don’t ignore risk – Lowell Sun


I recently read a column that said, “a fundamental responsibility of any investor is to manage the (market) risk of his (or her) portfolio.” It continued, “Investors who ignore risk in pursuit of returns expose themselves to intolerable portfolio declines. This prompts them to abandon their plans, thereby converting temporary losses into permanent ones.”

I couldn’t agree more with these two statements. It’s true that investors (and their advisors) must find ways to manage portfolio risk, and there is ample evidence that investors who don’t, end up with permanent losses.

That, however, is the end of where I agree. The author continued, “The world’s capital markets comprise different asset classes, each with its own risk and return characteristics. The three major categories are stocks, bonds and cash, (and) the appropriate mix of stocks and bonds will strike a comfortable balance between growth and stability and reflect the individual investor’s financial goals and ability to handle risk.”

Really? What is going to happen to that “comfortable balance between growth and stability” when interest rates go up? As interest rates rise, bonds tank since bonds are debt instruments purchased for the interest they return. A bond with a 5% interest rate is worth half of a bond with a 10% rate.

Equities, too, are susceptible to interest rates. One purchases equities because there is the potential for greater return. As interest rates rise, safer investments such as treasuries and CDs begin to offer rates of return more in line with risk-based assets. As the gap closes, people tend to move from riskier investments to safer ones, thereby bringing down the values of the equities.

To manage risk, you must first identify the risk you are trying to manage. It may be true that investing is largely a matter of managing market and interest rate risk, however retirement income planning is about something else entirely. While market risk is a major threat in this area, market rates of return are nearly meaningless.

Here is a sequence of market returns taken from 2001-2010. If you average the annual returns, you get 4.4% for the decade. That 4.4% average is true no matter how you scramble the numbers. However, this completely falls apart when you withdraw amounts from each year. If you take 7% a year out, in one scenario you have $306,000 left. Just by reversing the numbers, it goes to -$27,777. Remember, in both cases the rate of return was 4.4%. The issue is not rate of return, the issue is sequence of return.

So, what can we do? Start by identifying the risk you are attempting to manage. Is it really market risk? Only if you stay in the market! If you get out, the market risk goes away. Then the problem you need to solve is making your money last as long as you do.

Stephen Kelley is a recognized leader in retirement income planning. Located in Nashua, NH, he services Greater Boston and the New England areas. He is author of five books, including “Tell Me When You’re Going to Die and I’ll Tell You How Well You Can Live,” which deals with the problem that unknown lifespans create for retirement planning.

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