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Since retiring several years ago, the broad market endured one three sigma decline and the NASDAQ took a horrendous hit in 2001 and 2002. In addition, the S&P 500 remained static when measured over the first decade of the 2000s. How was a retiree to survive under such market conditions, and more importantly, what preparations are required going forward? To answer these questions, one needs to stress test their portfolio assuming another three sigma event will occur during the retirement years.

To run such a test, I am going to use a portfolio that has essentially been passively managed since late 2000. This portfolio experienced the tech bubble explosion of the early 2000s and the financial debacle of 2008 and early 2009. Nevertheless, this portfolio continues to outperform the broad market, as measured by the VTSMX index fund, by 2.0% annually.

Below is the Strategic Asset Allocation (SAA) plan for the portfolio and this allocation has remained nearly constant over the last ten years. Only commodities, bonds, and international REITs were added in recent years. This was essentially an equities portfolio during a period when equities were stagnant.

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A few assumptions are required to see if this portfolio can survive another three sigma event. This investor is 40 years of age, has saved $250,000, expects to retire at age 66, saves $12,000 per year, and will draw out $50,000 per year based on current dollars. Inflation is projected to average 3.5% and the S&P 500 is projected to return 7.0% annually.

In the following screen shot, we see the makeup of the portfolio. This is an actual portfolio, not a fictitious one. Make a note of the high projected standard deviation of 18.0% (rounded) as this figure plays an important role in retirement planning and the following stress test.

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Using Quantext Portfolio Planner (QPP) software to run this Monte Carlo analysis, we see this investor has a 10% probability or running out of money at age 76 and a 50% chance of experiencing poverty at age 103. The odds are such that this investor, with some adjustments in lifestyle, will likely make it. But what if another three sigma event occurs? In my investing lifetime, I've experienced three of these events. In the late 1960s, the DJI topped 1000 and in early August of 1982 it stood at 777. Imagine retiring in 1968.

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Now we run another retirement projection, but one that places a three SD stress on this $250,000 portfolio. Coming back to the projected SD of 17.98% or 18% rounded, a three SD event is 3 X 17.98% or 53.9%. For ease of calculation, let's assume a 50% figure. What this means is that this $250,000 portfolio has a high probability of being cut in half at some point during this investor's lifetime. In fact, it is likely to happen more than once. What does the probability of running out of money look like with a $125,000 portfolio?

Below are the grim projections. This investor has a 10% chance or running out of money at age 74 and a 50% chance of running out of money at age 103, in case one is now reduced 14 years to age 89. Those are odds most investors don't want to play with, so what are the options? Save more, work longer, or reduce the withdrawal rate.

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The fourth, and less painful choice, is to alter the Strategic Asset Allocation plan. Develop a more conservative portfolio. Drive the projected standard deviation down. That will also reduce the projected return. In this particular portfolio, the projected Return/SD ratio is 0.48. Rework the portfolio structure until that ratio exceeds 0.60. In reality, what is required is a combination of all these possibilities if one wishes to avoid going into poverty during retirement.

Disclosure: I am long BND, DJP, DVY, TIP, HYG, GSG, SLV, VBR, VO, VB, VUG, VOT, VOE, VTV, VNQ, RWX, VEU, VWO, VBK.

Source: Stress Testing Retirement Portfolio: Will It Last?