Risk: Your One Guarantee in Retirement
Editorial Note: Today’s post comes from Investment U favorite Steve McDonald. If you’ve been missing Steve’s popular “Slap in the Face” videos, be sure to check out the recent archives on WealthyRetirement.com.
We think we understand it. Few of us really do, though. And it will be the undoing of many retirees. In fact, more often than not, we ignore risk completely.
We have a thousand ways of calculating and estimating how much an investment could return, but not one that focuses on how much we could lose.
Our money myopia – that’s our inability to see beyond returns to the risk side – is not entirely our faults. The money business does a good job of blocking it out.
Take the disclaimer mutual fund companies provide. It seems pretty straightforward and simple. “Past performance is no indication of future returns.”
This statement satisfies the legal requirements of risk disclosure for the Securities and Exchange Commission, but doesn’t really do the job of making you aware of the real risks in funds.
I have always thought it should read “If you buy last year’s winner, you have a 99% chance of losing money.”
Or maybe the disclaimer should be “Our fund managers have consistently underperformed the indexes.”
Now those are accurate descriptions of the real risk involved. But let’s take a closer look at investment risk and the various ways it can eat into your retirement.
On the surface, company-specific risk appears simple. A company could hit rough times and your investment in it could drop in value, or even go to zero.
And the reasons individual companies do lose money are supposedly easily understood, too. Earnings are fickle and the market’s reactions to them can be even more bizarre. So, the risk here is pretty obvious, right?
Not really. Ever had a company report good earnings and the stock still tanked? Somehow that level of risk is never fully explained or understood.
But the most damaging part of company-specific risks aren’t the earnings, markets or even bankruptcies. It is how our brains deal with it.
When it comes to investing, our instinctual fear of endangering our well-being is overridden by our desire to hit it big. There is a mountain of new research on this subject, but it all comes down to this: Our irrational desire to make money is so strong we ignore the risks.
The part of our brain that is supposed to keep us on our toes about risks – our money in this case – doesn’t kick in until we are well on our way to big losses. Then reality sets in and we panic-sell.
The numbers here are so staggering that, to my knowledge, there has never been an attempt to count how much money has been lost by focusing only on return and ignoring risk.
And company-specific risk is only one of many kinds of risk that can sink your retirement.
Systemic and Contagion Risk
There’s also systemic risk.
That’s sort of what happened in 2007 and 2008 when the whole worldwide money system seized up. It’s easy to say no one saw that one coming, but the warnings were there.
Once again, though, the urge to get in on the big one blinded everyone, professionals and rookies alike. All the time-proven methods of protecting ourselves were ignored and the outcome was the same as it has been in every situation where the potential loss side of the equation was ignored.
What we really had in 2008 though was contagion risk. It is similar to systemic, but involves multiple collapses that eventually bring down the whole system.
The collapse started with issues in the mortgage markets and then spread to the banks who bought the mortgages and sold them to their customers. The customers lost so much they started liquidating their holdings, which finally drove the panic-selling in the stock market.
A 6,500 on the Dow. Now that’s a panic!
And it was all because the real risks of junk mortgages were not spelled out to the end buyers. If they had been, almost no one in their right mind would have owned them. Almost. There are always cowboys out there who seem to enjoy giving their money to someone else.
But the granddaddy of them all – the one risk category that affects every one in every market and forever – is inflation risk.
More than ever before in our history, this is the one that has the greatest chance of sinking our retirements.
No one really understands inflation risk. Not in today’s numbers, anyway. That’s because the one variable that will make our financial situations more difficult is the one that, on the surface, appears to be a giant benefit: our life expectancies.
The longer you live, the longer inflation has to erode your worth. Everyone understands this part of inflation risk. But here’s where it gets tricky.
Most people assume they will not be one of the ones who make it to the average life expectancy. So, inflation really isn’t a problem for them.
The fact is, if you don’t smoke, you exercise and you live in a low-crime area, you have a 50% likelihood of reaching the average life expectancy of 83 to 84.
For most of us, that’s about 18 years of inflation exposure. Remember, 83 to 84 is the average, not the maximum. A growing percentage will live even longer. The 90s is a very real possibility for many.
At the long-term average for inflation, just 18 years will reduce a nest egg of $250,000 to about $161,476 of buying power. You will need $383,654 in 18 years to buy what $250,000 will buy you now.
That’s an additional $133,654! At 83 or 84, it would be a neat trick to come up with that much money.
Throw what appears to be an ever-increasing tax burden into the equation and you have life at the poverty level.
The only salvation is to plan for this guarantee – this unavoidable fact of life – and put some money in places that will earn enough to pay your taxes, your annual inflation bite and still put money in your pocket.
The only places I know that can do all that are stocks and corporate bonds. In fact, I am so confident in that statement and the ability of these two asset classes to return enough to keep you afloat, I have bet my own retirement on it.
You cannot hide out in guaranteed investments like CDs and savings. You never could. You can’t own just guaranteed government bonds, either.
In fact, the closer you get to a guarantee, the more likely you are not earning enough to keep up with inflation and taxes.
History teaches us that no matter how much a bank investment pays, they all lose money long term to inflation and taxes, and are a direct route to less buying power in your later years.
Learn to see all the risks in your investments, especially inflation risk, or plan on living on a lot less.
About Steve McDonald
Somewhat of a renaissance man, Steve worked as a professional broker and has been an active trader of bonds for more than two decades, specializing in ultra-short-maturity corporate bonds. But before entering the investment industry, Steve was a naval aviator, flying fixed-and rotary-winged aircrafts, and also served as a surface warfare officer. Steve’s regular video series featured on Wealthy Retirement called “Slap in the Face” Award is some the most amusing investment content we republish.