Market-beating profit is undeniably the supermodel of the investment fashion show. It’s sexy and seductive — the object of boundless desire and the inspiration for an endless parade of fantasies.
And, like a supermodel, this profit is hard to meet in person and even harder to hold onto once you have it. Even if you do get to hold it, it’s probably only for a little while, and then it up and leaves — usually faster than it arrived in the first place.
If you’re looking for a comfortable, stress-free retirement, then counting on market-beating investment performance is no more likely than a supermodel to help you realize your dream. The fact is that, when it comes to planning for and managing your retirement finances, risk is a more suitable object for your obsession.
Risk is return’s less attractive and not nearly as seductive sibling. Frankly, risk can be pretty ugly and can do horrible things if not treated properly. But, when it’s all cleaned up and on its best behavior, it can be the perfect companion — delivering the kind of performance that is just what you need to make your retirement plan work.
Risk is a key element of any retirement plan for two basic reasons: One, it is unavoidable — and always seems to show up when least expected. Two, return — real return — won’t go anywhere without it.
Too many investors, and investment managers, focus so heavily on return that they overlook or underappreciate the effect that risk will have on their retirement plans. Properly managed, investment risk is your ally. Allowed to run unchecked, it can devastate your life in retirement.
The simplest approach to investment planning, one that ignores investment risk and one that has been practiced by professionals since the dawn of investment planning, assumes a constant rate of return for your portfolio each and every year for the rest of your life. If an adviser recommended an investment strategy with an expected average annual rate of return of 8 percent, then a plan was tested assuming that exactly 8 percent was generated by the portfolio in every single future plan year.
In the real world, this doesn’t happen, however. Even if you could invest in a contract that guaranteed 8 percent per year for life — a fixed, immediate annuity, for example — varying rates of inflation from year to year will affect the actual value of that return over the course of your life.
To do responsible retirement planning, you must accept that investment returns are uncertain and that, even if your portfolio produces the average rate of return you expect over your lifetime, the individual annual return numbers you realize will vary significantly from that average. When this uncertainty is combined with withdrawals from your portfolio, like the ones you’ll be relying on in retirement, the value of the portfolio can deviate considerably from the value we expect based on the average rate of return.
The more the series of annual return numbers deviates from the expected value, the wider the range of future portfolio values that can be produced by the strategy. This makes intuitive sense, since we expect a wider range of potential results from a portfolio composed of volatile stocks than we do from a portfolio of Treasury bills or certificates of deposit.
If a 30-year CD could be purchased that guaranteed an inflation-adjusted return of 5 percent per year, then the value of a $100,000 investment at the end of 30 years would be $432,194. You could plan to withdraw $6,500, adjusted for inflation, per year over that period and not run out of money before the 31st year. This is a risk-free retirement plan.
In the real world, however, we must invest in risky portfolios. A portfolio invested in a way that produces a 5 percent average rate of return, might do so by producing 5 percent one year, minus 10 percent the second year, 3 percent the third year and so on. Taking a needed withdrawal in one of those minus-10- percent years will have a lasting — and negative — effect on the ending balance.
The exact sequence of returns your portfolio realizes during retirement can mean the difference between success and failure. The luck of the draw can mean taking that $6,500 annual withdrawal for 30 years and having money — maybe even lots of money — left over at the end, or, running out of money with years of living left to do.
The trick to investing in retirement is to take enough risk to get the job done — to generate enough return to meet your objectives — without taking so much to produce an unacceptable probability of failure. Your investment strategy needs to be aggressive enough to produce the needed return in the long run without being so volatile that it results in financial failure.
Understanding the importance of risk in making investment decisions is prerequisite to finding the right investment strategy. Actually identifying that strategy can be a tricky process, but the information provided by the Thrift Savings Plan at www.tsp.gov is a good place to start.
Written by Mike Miles
For the Federal Times
Publication February 26, 2007