Root Ready

The Logic Behind Our 5-Year Root Reserves Strategy

• James Conole, CFP® • Episode 22

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Every advisor knows the hardest part of portfolio conversations isn’t the math, it’s helping clients feel safe enough to stay invested. And nothing tests that more than explaining why five years in reserves isn’t just a rule… it’s a risk-capacity engine that keeps clients grounded when markets break pattern.

This episode reframes the entire conversation advisors have around allocation: not as a static percentage, but as a time horizon matched directly to client cash-flow needs. Five years of Root Reserves, not theory, not guesswork, but a framework built from real market history, global diversification data, and the behavioral realities every advisor sees daily.

James walks through the narrative advisors can bring into meetings: the 2000s downturn, why global portfolios cut losses in half, how clients rarely tap reserves in straight five-year chunks, and why fixed income tends to strengthen exactly when emotions weaken. More importantly, he shows how to translate these facts into a story clients can actually hold onto: the kind that builds resilience long before volatility arrives.

By the end, you’ll have a clearer way to communicate risk capacity, a stronger rationale behind the five-year design, and a practical structure for helping clients understand why time, not percentages, is their real protection.

If you want a framework that elevates your client conversations and simplifies your planning process, this episode will sharpen the way you talk about risk, reserves, and long-term discipline.

Submit a question for James here: https://rootreadypodcast.com/

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The strategies, case studies, and examples discussed may not be suitable for everyone. They are hypothetical and for illustrative and educational purposes only. They do not reflect actual client results and are not guarantees of future performance. All investments involve risk, including the potential loss of principal.

Comments reflect the views of individual users and do not necessarily represent the views of Root Financial. They are not verified, may not be accurate, and should not be considered testimonials or endorsements

Participation in the Retirement Planning Academy or Early Retirement Academy does not create an advisory relationship with Root Financial. These programs are educational in nature and are not a substitute for personalized financial advice. Advisory services are offered only under a written agreement with Root Financial.


SPEAKER_00:

When we construct portfolios at root, we talk about the stock-to-bond allocation in a way that's very different than the way that a lot of the industry talks about. Given that, it's very important that we have a good way of communicating this to clients of why do we do this, when do we do this, and how do we go about defining how that was done. Welcome back to another episode of the Root Ready Podcast. I'm your host, James Cannoll. At Root Financial, when we talk about designing client portfolios, we don't talk in terms of you need a 60-40 because you're retired, or you need an 80-20 because you're retired, but you're okay with more growth. We talk about very intentional dollar amount allocations to a bond portfolio and then the remaining amount potentially being invested into a stock portfolio. So, what I'm going to do with today's episode is talk about why that framework, why does that matter? Why does it work? Why does it resonate with clients? But then number two, talk about why the specific amounts, talk about some of the research that backs a lot of that up. So when it comes to designing portfolios, specifically for clients who are in retirement or nearing retirement, there's two things that I like to think about. One is risk tolerance, of course. And this is what we're all familiar with. Client fills out a questionnaire. How would you react if this downturn happened versus that downturn happened? Whatever. There's value in that, there's a compliance purpose for that, but that's typical risk tolerance. The other thing, the other piece of that is risk capacity. Risk capacity tells us how much risk can a client portfolio afford to take on while still minimizing the risk of that portfolio being hit by a market downturn or being disproportionately impacted by a severe market event. Here's how risk capacity works out. Think of the stock market, of course. Why do we invest in the stock market? Because historically speaking, if we use the S P 500 as our guide, the stock market has grown by 10% per year on average. It's never actually returned exactly 10%, but it's averaged about 10% over about the past 100 years. That's great. If we could invest all of our money and all get 10% every year, all of our financial plans, all of our goals for the most part, are probably going to be realized because that's a very strong rate of return. The problem? The market doesn't give us the rate of return every single year. 10% is the average, but you could go months, you could go years with a negative return. So how do we think about bonds? Bonds are the things that we're going to invest in from a risk capacity standpoint, which is where I'm starting first. The primary purpose of bonds is to say how much do we need in this type of a stable, resilient asset class that's going to go up and down in value a little bit, but assuming it's short-term high-quality bonds, how much do we need there to insulate against a downturn? Well, to answer that, we need to understand what an average downturn looks like. Well, an average bear market, if we just look at the S P 500, it takes about two and a half years to recover from. And when I say recover, what I mean is the market is at its peak. Now, in the moment you don't know it's the peak, but in retrospect, the market peaks, it bottoms out. So you go through a bear market of 20% downturn or more, it hits its trough and then fully recovers back to its peak again. On average, that's two and a half years. When we look at how much we want to have in bonds, we simply double that. Number one, because it's just a good rule of thumb to say if we have twice the amount needed to protect a downturn, that's going to insulate us a bit more. But also because when you look at the worst cases in the S P 500, it's been a little over five and a half years that you've had a bear market, that you've had a market that hasn't fully recovered to its peak. So, what is doing that allow for? Well, if we have five years and high quality short-term fixed income, this isn't just an arbitrary percentage of a client's portfolio, it's a specific dollar amount. I need to be able to understand this client's portfolio, what are their cash flow needs? This is going to be driven by two very different things. Number one is what other income sources do they have? Social Security, pension, part-time work, annuity income, rental income, et cetera. What are their other income sources and what are their expenses? The gap between their expenses and their other income sources, their non-portfolio income sources, that gap is what needs to come from their portfolio. So if I have a portfolio and I'm trying to figure out how much do I need in root reserves, I need five years of root reserves, but I need the dollar amount of what that represents. Well, they have a million-dollar portfolio and they want to spend, let's say,$60,000 per year, and they have uh$20,000 per year coming in from Social Security, for example,$40,000, that difference, that's what needs to come from their portfolio. So what I would do is I work backwards and say, okay,$40,000, we need five years of that. So that's$200,000. We need$200,000 of this million dollar portfolio to be in root reserves, to be in something that, regardless of what happens to the SP, regardless of what happens to the stock market, we have very short-term, very high quality investments that don't have a guarantee attached to them, but historically speaking, have been very limited in terms of how much they go down in seasons like that and typically actually go up in value. So that not if, but when that downturn happens, we know we have this other bucket of money that could last us for at least five years, allowing us to weather that storm, allow us to meet our income needs without having to sell our great stock investments, allowing time for them to recover. So that's the first thing that we think about is from a risk capacity standpoint, we need a minimum amount in bonds, we need the minimum amount in root reserves to be able to protect against those time periods while still allowing us to invest the remainder potentially into growth investments, into stock investments. Now notice how this math changes. Use those same numbers. Person has a million dollars, they have$60,000 per year spending need, but now they have Social Security and a pension. And the combined amount there is$50,000. Well, that$50,000 leaves$10,000 of a gap.$50,000 coming in in income,$60,000 of expenses,$10,000 is what they need from their portfolio every year. The root reserves target in that example would be$50,000.$50,000 only represents 5% of the portfolio value at this point. So keep in mind here, we're not done with the analysis yet. We're not done with how we're framing this, but this just shows you that the dollar amount needed to make sure that we're addressing the risk capacity standpoint is in this example, this client might only need$50,000 in short-term fixed income of a million dollar portfolio. And the way I might explain that is saying, look, if you're a robot, if you have zero emotional attachment to seeing your portfolio go up and down, if that doesn't bother you one bit, I'd still want to make sure you had$50,000 in short-term reserves to protect against having to sell investments when there is a market downturn. But the reality is you're not a robot. The reality is we're all gonna have an emotional experience when we see the stock market go up and down. So that then leads into the risk tolerance questionnaire, or that then leads into the risk tolerance question or conversation, I should say, of do we need to add a little bit more? Not necessarily because you need more in conservative investments to be okay long term, but because it's gonna help you be a little bit more settled. It's gonna allow you to have more peace of mind during the next market downturn. And this is very much a conversation with your clients. A lot of clients, totally comfortable, even in retirement, very comfortable with more growth-oriented portfolio as long as you have that root reserves there, as long as you have that dollar amount that's tied specifically to their plan. And by the way, I'm using very simple examples here of spending 60,000 and you have, you know, 20,000 in Social Security or 50,000 in Social Security and pensions. One of the reasons we implement financial planning software or we use financial planning software is for most clients, it's not that simple. You have uneven income sources. Sure, you have social security, but that doesn't start for three years. And then your wife has her benefit too, and that doesn't start for five years. Then your pension's coming in, but that's not indexed for inflation. So every year there's a little bit of a difference there or delta there. Then on the expense side, you know, you have your core expenses that are consistent, but you're gonna take vacations at different intervals that are gonna cost different amounts. For the next two years, maybe you're still paying off your mortgage, so expenses are gonna be higher. Depending on where you're pulling income from, you might have different tax liabilities various years. So that's the complexity that actually happens in real life. And that's why software is very valuable to help us understand how that gap or that delta actually work and change year to year between income sources coming in and what you need from your portfolio. But when you define that, you've defined the risk capacity number. And then you can blend that or you can marry that with the risk tolerance conversation of here's the minimum amount. Think of this as like the floor that we amount need in root reserves, but we might add a little bit more if there'd be a reason to do so, more so from an emotional standpoint or a peace of mind standpoint. So that's the basic framework. Now, an advisor at root, he asked recently, he said, hey, why five years? He said, if you look since the Great Depression, the worst experience we've had in the S P 500 isn't five years to break even, it's five years and eight months. So excellent point. Hey, is this five years actually enough? Or are we potentially leaving ourselves on the hook here for a really bad market environment? And by the way, that's just the worst so far. If a client's retiring and has 30, 40 years in front of them, it's not inconceivable that there's gonna be a worse time period over the next 30, 40 years as there has been over the last few decades. We're just using history as our guide. We're not trying to assume that we can predict that's gonna be exactly the same going forward. So, why five years? Why do we use five years? Well, number one, when we look at that worst time period ever in the S P 500 name, excluding the Great Depression here. Great Depression, a little bit unique, separate podcasts for a separate time. Um, but yes, that was a horrible event. And yes, it took much longer than five years to recover. So since the Great Depression, five years, eight months is how long it took. And that was in the 2000s, how long it took where you could potentially be underwater in the stock market, but that's only if all of your money is in the SP 500. So let's look at some data around that. And by the way, as we're talking about this, these are things that we should be sharing with clients. When I was in Toastmasters, uh, one of the ladies that ran it, she was a longtime professional speaker. And the thing that she would hammer home all the time was this: she would say, Facts tell, stories sell. So if you're just telling a client a fact, that's one thing. That's you're telling them that, but a story that's gonna sell, that's gonna reinforce, that's going to be the thing that actually is impactful to them and something that they remember. So, yes, I'm gonna tell you facts, but use these to construct a story with your client. Put them in a situation, put them in the instance of, hey, let's actually take you and put you back when this happened. And I'm kind of just prepping here so that when I tell you these facts, don't just recite these at clients. Take their portfolio value, take their situation, take them and kind of put them in this as you guide them through what would have happened in their particular scenario. That's gonna give them the reassurance, okay, this isn't just looking at random stats. This is an understanding of what has market history been and how would my situation have been impacted by that. Not saying that that situation is gonna be the exact same, of course, going forward, but it helps to give some reassurance. So let's go back to what I was talking about. Five years, why five years when the worst experience in the SP 500 was actually five years and eight months, again, excluding the downturn of the Great Depression? Well, that was the worst experience in the SP. And if our portfolios, if the equity portion of our portfolios was only the SP, we might need more than five years there. But if we're diversifying, not just on large cap US stocks, but also small companies, also international developed markets, also international emerging markets, also real estate, as we're doing that, the reason we're diversifying, one of the reasons that we're diversifying, is it's going to shrink what some of those worst time periods look like in terms of how long it takes to fully recover. If you look at the worst five-year stretch in the SP 500 since the Great Depression, it started in March of 2004 and it ended in March of 2009. Now you can see where I'm going with this. March of 2009, that was the end of the 07-08 meltdown after the market had hit its trough and started the recovery time period. So that downturn, that five-year experience, the market lost 5% per year over those five years. That was March 2004 to March of 2009. Now, if you look at a global portfolio over that time period, so yes, you're still heavily invested in the US, but you're also owning international investments, et cetera. Your experience was you were down 2.4% over that same time period. Not a great experience, still actually a really poor experience, but it lessened the blow. Now that doesn't seem like a whole lot. 2.5% per year, but keep in mind that's average over five years. That's an annualized rate over five years. If you extrapolate that out, losing 5% per year for five years, that's a total return of negative 23% over that time period, versus losing 2.4% for five years, that's a total return of negative 11%. So only a 2.5% or so difference per year, but that led to having your losses cut by more than half. Instead of losing 23%, you lost 11%. Again, still not a great experience, but being diversified lessened the blow of that. And it still didn't fully protect over those five years. But what it did is it really minimizes, it really took some of the just hit out of that really bad downturn of the SP 500 and buffered you a little bit. So let's take a big step back here. Let's look at that. Five years. If our goal is actually to be able to protect against selling stock investments over that five-year time period, we've still failed. Yes, being in a global portfolio helped to buffer the experience a little bit. You were down 11% as opposed to being down 23%, but it still didn't fully insulate it. That's what it would seem if you're just looking at the facts. Going back to what I said before, let's paint the picture. Let's invite the client into a story here. That seems like maybe the five-year time period didn't quite accomplish its goal. And by the way, that five-year time period, part of that science, part of that is just you don't know what the market's going to do next. We have no idea what the future holds. So that five-year time period, part of it is just a nice round number that should cover a lot of that. So part of that is more a round number. A good part of it is science and research, but keep that in mind. There's not a perfect way to say here's the exact amount we need in all these simply because we don't know what the market is going to do next. But going back to what I mentioned, facts tell, stories sell. I just told you those facts, but let's now walk through a story of what that actually looked like. Let's go back to 2004. Well, we know that the next five years are pretty bad. If you're all in the SP 500, you're having a negative 23% return. If you're all in a global stock portfolio, you have a negative 11% total return. Both of those are bad. So you would think, well, geez, do we blow through all of our fixed income? Do we blow through all of our root reserves in those first five years and then still have a shortfall, which forces us to sell some stocks? The answer is no, because take a look at the story. Go back to 2004. Okay, you have your portfolio. You just retired. You're excited. You're excited to travel, do all these things. 2004 comes, and what actually happens is you're up 16% in your stock portfolio. And by the way, I'm just looking at the acqui index here. So a global index, this is, of course, not a specific client, but just to give some perspective. Hey, you're actually up 16% in 2004. So, okay, that's kind of odd. I thought the next five years were going to be a really bad experience, and they are, but then 2005 comes. And hey, you're up 11.5% in 2005. And then 2006 comes. And in 2006, you're up 21.5%. And so what you've done so far, even going back to our root reserves framework, you are spending your equity dollars in these years. You're not even tapping into the root reserves. You have five years of root reserves to protect against a serious downturn to give you money to live on while your stocks are down before they recover. But your stocks aren't down yet. In fact, your stocks are still growing double digits in each of these years. Then 2007 comes. And 2007 is when things start to turn for the worse. But if you look at the total return of 2007, you're still up over 12%. So you have this five years of reserve set aside that can buy you five years of time, but you haven't tapped into those and you're four years in. Well, the hammer drops in 2008, of course, the market's down 42%. And if you look at the five years total, that's why you get that really serious negative return. Is that five-year time period was really horrible. But in the first four years, you actually weren't tapping in to your root reserves. It's only that fourth year. And by the way, yes, technically this started in 2007. And some of this depends upon are you looking at calendar year returns versus what's the actual worst ever experience, which the market just doesn't decide to turn on a dime and go up or go down on the first of each year. Some of these returns, most of these returns, these good and bad experiences, start happening intra-year, which was the case here. But in this experience, as you paint that picture for a client, walk them through that. No, five years in root reserves wouldn't have fully funded that if you wanted to pull from root reserves every single year for those five years, but you weren't doing that. The first few years you were actually fully pulling from the equity portion of your portfolio. And it's only the last couple years that you even started dipping into root reserves. So in other words, it protected what it needed to protect. Now, a second point to this if we truly have five years in root reserves, what we're doing is we're assigning a dollar value to those root reserves. The coupon payments from those bonds is not really factored in to that initial dollar amount that we're setting in. And because we're using software to do this, so we're looking at right capital and right capital saying here's the net flows that are gonna be required for the next five years. Those net flows are already factoring in inflation. So yes, you could say, okay, well, the bonds are gonna go up in value, but that's just gonna offset inflation. Keep in mind the net flows, what we're matching these assets to, the liabilities we're matching these assets to have already factored inflation in. So when we look at the fixed income portion, when we look at the root reserves portion, yes, that's five years from a nominal standpoint, but it's actually gonna be more in a lot of cases. And it's actually going to be more because there's coupon payments on those bonds. And typically, not always, but typically when there's a really bad market event, the type of event that would cause us to start drawing from bonds as opposed to drawing from stocks, those are usually going to be years where on average bonds are actually going up in value even as stocks are falling. If we take the five-year time period that we just looked at, for example, if you just look at an aggregate bond index, it was up over 4% over that five-year time period. To be exact, it was up 4.2%. So not only are we avoiding spending our stock investments that have lost a lot of money when an 07-08 type of event happens, but the portion of the portfolio that we are spending is actually going up in value. The root reserves are going up in value. And the way we stagger that is it's not all just aggregate bond index, of course. We like to have very short duration fixed income, then some less short duration, but still short duration fixed income. And we kind of tailor that or stagger that to have uh maturities that are increasingly lengthening so that we have five years and can, for the most part, align when we might need it with shorter durations or shorter maturities for part of our root reserve, and then stagger that or ladder that up. But because of the way that structured that five years of root reserves tends to be more than five years when you factor in coupon payments on top of all that. And then finally, the last thing to keep in mind here is what I mentioned before. Of some of this is not a perfect science. In fact, most of this is an imperfect science simply because we're just looking at what happened historically and we have no idea what's going to happen going forward. But Nick Murray, and by the way, if you're an advisor that does not read Nick Murray, stop listening to this podcast and go download, go subscribe to Nick Murray's newsletter. It is paid, but is it a it is a fantastic resource for all advisors? But if you have not uh read him yet, make sure you do so. He has an excellent point that he makes. He talks about having two years set aside in cash and having all of your portfolio being invested fully in equities. And his point, you know, he has different triggers for when he talks about pulling from the cash versus pulling from the equities, is he says, look, you're not going to get this perfectly right. So what if you pull and drain all of your cash and the stock market's still down? What you're trying to do is simply buffer against the worst of it. Think of this as like being an airbag in a car. Think of this as being like something that's just buffering the worst of the impact. We just need to survive this to be unscathed and be able to continue moving forward. We don't need to be in a position where we fully avoid every last market downturn. That's going to be impossible. But if we have engineered our portfolio, if we've structured our portfolio such that we have the ability to be flexible of where do we pull income from? And how can we be intentional about that? So when markets are falling, we're not touching our stock investments. When stocks are rising, that is generating the income that we need. But his point is, and it's a point that we should all be making to our clients, is the goal of this is not to say you're never going to go through a downturn. We're not always going to be able to just draw from the thing that's perfectly at its peak, hasn't dipped at all below its all-time high. That's not realistic to think. What we want to avoid is we want to avoid a scenario where we are pulling stocks during the worst of it. So if this can buffer the worst market events, that is how we protect against sequence of return risk. That is how we preserve your ability to keep living the retirement lifestyle you want, even as markets are falling. So those are things to keep in mind of why do we use five years? Why isn't it longer? And then even to take it one step further. What this doesn't factor for, or what this doesn't include, is other things from a planning standpoint. Now, those could be simple things of look, is the market's dropping? Do you make spending changes? Now, root reserves is built to say, how do we support your desired retirement lifestyle? If things get really, really bad, do we say, can we hold off on taking that trip? If things get really, really bad, do we say, you know what, can we freeze spending? Maybe not give ourselves an inflation adjustment next year. Things get really, really bad, do we even say, do we even cut spending a little bit just temporarily to make your assets last? So those are things that would stretch the effectiveness of having root reserves, even if it's not fully covering the full duration of the downturn. Other things too, from a plan standpoint, maybe you plan on collecting social security at 70 and your client at 63. Well, if there's a really, really serious downturn, sometimes there is a good case to be made of do we collect social security early? So it starts to put less pressure on your portfolio, allowing more of your portfolio to compound and grow as opposed to starting to draw it when markets are at their lowest. So this is just a general framework that we use. And to recap, root reserves is our goal or it's our intention of saying how do we not just look at risk tolerance, but also fully understand risk capacity and actually start with that as a starting point. Once we have risk capacity, then we can also understand your risk tolerance to build the portfolio that's right for you. From there, why do we use five years? Well, we use five years because typically that's going to cover most downturns, especially when you factor in the fact that we're not just fully investing in the SP. And then also keep in mind that we're on market downturns, fixed income on average tends to go up. Also keep in mind the fact that this isn't designed to perfectly protect against everything. It's designed to buffer the blow. It's designed to help insulate from the worst effects of a market downturn. And then finally, as a planner, are there other things you can look at doing? Helping your client understand what expenses to maybe temporarily cut. Can we change our social security strategy to mitigate some of the downturns or some of the impacts from a market downturn? So that is why and how we implement root reserves the way we do. Thank you for listening. If you are enjoying the show, please leave a review on Spotify or Apple Podcasts. If you're listening to the podcast, check it out on YouTube too. Root Ready is a show name. You can find it there. You can watch instead of just listening. Thank you as always for tuning in, and I'll see you next time.