WITHIN your original nestegg, but re-assigns a specified percentage of it to be your stable value reserve.
Even though this reduces the amount of assets earning the market investment yield, the extra stability does support larger payouts during a crash, at a given level of crash resistance.

This is a trade-off you can try, but use this with CAUTION!
The default is "NO Haircut", which would be the same as a "Haircut to 100%".
If you select a "Haircut to NN%" (5% steps ranging from 95% to 65%) --
More money is made available for payouts during the crash BUT --
Big CAUTION here: That extra money has to come from somewhere, and that somewhere is your FUTURE payouts AFTER the crash!
We believe this is less effective than the stable value Reserve because it requires using more of what would be your currently crashed funds, but it offers simplicity, and is one more option you can explore.

Don't worry if it takes you dozens of tries to reach a good compromise of Payout versus Crash-Point.
Each try takes mere seconds, and this is your retirement we're talking about!

We typically look at retirement payout periods of 30 or 40 years, and long term investment yields around 7.0% above inflation. You can enter whatever values suit your situation, but for perspective, we have pre-calculated some payouts that provide crash-points a little under 1.00.

EX1: PAYOUT 5.75%; YIELD 7%; TERM 40 years
This will stand up to a crash to 60% for 2 years, or 80% for 3 years, or 100% for 4 years.
In a 5 year crash, the crash-point is 1.125. and even at 100% portfolio value, we'd need to take 11.13% from reserves, or do without.
You need to make your own judgement call, as to how crash-safe you need to be.

EX2: PAYOUT 6.21%; YIELD 7%; TERM 30 years
This provides almost the exact same risk profile, but because we only need the money to last 30 years instead of 40 years here, we can take a 6.21% payout instead of 5.75%

EX3: PAYOUT 6.21%; YIELD 7%; TERM 40 years
This uses the same payout, 6.21%, as in EX2, but shows what happens if applied to the 40 year retirement.
With a crash-point of 0.68738, a 2 year crash here is safe down to 68.7%, which is fine, but only for 2 years.
In a "Crash to 100%", at 3 years, you'd need to take about 0.50% from reserves, and by 4 years, you must take 23.30% from reserves.

Author's Note:
These examples were developed early into this project, to illustrate that we can find different scenarios with similar Crash-Points.
All these weeks later, these now look far too risky, as the advice elsewhere in this posting, developed later, clearly shows.
If you run them now, you will see warnings that they are "Too BRITTLE!"
No reserves were explored in these examples, as the math had not yet been developed!
As an exercise for the reader, try re-working these examples until they conform to this posting's other advice.

Explaining the Report's Column Headers for each crash:

RESERVES to make up "n" year CRASH Shortfalls, Gentlest crash first:

                 Take from:       Take from: 
   Crash To      CRASHED EQUITY      RESERVE    RESV_as_%_of_Payout    WHAT_IF1    WHAT_IF2
	Crash To
		The percentage of portfolio REMAINING at start of the crash

		The dollar amount (on basis of a million dollar portfolio)
		you could take from your crashed equity portfolio without incurring long term harm.

	Take from RESERVE
		The dollar amount (on basis of a million dollar portfolio)
		you would need to take from fixed income reserves to complete your full payout,
		or do without.

		This normalizes the amount from reserve, as a percentage of the whole payout.

		Answer #1 to: "What if I take the whole amount from the crashed portfolio anyway?"
		by showing the RATIO of (PRINCIPAL you'll HAVE) / (PRINCIPAL you'll NEED) 
		after the crash, toward sustaining your post crash payouts. 
		IF less than 1.00, you'll have to reduce your post-crash payouts by that proportion,
			OTHERWISE you will run out of money too soon.

		Answer #2 to: "What if I take the whole amount from the crashed portfolio anyway?"
		by showing the RATIO of 
			(YEARS you could have FULL payouts) divided by (YEARS you'll NEED PAYOUTS)
				after the crash.
		IF less than 1.00, you'll run out of money and have NO payouts in that proportion.
		For example if you have 36 post-crash years and this number is 0.75, 
			your payments and money
			will be GONE after 0.75 times 36 = 27 years.
		IF greater than 1.00, you'd have more than enough through end of retirement term.
		IF 999.9999, you'd have enough to get payouts FOREVER.

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