What You Don’t Know About Risk Could Disrupt Your Retirement

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?

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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.

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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.

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