January 27, 2015 - To take risk or not take risk is NOT the question. But rather, what percentage of retirement assets should be exposed to risk?

You see, by not taking any investment risk, your retired clients will pretty much assure themselves that their retirement nest egg will experience loss of purchasing power or worse yet, they’ll offset inflation by withdrawing principal and eventually deplete it to zero. Think it through…if it weren’t for inflation (which we have had every year since 1954) the only investments retirees would need are cash and bonds. These two asset classes can deliver a reliable income stream with little or no risk to principal. But, as soon as you need a growing income, then you need to introduce growth into the retirement portfolio. And, once you bring growth into the mix, along with it comes risk. What a dilemma….”I want a growing income, but I don’t want to take risk”. Fortunately, there is one strategy to minimize risk and seek inflation fighting performance.

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What’s the strategy?  TIME.  Consider this…since 1926 riskless investments (T-Bills) have averaged 3.77% and the S&P 500 has averaged 11.25%. Unfortunately, the S&P 500 doesn’t earn 11.25% year in and year out. In fact we recently experienced nearly a 50% loss during the 2008-2009 recession. This leads us back to our time theme because you’ll see that the probability of higher risk investments outperforming riskless investments increases with time. 

The real question, then, becomes….”how long must your client hold a riskier investment to achieve the level of probability that is acceptable to them”. In other words, if they take risk, what percentage of time do they need to be “right” to justify it. Let’s look at some data comparing stock market risk vs. riskless investing*. For purposes of simplification this compares the one true “riskless” investment (T-Bills) to the S&P 500. This comparison will use data dating from 1926 to the present.  It compares 1 yr., 5 yr., 10 yr. and 15 yr. holding periods. The data demonstrates that when held for 1, 5, 10 and 15 yrs., what percentage of the time did the S&P 500 outperform Treasury Bills. Here are the results:

1 yr.—65%

5 yr.—78%

10 yr.—88%

15 yr.—95%

Furthermore, when you examine the 15 yr. holding periods since 1926 there were only 3 that the S&P 500 underperformed T-bills. The worst was 1968-1982 and it only lagged T-bills by 4/10th's of one percent (7.4% vs. 7.0%)*.

So, do you want to be right 65, 78, 88 or 95% of the time?  That shouldn’t be a hard choice.  I want to be in the 88-95% category. By now you should be appreciating the need to segment your clients’ retirement assets into those that will be needed during the first 10 yrs. of their retirement and those that they can leave alone for 10 yrs. or longer. How do you know how to determine the proper percentage of riskless vs risk assets? That will obviously vary with their individual risk tolerance, time horizon, the amount of retirement assets, the monthly income required and the balance they would like to have at the end. As a rough rule of thumb the average retiree will need to have about 30%- 40% of their portfolio in equities to have an income that can keep pace with inflation and have a beginning withdrawal rate of 4.5%. Imagine, by not taking risk a retiree can either lose purchasing power or go broke. On the other hand, by exposing 30%-40% of their beginning retirement portfolio to stock market risk and leaving it alone for 10-25 yrs. while they live on the other 60%-70% that is in fixed asset classes, they can inflation proof their income and potentially preserve their principal. 

Hopefully you now understand why taking no risk could be the biggest risk. 

 

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 *Ibbotson SBBI 2013 Classic Yearbook

 

Disclosure: The opinions herein are those of the author and are for information purposes only. A reader should consult with their investment advisor to determine the appropriate investment strategy based on the individuals specific facts and circumstances.