Tag Archives: risks

Sequence of returns risk, what is it and how to manage it?

Sequence of returns risk can certainly be a retirees worst nightmare. Completely out of your control, and at the whims of the market.

 

To recap: sequence of returns risk is a portfolio risk that is based on the order of your returns, rather than your average return when in the decumulation phase of your investment strategy. You see, if you aren’t withdrawing, the order of your returns makes no difference, but if you are withdrawing the order of your returns makes a massive difference.

 

Let’s look at 4 simple examples. Each portfolio with $100,000 and averages 4.75% over the three yer period. The first will have no withdrawals and have bad returns first, the second will have no withdrawals and have good returns first. The third will have bad returns first with $10,000 per year withdrawn at the end of each year. The fourth will have good returns first with $10,000 per year withdrawn at the end of each year.

 No Withdrawals, Bad Returns First:

 

Table showing returns over the years

 

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The Three Primary Investment Risks

Three primary investment risks

 

When I sit down with new clients to discuss their financial goals, one of the most important parts of that conversation is how much risk they are comfortable taking. 9 times out of 10 the answer is somewhere along the lines of normal risk, or medium risk. The only reason I get this answer is because people don’t want high risk, and they know they need more than low risk. Oftentimes this is just the answer that makes the most sense to them, but they really don’t have a good understanding of what risks investing entails.

 

Today, I’m going to go over the three primary risk types of a properly diversified portfolio. I want to highlight the properly diversified portfolio part. If you are out there picking your own stocks, or you have a 20 stock portfolio, this is not applicable to you. Those portfolios are poorly diversified and have a magnitude of additional risks, with no additional upside. The three primary risk types of a properly diversified portfolio are: Economic Collapse, Emotional Capitulation, & Sequence of Returns risk.

 

Let’s start with the easiest to understand, and also the one least likely to matter. Economic Collapse. This risk is that something so major and powerful happens within the economy that you see the stock market & bond market effectively fail or drop to 0 in value. Believe it or not this is something a lot of people worry about. “What if I lose all my money???” The only way to lose all of your money is to have the market drop to 0 in value. The only way this could happen is if we have such a major event that capitalism collapses. With it, the North American economy, Europe, Asia, etc etc. This risk isn’t worth worrying about, purely because if this does play out nothing is going to have value anymore. Had you kept your money in the bank, under your mattress, or in gold bars, it wouldn’t matter. People will be fighting for survival and food and weapons will easily be the most valuable resources. In other words, if this happens, you’re screwed, but so is everyone else and there is nothing you could have done to avoid it. Only the doomsday preparers come out ahead in this scenario.

 

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