Stress testing

[Steveam]

The banks have recently undergone some quite severe stress tests and this led me to think about my personal financial resilience. This is all very much circumstance dependant but I'm mid 60s, no dependants, no pension other than the state pension (currently in deferral), substantial SIPP, ISA and unprotected share investments, and a cash or equivalents "buffer" of three times annual expenditure. My house is mortgage free. My expenditure is fairly extravagant with donations to charity and business class travel.

What would happen if markets dropped by 50% and stayed down? I would expect income to drop by less - say 30% - this being based on my experiences from 2007/8/9. I could survive this indefinitely.

There are many other things to knock around such as a major set of changes to the tax regime to penalise unearned income or a wealth tax or run away inflation.

I have not considered either the psychological impact of losing 50% of one's wealth (my expenditure would probably drop) or of major life-style changes such as care home fees (which I'm told could be £60k/annum in London).

I'd be interested in peoples' thoughts in this are.

[tjh290633]

When the market crashes, dividends often do not fall to the same extent, and looking at my records since 1970, I see that dividends rose when portfolio value fell in 1974, 1977, 1994, 2001, 2002 and 2011. 2008 was anomalous as the fall in income came in the following year.

Obviously it depends on where you are invested.

TJH

[scotia]

or of major life-style changes such as care home fees (which I'm told could be £60k/annum in London).

This is the major unknown in stress testing that troubles me. How much should we (myself and spouse) hold onto to ensure if the worst happens, we can cope with care home fees. If I could reliably quantify that eventuality, I could possibly be more generous in charitable donations, and gifts to family.

[BusyBumbleBee]

or of major life-style changes such as care home fees (which I'm told could be £60k/annum in London).

This is the major unknown in stress testing that troubles me. How much should we (myself and spouse) hold onto to ensure if the worst happens, we can cope with care home fees. If I could reliably quantify that eventuality, I could possibly be more generous in charitable donations, and gifts to family.

And to compound the problem, care home fees are likely to rise by more than inflation as Chris Dillow explains this week in the IC : to quote a small piece

Generally speaking, productivity improvements are more likely in goods-producing industries than in services. Prices of services, therefore, tend to rise faster than goods prices over time. In the past 20 years, goods prices have risen only 18 per cent (0.8 per cent per year) while services’ prices have almost doubled.

[GeoffF100]

What would happen if markets dropped by 50% and stayed down? I would expect income to drop by less - say 30% - this being based on my experiences from 2007/8/9. I could survive this indefinitely.

In the US, reliable stock market records go back into the 19th Century. There have been several instances of dividends falling by more than 50% in real terms and taking 30 years or more to recover.

[toofast2live]

And they probably occured at the same nose bleedingly high valuations we see today. Were I stress testing i would assume a capital and income loss of 50%.

But what to buy in its place? Until the alternatives start to look better equities will "melt upward" due to human desire to Not Miss Out. If only NS&I Linkers were re-introduced but pigs might fly before that.

I sold a goodly chunk of pure equity in May and moved into Personal Assets, Capital Gearing and Seneca Global Income and Growth. As the highs get higher i might just sell and move into cash and wait for a correction.

[GeoffF100]

There have been several instances of dividends falling by more than 50% in real terms and taking 30 years or more to recover.

On reflection, I should have written "20 years or more" rather than "30 years or more". There were various nasty events. The American Civil War did not help dividends at all, for example. I have searched a little with Google, but I cannot find the data. Most people are more concerned with historical total returns than with historical dividends, which makes sense.

[Steveam]

Thank you all for your useful contributions and thoughts.

Not a lot here which leads me to change my position but it does re-inforce the message that markets can and do drop for extended periods and, although dividends tend to drop less, the loss of income can be extensive. I will probably just let the cash (or equivalents) buffer gradually increase by not reinvesting surplus income until I get to a three year buffer (quite close already). I do have a super backstop which would be to downsize - I may do this anyway at some point to suit my life needs.

The comment above about services costs rising faster than goods inflation is very pertinent. I’m just at that stage in life where I see my personal inflation rate becoming quite divorced from anything published.

Thanks again.

Steve

[hiriskpaul]

Mid 60s to mid 70s was probably the roughest period in modern times. From 1965 the value of the UK stock market was extremely volatile and the real value of the dividend income from it started to drop. The income bottomed out in 1976, 40% down in real terms from where it was in 1965 and then climbed to eventually exceed the 1965 real income in 1987 - 21 years later! One saving grace was that the yield of the market was much higher then than it is now, starting at 5.2% in 1965, but taxes on dividends were much higher as well and there were no ISAs for shelter.

The capital value of the market was very volatile, with the real value up about 50% at the end of 1968 and down about 70% at the end of 1974. From the depths in the mid 70s, It took until 1985 for the real value to get back above where it was in 1965. Holding gilts would not have helped either - they did even worse than equities. Possibly holding gold might have been worthwhile, don't have any figures to hand to say.

Stress testing is certainly a good idea, but hard to know precisely how much stress and what sort of stress is realistically required. The last 40 years have been great for investors, with high returns, short bear markets, declining inflation and declining taxes on investments. Things should continue to be rosy for most investors provided we don't get major reversals in taxes and inflation, even if returns are lower over the next 40 years. Even bear markets are not too much of a problem provided they continue to be short duration. In the rosy scenario, I would think that having investments worth around 25 times desired income levels should be sufficient to get through a 30-40 year retirement period. The difficulty comes if taxes on investments revert to 60s/70s levels, inflation takes off and equities and bonds get trashed again over a prolonged period. To comfortably survive that I think a starting capital amount of over 50 times income would be required.

However, I may be too pessimistic here. I was given a copy of a "Living off Your Money" by Michael H. MCClung for Christmas (https://www.amazon.co.uk/Living-Off-You ... 0997403403) and have only really just started looking at it, but the impression this gives is that 25 times required earnings should be enough, based on the worst back tested periods, provided you pick amongst the better drawdown strategies tested. It should even be possible to get by on less than this if a variable withdrawal strategy is adopted. Personally I think life will quickly disrupt the plans that many people might have of sticking to a fixed withdrawal strategy anyway.

[TUK020]

Things should continue to be rosy for most investors provided we don't get major reversals in taxes and inflation, even if returns are lower over the next 40 years.

hiriskpaul,
how do you think a Corbyn government would affect these asumptions?
tuk020

[scotia]

how do you think a Corbyn government would affect these asumptions?

I have seen a similar question in several of these boards, and I have to say that I take a relatively relaxed position on a Corbyn government - if it ever happens. I admit that a Labour government is a possibility, but with 80% of the Labour MPs disagreeing with the Corbynistas, I think that many of the wilder ideas are highly unlikely to be implemented. Possibly there will be higher taxes for the extremely wealthy, with a redistribution to more needy recipients, who are likely to spend it all and so get the economy moving.

[hiriskpaul]

Things should continue to be rosy for most investors provided we don't get major reversals in taxes and inflation, even if returns are lower over the next 40 years.

hiriskpaul,
how do you think a Corbyn government would affect these asumptions?
tuk020

Cannot say I have taken much notice of Corbyn, what he says or what others say about him, but I guess the 2 main risks are 1) A slump in the pound, possibly intensified by a shambolic Brexit; 2) Increased taxes. The first risk will feed through into a one off rise in UK inflation, but can be mitigated against by diversifying with foreign stocks and non-GBP fixed income. Global inflation, as we had in the 70s, would be a much bigger problem, but Corbyn could note stoke that. The second risk is potentially a much bigger problem unless one is prepared to emigrate. Personally I am not prepared to be driven out of my own country, so I will just have to deal with whatever he throws at me.

I currently think it quite likely that Brexit will be a shambles, the Tories will be blamed for it and Corbyn will be in next time. To what extent he can enact hard left policies will depend on his majority, which might only be slim, but who knows? If a lot of hard left policies are enacted that end up trashing the UK economy (or Brexit does), then Corbyn will probably only last one term. That should give the Tories the opportunity to grab the middle ground, win next time and start repairing the damage. There is a risk that the Tories will lurch further to the right after tearing themselves apart and become even more unelectable than Corbyn, but I would hope that pragmatists would win out. All getting very speculative now - short answer, have more wealth than you need.

[johnhemming]

There are two other financial issues:
a) That in trying to get in more tax, taxpayers who can reduce their taxes through mobility do so and we lose that tax revenue and also their spending.

b) In increasing borrowing as they have said they will do we have an increase in sovereign debt interest rates.

Both of these add up to a fiscal crisis where government spending gets in a mess and substantial cuts in public spending are required.

[scotia]

b) In increasing borrowing as they have said they will do we have an increase in sovereign debt interest rates.

This doesn't seem to worry the Republicans in the USA. And their projected increased borrowings make anything we can do look like chickenfeed.
Incidentally, if a UK government felt the need to offer me a sensible savings interest rate that exceeded RPI, then I would be happy to oblige - I suspect along with a large number of the elderly. Bring back index linked savings certificates!