One of the most important retirement concepts to understand is that loss of principal overshadows gains. Protecting a portion of your retirement assets against losses may be the single most important step you can take toward financial security. The less time you have to make up for losses, the more important it becomes to protect your principal.
For example, assume a hypothetical $100,000 declines by 20 percent (see chart). To break even, the $80,000 would have to increase by 25 percent # which is higher than the previous year’s percentage loss of 20 percent. As the percentage loss increases, you would need an even higher percentage gain to break even.
Historical averages don’t matter
Many of us have heard the expression, “The stock market has averaged 9 percent over the past 100 years, so as long as you just leave it in for the long haul, you’ll be fine!” On the surface, this seems to be a very compelling argument for having the bulk of your assets in the stock market, but unfortunately, history tells a very different story.
What the stock market “averages” over a certain period of time tells us very little about what effect the volatility of the market will have on our portfolios. What dramatically affects our hard-earned retirement assets is not the “historical average return,” but how the stock market actually performs when we begin taking withdrawals. This is called “sequence of return risk.” Losses in the beginning of retirement can have a devastating effect on your portfolio.
We can illustrate the sequence of return risk with the story of Bob and Susan. Both enter into retirement with a $500,000 portfolio at age 65, both start taking withdrawals each year of 5 percent, which increase each year by 3 percent to keep up with inflation. Both average an 8.03 percent annual return, and both experience three consecutive significant negative years in the market.
All things being equal, Bob and Susan had dramatically different results. How could that be? The difference was due to when the market losses occurred: Bob was hit with the market losses in the beginning of his retirement, at ages 65-67. Susan experienced the same losses, but at a much later date in retirement. The data shows that incurring losses earlier in retirement can be devastating to a portfolio.
Chart 1a shows the dramatic difference. 1
Simply due to when the stock market losses occurred, Bob depleted all of his retirement savings at age 83, while Susan still had $1,677,975 at age 89 to last her through the rest of retirement, or to pass on to beneficiaries. The difference is striking!
One of the key strategies to help avoid the depletion of assets due to sequence of return risk is to protect at least a portion of your retirement assets from stock market losses. Having a conservative income bucket as a part of your portfolio will help provide reasonable returns with minimal risk.
1 Data pulled from Security Benefit product brochure TVAB (3-12) 6/172013. Security Benefit is indirectly controlled by Guggenheim Partners, LLC.
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