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Investing for retirement: The four risks

May 1, 2008
Have you ever completed an investment risk-tolerance questionnaire? Isn’t it a silly exercise?

For more on this topic, go to www.dentaleconomics.com and search using the following key words: investment risk, market risk, inflation risk, portfolios, risk tolerance, retirement.

Have you ever completed an investment risk-tolerance questionnaire? Isn’t it a silly exercise? Investment advisors use the questionnaire for legal protection in the existing regulatory environment. In reality, who can withstand the market risk associated with the 2000-02 bear market or normal bear markets that last approximately a year and drive stock market indices down by an average of 27 percent? How does a retirement investor allocate a portfolio to experience the highest probability of success?
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Perhaps only one tool — an investor’s time horizon — can adequately provide guidance for an investment allocation among stocks, bonds, and cash for a retirement investor. Even a 60-year-old has an investment time horizon of 25 to 30 years based upon mortality tables. Most investors act like stocks are appropriate while working, then during retirement it is time to switch to investments that produce cash flow — bonds, bank certificates or high-dividend stocks with low volatility. Perhaps this is a good way to address stock market volatility, but market risk is only one of four risks that an investor faces during the retirement time horizon.

The four risks that every retiree must face are: 1) Market risk: the risk that an investor will lose money in an adverse market 2) Inflation risk: the risk that inflation will reduce retirement purchasing power 3) Goal risk: the risk that there won’t be sufficient retirement capital to support spending, and 4) Longevity risk: the risk that a retiree will outlive savings.

Most retirement investors only address market risk. They fail to properly address the other three risks. Based upon the investment characteristics of stocks, bonds, and cash, the definition of what a risky investment is can change when filtered by the four-risk concept. The table above illustrates this.

When seen from the prospective risks of inflation, goals, and longevity, investing only in cash and bonds can be risky. Humans are very loss-averse. Risk-tolerance questionnaires really fail to scratch the surface of how loss-averse we are. Studies in behavioral finance show we feel the pain of an investment loss 2.5 times more intensely than the pleasure of investment success. Thus, when it comes to solving the problem of investing successfully for retirement, this is perhaps why the only risk that is heeded is market risk — the risk that we might experience a loss in an adverse market.

There are many sins committed in portfolio construction by so-called “investment advisors” who justify a retiree’s fear of owning stocks. Many times basic principles of diversification and asset-class construction are ignored by people who simply wish to make a commission by selling the next hot product. In this case, perhaps concerns about stocks are justified. But, in a properly constructed and diversified portfolio, it is possible to calculate the probabilities of success during a 30-year retirement with different blends of cash, bonds, and stocks.

Suppose you have $3 million of retirement savings and wish to withdraw $150,000 per year adjusted for inflation. Let’s say you have three portfolio choices1 that are properly constructed and diversified. The first portfolio is 50 percent CDs and 50 percent investment grade bonds, the second portfolio is 60 percent stocks and 40 percent investment grade bonds, and the last portfolio is 100 percent stocks. What are the probabilities of success assuming all four retirement risks? The first portfolio only has a 7 percent probability of success through 30 years of retirement. The second portfolio has a 77 percent probability of success, and the third portfolio has an 80 percent probability of success. These outcomes are probably the reverse of how many view retirement. The problem with the all-stock portfolio is that the probabilities are presented on a median outcome basis. At the fringes of probability, in the worst-case scenario — where statistically 90 percent of outcomes are better — the all-stock portfolio runs out of money more quickly than the balanced portfolio. Thus, most retirees would probably prefer the second portfolio, a balance between stocks and bonds.

1 The investment allocations and simulations of different investment outcomes are not intended, nor can they be construed, as investment advice. The probabilities presented here are based upon Monte Carlo simulations of past investment performance of cash, bonds, stocks, inflation, and retirement cash flows. A simulation is merely a mathematical model. Actual future investment performance will likely not conform to a mathematical simulation.

Brian Hufford, CPA, CFP®, is CEO of Hufford Financial Advisors, LLC, an independent, fee-only planning firm that helps dentists achieve financial peace of mind. Contact Hufford at (888) 470-3064, or at [email protected].

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