What You Don’t Know About Risk Could Disrupt Your Retirement
There comes a point when assuming additional risk doesn’t mean additional benefits.
We’ve all heard the old saying “no risk, no reward.” And when it comes to investing, it’s definitely true.
Every investment carries some risk. Land … gold … even CDs, thanks to inflation. It’s all a bit of a gamble, which makes it thrilling and scary all at the same time — and tempting, oh so tempting, to go big.
After all, with bigger risk, you’ll get an even better reward, right?
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
Not necessarily.
The law of diminishing returns teaches us that eventually there comes a point when assuming additional risk doesn’t mean additional benefits. And we’ve found that to be true with investing — especially for those who are near or already in retirement.
Evaluating two different risk-reward strategies
For example, let’s say we have two (imaginary) friends, Jack and Diane, who are in their late 50s.
Jack has always been less willing to take risk with his investments, but he hears Diane talking about her big returns all the time, so they decide to do a side-by-side comparison for four years.
Jack makes 10% in the first three years on his $100,000. Then in the fourth year, the market drops and he loses 20%.
Diane makes 20% in the first three years on her $100,000, and in the fourth year, she loses 40%. She takes twice the risk, so she makes twice as much on the upside, but she also loses twice as much on the downside.
And at the end of that fourth year, Jack actually has more money. Not a lot — but certainly enough to make him question Diane’s taking twice the risk with her nest egg.
A 2.5% avg. return can beat a 5% avg. return in the end
Of course, that’s not how it would look if they’d spoken only about their “average rate of return” for the period. Jack would have had a 2.5% rate of return for those four years, and Diane’s would have been 5%. But there’s a big difference between average return and actual return. Clearly, Diane didn’t make twice as much as Jack.
So was it worth it for Diane to take the bigger risk? Maybe, if she doesn’t mind the ups and downs of the market and the financial vehicles she’s invested in align with her risk tolerance — or if she has a long time before she plans to retire. But for Jack, whose risk tolerance is much lower than Diane’s, clearly less risk is the way to go.
And for most investors, that’s the goal — to reach a desired outcome with the lowest possible amount of risk.
How can you make sure your portfolio is set up with that in mind?
- Talk to your financial professional about average return vs. actual return. (Or arithmetic mean vs. geometric mean, if you want to get technical.) Many in the financial industry use averages as a marketing tool, so be sure you know the difference. (I use a website called moneychimp.com to find actual return.)
- Ask about sequence of returns and what risk means in retirement. When the market drops is as important as how much it goes down. If you are near or in retirement when there’s a major downturn, time is no longer on your side, and you’ll likely have a difficult time bouncing back. If you’re already taking distributions from an account, the loss could be distressing. You can’t predict the market, but you can lower the amount of risk in your portfolio.
- Discuss the impact of a loss vs. a gain on your bottom line. Avoiding a bear market is just as important as participating in a bull market. It’s tempting right now, when you see the numbers on your statements growing, to stay in a riskier mix — or, if you’re in a moderate or conservative portfolio, to question why you’re not making more money. Try to think in dollar amounts instead of percentages: How much are you willing to lose if the market drops like it did in 2008?
It’s tough to listen to your friends bragging about market wins and not want to get in on the kind of money they’re making. Just remember, there’s a lot more to the story. And you’re looking for a happy ending.
Kim Franke-Folstad contributed to this article.
Representative is registered with and offers only securities and advisory services through PlanMember Securities Corporation, a registered broker-dealer, investment advisor and member FINRA/SIPC. 6187 Carpinteria Ave., Carpinteria, CA 93013, (800) 874-6910. Investment Management Group and PlanMember Securities Corporation are independently owned and operated. PlanMember is not responsible or liable for ancillary products or services offered by Investment Management Group or this representative. 8771 Perimeter Park Ct. #103, Jacksonville, FL 32216.
The opinions expressed in this article are for general information only and are not intended to provide specific investment advice or recommendations for any individual. Consult your financial professional, attorney or tax advisor with regard to your individual situation. The views expressed may not necessarily reflect those held by PlanMember Securities Corporation.
The above example is hypothetical and for illustrative purposes only. Please note that each person’s situation is different. Please consult your financial or tax professional regarding your circumstances.
Investments are not guaranteed and are subject to investment risk including the possible loss of principal. The investment return and principal value will fluctuate and, when redeemed, the investment may be worth more or less than the original purchase price.
Get Kiplinger Today newsletter — free
Profit and prosper with the best of Kiplinger's advice on investing, taxes, retirement, personal finance and much more. Delivered daily. Enter your email in the box and click Sign Me Up.
Philip Detlefs is an Investment Adviser Representative with Investment Management Group. He has passed the Series 7, 63 and 66 securities exams and is a licensed insurance professional. He has a bachelor's degree in finance and marketing at Florida State University. He is married and has three children, Olivia, Harry and Hutch.
-
Winners and Losers of Fed Rate Cuts
Navigating interest-rate changes can seem daunting, but these areas of the fixed-income market could perform better (or worse) than others.
By Jeffrey R. Kosnett Published
-
What You Should Know About Spousal IRAs
Without spousal IRAs, you would need an earned income to contribute to your retirement account.
By Sandra Block Published
-
Six Ways to Optimize Your Charitable Giving Before Year-End
As 2024 winds down, right now is the time to look at how you plan to handle your charitable giving. The sooner you start, the more tax-efficient you can be.
By Julia Chu Published
-
How Preferred Stocks Can Boost Your Retirement Portfolio
Higher yields, priority on dividend payments and the potential for capital appreciation are just three reasons to consider investing in preferred stocks.
By Michael Joseph, CFA Published
-
Structured Settlement Annuity vs Lump-Sum Payout: Which Is Better?
As the use of structured settlement annuities grows, it can be tough to decide whether to take the lump sum to invest or opt instead for guaranteed payments.
By H. Dennis Beaver, Esq. Published
-
What to Do as Soon as Your Divorce Is Final
Don't delay — getting these tasks accomplished as soon as possible can help you avoid costly consequences.
By Andrew Hatherley, CDFA®, CRPC® Published
-
Many Older Adults Lack Financial Security: What Can We Do?
Poor financial literacy and a lack of foresight have led to this troubling reality. It's going to take tax policy changes, education and more to address it.
By Ryan Munson Published
-
Winning Investment Strategy: Be the Tortoise AND the Hare
Consider treating investing like it's both a marathon and a sprint by taking advantage of the powers of time (the tortoise) and compounding (the hare).
By Andrew Rosen, CFP®, CEP Published
-
How to Fight Inflation's Hidden Threat to Your Savings
If higher prices are putting your savings goals on hold, you're in danger of financial erosion. Fortunately, several strategies can help stop the spread.
By Kevin Brauer, MBA, CPA, CMA Published
-
10 Inefficiencies I Look for on Rich Retirees' Tax Returns
Your tax return could hold clues to several missed opportunities and important gaps in your retirement planning.
By Evan T. Beach, CFP®, AWMA® Published