The 30% Test: Could Your Retirement Survive A Market Drop?

Right now, investors are getting two very different messages.

On one hand, there are a record number of 401(k) millionaires. For someone who has spent decades saving, that's worth celebrating.

On the other, major financial institutions have been warning investors to take a hard look at how much risk they're carrying.

Should you be celebrating or worrying?

For investors in their 50s and 60s, I think there's a better question: What would a 30% market decline do to your life?

I'm not asking whether you think the market is going to crash. I don't know if it will. Neither does anyone else.

I'm asking what happens if it does.

A 30% drop means different things at age 35 vs 55

If you're 35 years old and your 401(k) suddenly drops 30%, you probably won't be thrilled. But you have something a 60-year-old doesn't have: Time.

You're still contributing to your retirement account. You're not depending on that money to pay next month's mortgage. A major decline could mean your future contributions are buying investments at lower prices.

At 55 or 60, the conversation changes.

If you're nearing retirement and your portfolio falls 30%, you don't have decades to recover. Worse yet, you might soon need to start taking money out of that portfolio.

That's when a market decline can become a retirement problem.

That's why I don't want people trying to predict the next 2008. I want them to understand who they are as an investor.

You might own more of the market than you think

Diversification is a term that's thrown around a lot in financial circles, but it's often misunderstood.

Someone might own 15 mutual funds, 10 ETFs and several different accounts. Sounds diversified, right?

Not necessarily.

When you look through those funds at the individual stocks they own, you can find significant overlap.

I recently saw a portfolio in which an investor believed they were extremely diversified, but after looking through their holdings, we found they effectively owned one popular technology stock dozens of times. The same thing was happening with other major tech companies within their portfolio.

Now, there's nothing wrong with owning those companies. The problem was that the investor had no idea how concentrated their portfolio really was.

You can own several funds and still be making essentially the same investment over and over again. That's not true diversification. That's called hidden concentration.

Who are you?

There's one exercise I'd like every investor approaching retirement to do.

Imagine you wake up tomorrow and the market is down 30%. Which one of the following people are you?

Investor No. 1: 'It doesn't change my life.'
You have enough pension, Social Security, rental income, cash and other reliable income to keep paying your bills.

Investor No. 2: 'I'll wait it out.'
You don't need to sell investments, so you can leave the portfolio alone and give it time.

Investor No. 3: 'I'd probably start selling.'
You know yourself well enough to admit that watching your portfolio fall would cause you to take action.

Investor No. 4: 'I'd have to change my lifestyle.'
The market decline would mean postponing travel, cutting spending or changing plans for your family.

Investor No. 5: 'I'd panic.'
You know a 30% decline would be so uncomfortable that you'd want out.

There's nothing wrong with any of these answers, but there is something dangerous about not knowing which answer is yours.

Don't let the market decide for you

A market correction isn't necessarily a death sentence. Markets go up and down. That's investing.

The problem comes when you need to sell investments when they're down because you don't have another way to fund your life.

That's why retirement planning isn't simply about asking, "How much money do I have?"

It's asking, "How much of my lifestyle depends on that money to continue growing?"

• Could you cover essential expenses for several years without selling investments after a major market decline?
• Could you take the vacation you've dreamed about?
• Could you help support your family?
• Could you sleep at night?

Those are very personal questions, and the answers should drive our planning — not what your adviser wants, what Wall Street wants or what the market happens to be doing this week.

You don't need to predict the next crash. You need to know what happens if you're wrong.

The worst time to discover your portfolio was carrying too much risk isn't before a market decline. It's in the middle of one.

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• Investing Lessons From 'The Three Little Pigs': Ways to Help Build a Portfolio the Big Bad Wolf Can't Blow Down
• Use This Stock Market Recipe for a Well-Diversified Portfolio
• You Might Be Retired, But You Still Need a Paycheck — Here's How to Create One

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.