Risk-a-Palooza: All that can go wrong and how to prevent it

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.

Volatility
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.

AwkwardFamilyPhotos
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.

Inflation Risk
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.

Income Risk
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.

Longevity Risk
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.

Advisor Risk
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.

Cognitive Decline
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.

Have Fun!
Now, go do that happy activity you thought of at the beginning of this post. You've earned it.

More about...Insurance, Investing, Planning, Retirement

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Greg@ClubThrifty
7 years ago

Arrrgh! You’re making my chest hurt! All of this talk about risk is stressing me out:)

Seriously though, good post. As you elude to, the best way to combat risk is to be prepared and diversify yourself. In that way, you are not putting too many eggs in one basket.

getagrip
getagrip
7 years ago

The biggest risk reducer I see is the five year buffer. So many lost so much in the 2008 slide because they had no buffer and had to liquidate investments at historic lows to live on and that is what took the huge chunk out of their nest eggs. Someone with even a modest need for $30K a year would then have $150K siting in a CD or CD ladders. During good times you are guaranteed to be made to feel foolish, by others or by yourself, for not moving that much money to a higher yielding account. You would… Read more »

Nicoleandmaggie
Nicoleandmaggie
7 years ago

Another great post!

Rya @ bulgarian money blog
Rya @ bulgarian money blog
7 years ago

Wow, Robert! I really appreciate all the effort you put into this post. (I only wish the risks were presented in a numbered list, but it’s no biggie.) As for risks… everything you do with your money carries risk. Keep them in a cash deposit and you risk inflation eating up at it. Keep them in stocks and you risk stock crashing. Keep them in real estate and you risk not being able to sell right away (or not getting tenants). I think a person should: 1. always keep some money in cash 2. only invest in instruments you understand… Read more »

Holly
Holly
7 years ago

I work in aging services and can add a bit to the solution for cognitive decline. There is a segment of the population which develops cognitive impairment due to lifestyle issues. There are several things you can do now to reduce the chance that this will be you. Eat a healthy diet with low fats and limited sugar, exercise, maintain a healthy social life, and exercise your brain. (Another segment of the population develops cognitive impairment due to medical issues, and that can’t be helped right now.) If you want to learn more about cognitive impairment research, the Nun Study… Read more »

Mad Fientist
Mad Fientist
7 years ago

Great article! Risk is hugely important and a lot of people don’t focus on it enough when choosing investments. Before I started focusing on risk, I would be impressed by people who outperformed the market indexes. Now, I realize that the outperformance is usually just an indication of increased risk. Another important type of risk that could be added to the list is unique risk. It is important because it is a type of risk that investors can reduce significantly with their investment choices. I wrote a three-part series on unique risk (http://www.madfientist.com/unique-risk-diversification/) that is a bit heavy on financial… Read more »

EMH
EMH
7 years ago

Thank you for the informative article. I worry that I will retire in a down market and have been putting money aside for my “cushion”. Right now, I have three years of a decent monthly income from my savings account but your article is inspiring me to save for a 5 year cushion. Thank you!

Matt at Healthy N' Wealthy
Matt at Healthy N' Wealthy
7 years ago

This article isn’t a downer at all! (except the parts about death and mental health). It’s a great article. Thanks, Robert! I’m confused about interest rates: you say that stocks could go up if interest rates rise from a very low level because it signifies that the economy is doing better. I disagree. At least in today’s market, I think stock investors are addicted to low interest rates. All investors are thinking about is that low rates mean easier financing, greater spending, and therefore inflated earnings.If the Fed announced even a tick up in interest rates tomorrow (which it would… Read more »

Anne
Anne
7 years ago

Mayabe it is just me, but everyday I notice other financial bloggers seem to be the first to comment on the day’s post.

I can’t help feeling they are trying to ride on the coattails of GRS.

Bella
Bella
7 years ago
Reply to  Anne

well duh.
I mean – it’s a ‘free’ way to advertise your blog to thousands (millions?) of viewers who are your exact audience.
As long as they have something interesting to say – I don’t mind it.

Matt at Healthy N' Wealthy
Matt at Healthy N' Wealthy
7 years ago
Reply to  Bella

Thanks!

Anne
Anne
7 years ago
Reply to  Bella

Sorry, but it strikes me as cheesy.

Matt at Healthy N' Wealthy
Matt at Healthy N' Wealthy
7 years ago
Reply to  Anne

The one time I’m able to comment early I get slammed! Haha!

Anne, I guess I’m “riding the coattails.” Isn’t that the point of leaving a link to one’s site? I like this site, and I love the comments. If I write something here and someone is intrigued enough to follow the link to my site, well how is that a bad thing?

I don’t even make any money off of my blog (even if I tried I’d make way less than a penny a day).

Rya
Rya
7 years ago
Reply to  Anne

#12 @Anne

You’re right, actually I thought the same thing.

brian
brian
7 years ago

wow… another fantastic through-provoking and insightful post.

Not every GRS article needs to be about stocks or investing, but it sure is nice to see some posts with real meat to them. How many times does one need to read: “Spend less than you earn!” and, “Get out of debt, now!” and then, “Build an emergency fund, asap?”

I don’t find this post so depressing. This stuff is fun to think about, developing one’s financial strategy for the game of life.
Thanks again, Robert, for the insight.

Andrew
Andrew
7 years ago

Longevity coupled with cognitive decline can lead to years or even decades of increasingly expensive at-home and nursing home care. This can kill even the most secure retirement plan, and can also damage the lives, careers, and finances of younger generations who are forced into caregiver roles.

With the future of even the unpleasant safety valve of Medicaid in question, these issues can lead to a lot more than just “vulnerability to bad financial advice.”

SLCCOM
SLCCOM
7 years ago
Reply to  Andrew

Please, if you love your family members, do NOT force them into caregiving. Odds are that the result will be an impoverished old age, particularly for the women. It also really changes your relationship with them, frequently for the worse.

Laura
Laura
7 years ago

Great article, Robert! In fact, one of the best in recent memory.

Cortney
Cortney
7 years ago

A five-year income cushion? That sounds like a great idea. Does it matter if this is saved as part of an Roth IRA or non-qualified account? I’d imagine you’d want it as part of a Roth IRA to eliminate taxes you’d pay, yes?

One other way to reduce the risk of longevity is to either retire later or see about working part-time in your retirement.

Bella
Bella
7 years ago

Great article – though I think I actually miss the cat pictures.

W at Off-Road Finance
W at Off-Road Finance
7 years ago

While this advice is not bad, it makes the classic financial planner mistake of assuming that the greater than baseline rate of return the US has experienced historically will continue. That’s unlikely – there is no second baby boom, and we can’t go back and win WWII again.

Try doing your retirement planning with a real (post inflation) rate of return of 0.5% on your investments, and see where that leaves you.

KSR
KSR
7 years ago

YOU have a clever egocentric spin on the fundamental operations that can’t be appreciated here without your own guest post–and probably not even then. I was just directed to your site this morning by Jacq, whom I find fascinating all on her own. I plan to find some time today to work through your original posts since you not only crack me up–you are damn near brilliant. That said, what’s your opinion on the effects of the world economy on your play? I’m not talking BRICS, as in the effects of those economies in the market. I’m talking about the… Read more »

W at Off-Road Finance
W at Off-Road Finance
7 years ago
Reply to  KSR

My honest answer re: emerging markets is that I don’t know. At the hand waving level globalization and emergence ought to allow for fabulous growth stories. I mean, think how the world would change if 1 billion Chinese went from $2000 per capita GDP to $50,000 in constant dollars.

But it never seems to pan out that way. And I don’t understand the BRICs or the rest of the developing world well enough to grasp why. But for some reason they’re always emerging and yet never emerge.

Lincoln
Lincoln
7 years ago
Reply to  KSR

I really like this comment. I think people forget to subtract inflation from their returns, and I think the financial planner’s default of 10%, 7%, or even 5% annual returns for the future is literally backwards-looking. It’s like saying in the future, the Celtics and the Lakers will win 50% of the NBA titles just because that’s what happened in the past. You know what financial planners never/rarely include in retirement modeling? A 10 year gap where your retirement fund actually loses money when accounting for inflation (say 1999-2009). If you make an Excel spreadsheet where your annual returns are… Read more »

Babs
Babs
7 years ago

I ran the retirement calculator on our 401(k) plan website. It wouldn’t even let me use a rate of return lower than 1%. The suggested default was 7%. That’s a laugh.

Babs
Babs
7 years ago

Very helpful post and great comments!

SLCCOM
SLCCOM
7 years ago

Re: power of attorney for when you cannot manage your affairs any more: set it up so that whoever has it has someone looking over their shoulder. As my father used to say, locks only keep honest people out. Remove temptation to cheat by having someone else checking.

Tracy (the other one)
Tracy (the other one)
7 years ago

As per W’s comment above, I’m curious what people use as expected overall rate of return on say, a typical index fund with a diversified portfolio, going forward. Back in the day (AKA before 2008), 7% seemed to be the financial planners’ default (which always struck me as wildly optimistic). And it seems like some financial gurus still promote that (Dave Ramsey, etc.) But I wonder how realistic that is? When I plan, I’ve always estimated 2% growth after inflation, and about 3% withdrawal rate. My reasoning is: at this rate of return, we will meet our minimum goal with… Read more »

Tracy (the other one)
Tracy (the other one)
7 years ago

Having looked at Robert’s linked article, it appears I’m pretty much in line with his recommendation. 6%-4% inflation.

@CircusofHumaniT
@CircusofHumaniT
7 years ago

Howdy,
I understand this was written by someone whose focus is stocks. But, one thing stock guys seem to forget about is that “diversifying” and “risk” can be mitigated by choosing different types of investments. For example, you might invest in a trust deed where you get to “be the bank” on a piece of real estate which is secured by a piece of property, rents, equity, utility, and insurance. To me, that’s a lot less risky than only having stocks.

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