Manage Risk, Not Return
When talking about reaching investment goals, people tend to focus on what rate of return they can achieve. This can be a mistake – because the rate of return that you get is often just luck (good OR bad). Our opinion is that it’s better to manage the risk in your portfolio, with the ultimate goal of decreasing our range of potential outcomes over a given time period.
Let’s take a hypothetical situation: two individuals retire on January 1, 1990. Both have $1 million, and want to take $45,000 of annual income with an adjustment each year for inflation. One investor diversifies with an equal mix of US stocks and bonds, international stocks and bonds, real estate, and some commodities. The other one just places his assets in the S&P 500. Unknown to them, they retired at the start of a wonderful decade for US stocks. Here’s how these hypothetical investors did after 10 years:
Our investor in the S&P 500, the red line, had a huge decade, ending with a little over $3.5 million. At about 3 percent inflation, he was taking a $60,000 income by the year 2000 – that’s 1.7% of his portfolio. Our diversified individual, the green line, hit the year 2000 with almost $1.3 million, and was taking a 4.7% income withdrawal. Not as good as the S&P guy, but in this hypothetical situation, still pretty solid.
So let’s say their two younger friends heard about how well these two did, and both of them decided to do exactly the same thing. They retired on January 1, 2000, with $1 million, and started taking $45,000 per year of inflation-adjusted income. One of them diversified, the other went the S&P route – just like the previous two. But little did they know that they retired at the beginning of a really bad decade for US stocks. Here’s how THESE hypothetical investors did after 10 years:
The red-line S&P 500 investor had a really bad ten years, and had just $369,000 left. At about 2.5% inflation, his $58,000 ending income withdrawal represented 15.6 percent of his total portfolio’s value. That’s bad. Our green-line diversified investor, though, ended up with over $1.3 million – almost exactly the same as his older diversified friend – and he’s drawing just 4.3 percent from his portfolio for income.
What this tells us is that if you retire just as a good run for stocks is getting started, you’re in a potentially better position than if you retire just prior to a bad run for stocks. Will you experience positive or negative returns early on? Impossible to predict. That’s why managing risk matters.
We showed you today how two sets of hypothetical portfolios fared over ten years. Next week, we’ll see how these same scenarios would end up over a 20-year period of time, and how reducing your likely range of outcomes through risk management may actually give you that better overall rate of return.
The information provided should not be considered specific tax, legal, or investment advice and is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. This material was gathered from sources believed to be reliable, however, its accuracy cannot be guaranteed.
These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.
Rates of return are hypothetical, are for illustrative purposes only, are not guaranteed, and do not represent the performance of any one investment. There is no guarantee that you will achieve the results illustrated or that the investment strategy will meet its stated objectives. You should always seek counsel of the appropriate advisor prior to making any investment decision.
All investments are subject to risk including the loss of principal. Diversification does not guarantee a profit or protection from loss. Past performance is no guarantee of future results.
No client or prospective client should assume that the presentation (or any component thereof) serves as the receipt of, or a substitute for, personalized advice from Lucia Capital Group or from any other investment professional.
Investments in stocks and bonds issued by non-U.S. companies are subject to risks including country/regional risk, which is the chance that political upheaval, financial troubles, or natural disasters will adversely affect the value of securities issued by companies in foreign countries or regions; and currency risk, which is the chance that the value of a foreign investment, measured in U.S. dollars, will decrease because of unfavorable changes in currency exchange rates. These risks are especially high in emerging markets.
The S&P 500 Index is an unmanaged index and includes a representative sample of large-cap U.S. companies in leading industries. An investment may not be made directly in an index.
Rick Plum is a registered representative of, and offer securities through, Lucia Securities, LLC, a registered broker/dealer, member FINRA/SIPC. Advisory services offered through Lucia Capital Group, a registered investment advisor, and an affiliate of Lucia Securities, LLC. Registration with the SEC does not imply a certain level of skill or training.