R101 #4 - You think you know Market Risk?
I think most people know they need to be concerned about investment returns during retirement. But do you know exactly what you should be worried about?
Similar to “average” life expectancy, “average” market return expectations mask the fact that returns are rarely average from year to year. Unlike life expectancy, you get another chance next year to be above average (sorry…a little financial planner humor there).
When making a retirement income plan, we need to assume some sort of investment returns over time. We don’t use the average. Usually, we use what’s called a “Monte Carlo” simulation that produces a bunch of different values and creates a graph of the potential set of outcomes. I don’t know what the market’s going to do in the future any more than you do. As an investor, it’s reasonable to assume that taking more risk can lead to higher returns. But the flip side is that it can also lead to lower returns.
Let’s unpack two things I think you need to understand about risk.
First, stocks are not the only investment that brings risk. Cash has risk - does that $20 bill you have from 20 years ago have the same purchasing power now (inflation risk)? Certificates of Deposit have risk - anyone lock into a 1% 5-yr CD in 2021 and kicking themselves now (interest rate risk)? Bonds have risk - anyone have WorldCom bonds back in the day (credit risk)? Real estate has risks - took me 7 years to sell my condo I bought in 2008 and I STILL took a loss. I think you get my point.
Let’s just agree that everything you do with your money has risk, and most decisions involve more than one risk. It’s important that you understand which risks each decision involves. You need to understand the magnitude of the risk. You need to understand the likelihood that the risk happens. And you need to know if there are ways to mitigate the risk.
Simple enough?
The second thing you need to know about risk is that negative outcomes can happen several times row. This is called Sequence of Returns Risk. It’s like flipping a coin 5 times and getting tails 5 times in a row. Is that likely to happen? We can calculate how unlikely, but it doesn’t matter how unlikely it is if you’ve agreed to give your friend $1 every time tails comes up, and the unlikely happens to YOU.
Market risk is kind of like that in retirement. It might be unlikely that returns are bad for several years in a row, but it CAN happen. And if it happens to YOU in the several years before you retire, or even worse, right after you retire, it can be really bad news for your retirement plan. This is because if you have $100 that goes down 20% one year, to $80, you need a 25% positive return the next year for it to get back to where it was. And if you had to spend some of that $100, you need an even higher return to get back to where you were.
And lest you think that putting all your assets into an annuity is the “safe” choice - even annuities have risk (annuity companies fail, inflation eats away at purchasing power, the money may not be liquid if you need it).
My point is not to paralyze you with fear because of all the risk. My point is to help you expand your definition of risk, and to help you think through which risks apply to you - and which ones you’re more comfortable with. Because you’re going to have to get comfortable with some - even if you stick your cash under your mattress!
