Note: Robert's post is particularly timely this week, which is National Financial Planning Week. Time to get your finances in order!
Let's get this out of the way up front: This post is going to be a downer. So — right now — I want you to think of something happy to do after you've read it.
Got it? Good. Because this article is all about risk — in other words, all the things that can go wrong with your financial plan. We'll talk about ways to mitigate these risks, but thinking through this stuff isn't going to be all rainbows and cupcakes (though we've attempted to lighten things up with photos from the hilarious website AwkwardFamilyPhotos.com). Still, it's better to know what's possible and take preemptive action rather than stick your head in the sand, especially because getting sand out of all your head holes can be very difficult. So let's take a deep breath and confront the potential grim side of reality.
Although volatility is the best-known measure of risk (it's the degree to which an investment goes up and down), it's one of the least important for long-term investors. In fact, volatility is necessary; stocks have historically returned more than bonds partially because they're more volatile. If they weren't, then the so-called risk premium — the amount that stocks have historically outperformed bonds and cash — would disappear. Plus, there are other benefits to volatility: When stocks are up, your net worth increases; when stocks are down, you have more buying opportunities at cheaper prices.
Solution: Keep any money you'll need for the next three to five years out of the stock market. Diversify your investments, because different asset classes have different levels of volatility at different times. By owning a variety of investments and doing some occasional rebalancing, you can lower your portfolio's volatility and enhance its return.
Not Having Enough Money to Retire
There are a lot of reasons someone wouldn't have enough money to quit working: getting lower-than-expected investment returns, not saving enough (a.k.a. spending too much), having a too-conservative portfolio, and simply not knowing how much to save.
Solution: Analyze your net worth and your savings rate using a reliable retirement calculator, or hire an hourly financial planner to do it for you. Use conservative assumptions about future investment returns. Follow a budget or use software such as Mint, Quicken, or Hello Wallet to ensure you don't spend too much.
Interest Rate Risk
The value of existing bonds falls as interest rates rise, though the bonds eventually return to their original value as they approach maturity. But with stocks, interest rates have a less predictable effect. According to the Leuthold Group, rate increases from a very low level can be good for stocks, as they indicate that a struggling economy might be recovering. However, rising rates from a level just under 6% can drag on stocks.
Solution: Keep the duration of your bond funds in the short-term range (one to three years), especially for money you need in the next few years. Also, consider certificates of deposit if you need more confidence about the exact amount you'll get at a future date. Be aware of how interest rates affect your stocks. For example, a business that relies on debt would see its costs rise if interest rates spiked.
Credit and Bankruptcy Risk
While credit risk and bankruptcy risk are often considered different, they address the same potential problem for investors: not getting all your money back. Credit risk pertains mostly to bonds, whereas bankruptcy risk applies to bonds and stocks. Keep in mind that if a company declares bankruptcy, in most situations bondholders get some of their money back, though they have to wait, and the average amount is about 40%. As for stock investors, a bankruptcy can wipe out an entire investment.
Solution: Choose bonds rated A or higher (or funds that invest in them), knowing that even companies with investment-grade ratings go bankrupt. Bond and stock investors alike should have no more than 5% of their portfolios riding on one company, at least until they have the experience and skill to manage a concentrated portfolio.
Which period in U.S. history do you think was the worst-case scenario for retirement portfolios? The start of the Great Depression? Those years were bad, but that wasn't the worst period because of the deflation at the time. Although portfolio assets had dropped, so did the cost of living, so retirees didn't need to withdraw as much. The worst periods were the ones that began in 1937 and 1966, because those market downturns were accompanied by high inflation. Retirees had to withdraw increasing amounts from sinking portfolios, which is a recipe for disaster.
Solution: A 4% withdrawal rate gives you a built-in margin of safety, because it provided inflation-adjusted income through the worst 30-year periods in history. You could also include inflation protection in your portfolio, such as Treasury inflation-protected securities (TIPS). But a retiree's portfolio should also include stocks, as they have historically provided capital gains over the long term, as well as dividend income that, on average, grows at a rate that exceeds inflation.
If you're working, you could lose your job, or your paycheck could be reduced. If you're self-employed, your income could be even more unpredictable. And then there's the risk that you could become incapacitated or pass away, leaving your family without enough income. (We told you this wouldn't be a cheery article.)
Solution: Continually enhance your human capital, which is your ability to earn money and includes your education, experience, skills, charisma, and ability to play nice with others. Make sure you're adequately insured if others rely on your income.
A long life should be seen as a blessing, not a curse. But the reality is that the longer you live, the longer your retirement will be, and the greater the chances are that you'll run out of money.
Solution: Withdrawal-rate studies assume a 30-year retirement. That means that someone who retires at 65 can live to 95 and still have money in his portfolio, as long as markets don't perform any worse than what we've seen over the past century or so. This builds in a margin of safety because only about 10% of the population lives that long.
You might already have some longevity protection in the form of Social Security or a defined-benefit pension, both of which send you a monthly check for as long as you live. If you don't have such a pension, you can buy one in the form of an income annuity from an insurance company.
Just by reading this post, you know more about retirement planning than the vast majority of investors and, sadly, many people who call themselves financial advisors. I was never taught this stuff back when I worked for a big-name brokerage (though I did learn how to make a cold call). The truth is, most people don't know much about risk and what to do about it. But that doesn't stop “professionals” from telling you what to do — and charging you a pretty penny for the advice.
Solution: You've already taken the first step toward becoming an informed investor by reading this post. If you're paying someone to invest your money — whether that's through a financial advisor or an actively managed mutual fund — make sure the extra money you're spending is worth it by comparing your returns with their benchmarks. Also, consider a fee-only planner, such as the folks at the Garrett Planning Network or the National Association of Personal Financial Advisors, who often charge by the hour and tend to have fewer conflicts of interest.
Sequence of Returns Risk
Volatility is a bigger threat when you're in or near retirement because a bear market can threaten a portfolio's ability to last as long as the investor. Rather than buying stocks when they're down — as a saver does — a retiree may have to sell stocks when they're down to pay living expenses. As Jim Otar, an author and Certified Financial Planner, put it: “Each time you make a withdrawal after a loss, you create a permanent loss in the portfolio. Subsequently, you need to recover from the initial losses as well as from these permanent losses.”
Let's say you're not yet retired and your portfolio loses 20%. To get back to breakeven in three years, you'd need 25% growth over that stretch, according to Otar. However, if your portfolio declines 20% and you're already using a 4% withdrawal rate, your portfolio would have to return 42% over three years to get back to breakeven. That's a tall order.
Such losses can be especially devastating if they occur in the first few years of retirement — these “permanent losses,” or withdrawals, deplete a portfolio that has to last more than two decades.
Solution: Retirees should have an “income cushion” of cash and short-term bonds sufficient enough to cover five years' worth of expenses that are not otherwise covered by Social Security or a pension. This reduces the risk of needing to sell stocks at depressed prices. You should start to build this cushion before you retire. And after big market drops, retirees should withdraw as little as possible from their portfolios to create the smallest permanent loss.
As Harvard professor David Laibson explained to us last summer, about half of the population over 80 is suffering from some mental impairment, which can lead to financial mistakes and vulnerability to bad advice.
Solution: Have your legal affairs in order, which can include eventually granting power of attorney to a trusted friend or relative. As much as possible, monitor the finances and mental state of your older relatives, and be ready and willing to accept help when you get older yourself.
Now, go do that happy activity you thought of at the beginning of this post. You've earned it.