I have this concern as well, 5 years from FIRE. I'm willing to ride through the routine 10-20% drops, but I remain concerned about the 30-50% drops which sometimes occur and could set back my retirement by a decade (simply going from a 4% rule or similar approach). I am also concerned about public issues that could lead to the next 1973 or 2008, such as tariffs, rising corporate debt, political independence of the Federal Reserve, aging demographics, and a lack of R&D/education spending compared to timeframes before rapid economic growth.
My personal solution is to use options as an insurance policy to prevent losses beyond a particular point. Because options markets are highly efficient, you can insure your equities for right about the probabilistic expected value of the insurance, and perhaps better than that if you buy during periods of low volatility (VIX) when insurance is on sale.
CAPE is high, so I am willing to sell some of my upside risk to buy protection from downside risk. Therefore, I am employing a collar strategy:
https://www.optionseducation.org/strategies/all-strategies/collar-protective-collarFor example, I might buy a put that limits my losses to 10%, and then sell a call that limits my upside to 20%. This means I pay more for the put than I receive from the call, but the cost of insurance is minimized this way, while leaving lots of upside potential. Alternately, you could buy puts and sell calls for a net outlay of nothing - a "costless collar", but I personally find this approach either too limiting on the upside or exposing me to too much risk on the downside. Such a hide-and-wait approach would still allow one to collect dividends through whatever happens and is much safer than holding bonds.
Instead of doing this on an every-few-months basis, I am using LEAP options on SPY and QQQ to insure myself for years at a time. This approach has at least 3 benefits: (1) slower time decay of my put option, which is usually more valuable than the call, (2) not finding myself in a position where my insurance is expiring during a market fit when volatility is high and the price of re-establishing the position is high, and (3) lower transaction costs - which is just a few bucks so no biggie anyway. Thus I maintain a 90+% equities portfolio with confidence. This approach seems to me like it will yield higher and be less risky than a bond-heavy portfolio (returning what? 2.5% best case scenario if defaults and rates don't rise?).
With this approach, you need to have a written investment policy statement reminding yourself of when you will cash in your insurance. I suggest one of the following:
1) Never. Hold the options until around the time they expire. Then set up a new collar.
2) When the market is down X%. Then wait for the rebound before re-establishing insurance.
My IPS says to sell my collars if the market drops 20% from its high. This worked wonderfully for me in December 2018, when the market dropped almost exactly 20%, I sold my collars for thousands in profits, and the market zoomed right back up. I then re-established my collars during the low volatility times of March-April 2019. The profits were applied to buying more shares of equity near the bottom. In this way my IPS
forced me to helped me sell options high and buy equities low.
Caveats:
>Had the market dropped 40% or 50%, I would have dropped my insurance only halfway through the panic. This would be unfortunate, but down-20% events are far more frequent than down-40% events, so I chose to harvest gains more frequently so that I can plow those gains back into the market more frequently. This is akin to the decision about how high to set your auto insurance deductible. YMMV.
>Dropping your shields in the midst of a even a mild market panic is easier said than done. I found myself questioning my logic in Dec. 2018, but ultimately stuck with my IPS and the research behind it. Had I ignored my IPS, I'd have watched the inflated value of my options portfolio evaporate as the market recovered and would own fewer shares today. So the "never" approach might be better for you if you don't want to have to execute a game plan under pressure.
>The strategy I described will underperform the index 95% of the time and save your retirement 5% of the time. If you can't stand to watch a multi-thousand dollar options portfolio steadily sink in value - for years - as time goes by and stocks rise, you might not have the guts for this strategy. Think of it this way: Your auto and homeowners' policies drop in value every day you don't suffer a loss, eventually reaching zero.
>Your 401k at work probably cannot be hedged, but you could hedge your 401k with a collar position in another account. If that other account was a Roth, a stock crash would cause money to flow out of your 401k and into your Roth with no tax consequence. However, vice versa is also true as stocks go up.
>The long-term success of this strategy is very hard to model, so nobody I am aware of has done it.