This article is going to be a downer. So, right now, think of something fun to do after you've read it.
Got it? Good. Because we're going to talk about risk -- about all the things that can go wrong with your investments and ruin your near- and long-term financial plans. While thinking through this stuff isn't all rainbows and cupcakes, it's better to confront the potential grim side of reality now so that you can take pre-emptive action.
So, take a deep breath and let's go through seven things that could go horribly, awfully wrong with your investments and -- on a happier note! -- some ways that you can lessen the chances of them happening to you.
Although volatility is the best-known measure of risk (it's the degree to which an investment goes up and down) and the one that gets all the attention in headlines, it may be less of a threat to your financial future than you'd assume. The more time you have for your investments to ride out the market's (or an individual investment's) ups and downs, the less volatility actually matters. (We'll get to the havoc-wreaking powers of volatility over the short term in a moment.) In fact, for long-term buy-and-hold types, volatility is necessary; stocks have historically returned more than bonds partially because they're more volatile. If they weren't, then the so-called risk premium — the amount that stocks have historically outperformed Treasuries — would disappear. Plus, there are other benefits to volatility: When stocks are up, your net worth increases; when stocks are down, you have more buying opportunities at cheaper prices.
Solution: Keep any money you'll need for the next three to seven years out of the stock market. Diversify your investments, because different asset classes have different levels of volatility at different times. By owning a variety of investments and doing some occasional rebalancing, you can lower your portfolio's volatility and enhance its return.
2. Sequence of Returns Risk
Volatility is a bigger threat when you're in or near retirement because a bear market can threaten a portfolio's ability to last as long as the investor. Rather than buying stocks when they're down — as a saver does — a retiree may have to sell stocks when they're down to pay living expenses. As Jim Otar, an author and Certified Financial Planner, puts it: "Each time you make a withdrawal after a loss, you create a permanent loss in the portfolio. Subsequently, you need to recover from the initial losses as well as from these permanent losses."
Let's say you're not yet retired and your portfolio loses 20%. To get back to breakeven in three years, you'd need 25% growth over that stretch, according to Otar. However, if your portfolio declines 20% and you're already using a 4% withdrawal rate, your portfolio would have to return 42% over three years to get back to breakeven. That's a tall order.
Such losses can be especially devastating if they occur in the first few years of retirement — these "permanent losses," or withdrawals, deplete a portfolio that has to last more than two decades. This possibility is known as sequence of returns risk.
Solution: Retirees should have an "income cushion" of cash and short-term bonds sufficient enough to cover five years' worth of expenses that are not otherwise covered by Social Security or a pension. This reduces the risk of needing to sell stocks at depressed prices. You should start to build this cushion before you retire. And after big market drops, retirees should withdraw as little as possible from their portfolios to create the smallest permanent loss.
3. Interest Rate Risk
The value of existing bonds fall as interest rates rise, though, as they approach maturity, the bonds eventually return to their original value. But with stocks, interest rates have a less predictable effect. According to the Leuthold Group, rate increases from a very low level can be good for stocks, as they indicate that a struggling economy might be recovering. However, rising rates from a level just under 6% can drag on stocks.
Solution: Keep the duration of your bond funds in the short-term range (one to three years), especially for money you need in the next few years. Also, consider individual bonds and certificates of deposit if you need more confidence about the exact amount you'll get at a future date. Be aware of how interest rates affect your stocks. For example, a business that relies on debt would see its costs rise if interest rates spiked.
4. Credit and Bankruptcy Risk
While credit risk and bankruptcy risk are often considered different, they address the same potential problem for investors: not getting all your money back. Credit risk pertains mostly to bonds, whereas bankruptcy risk applies to bonds and stocks. Keep in mind that if a company declares bankruptcy, in most situations bondholders get some of their money back, though they have to wait, and the average amount is about 40%. As for stock investors, a bankruptcy can wipe out an entire investment.
Solution: Choose bonds rated A or higher (or funds that invest in them). Because even companies with investment-grade ratings go bankrupt, bond and stock investors alike should have no more than 5% of their portfolios riding on one company, at least until they have the experience and skill to manage a concentrated portfolio.
5. Inflation Risk
Which period in U.S. history do you think was the worst-case scenario for retirement portfolios? The start of the Great Depression? Those years were bad, but that wasn't the worst period because of the deflation at the time. Although portfolio assets had dropped, so did the cost of living, so retirees didn't need to withdraw as much. The worst periods were the ones that began in 1937 and 1966, because those market downturns were accompanied by high inflation. Retirees had to withdraw increasing amounts from sinking portfolios, which is a recipe for disaster.
Solution: A 4% withdrawal rate gives you a built-in margin of safety, because it provided inflation-adjusted income through the worst 30-year periods in history. You could also include inflation protection in your portfolio, such as Treasury inflation-protected securities. Short-term bonds can be an excellent inflation hedge because rising inflation is often accompanied with rising rates, and you don't have to wait long for a short-term bond to mature.
But a retiree's portfolio should also include stocks, as they have historically provided capital gains over the long term, as well as dividend income that, on average, grows at a rate that exceeds inflation.
6. Advisor Risk
Just by reading this article, you know more about retirement planning than the vast majority of investors and, sadly, many people who call themselves financial advisors. I was never taught this stuff back when I worked for a big-name brokerage (though I did learn how to make a cold call). The truth is, most people don't know much about making a retirement portfolio last. But that doesn't stop "professionals" from telling you what to do — and charging you a pretty penny for the advice.
Solution: If you're paying someone to invest your money — whether that's through a financial advisor or an actively managed mutual fund — make sure the extra money you're spending is worth it by comparing your returns with their benchmarks. Also, consider a fee-only planner (which you can find through the National Association of Personal Financial Advisors), who often charge by the hour and tend to have fewer conflicts of interest.
7. Longevity Risk
A long life should be seen as a blessing, not a curse. But the reality is that the longer you live, the longer your retirement will be, and the greater the chances are that you'll run out of money.
Solution: Withdrawal-rate studies assume a 30-year retirement. That means that someone who retires at 65 can live to 95 and still have money in his portfolio, as long as markets don't perform any worse than what we've seen over the past century or so. This builds in a margin of safety because only about 10% of the population lives that long.
You might already have some longevity protection in the form of Social Security or a defined-benefit pension, both of which send you a monthly check for as long as you live. If you don't have such a pension, you can buy one in the form of an income annuity from an insurance company.
Over the past decade Robert Brokamp, CFP, has helped countless people navigate the road to financial freedom through The Motley Fool Rule Your Retirement Service, where this article originally appeared. For more advice, resources and guidance on managing your money, your non-portfolio assets, and your financial habits, try any of Motley Fool newsletter service free for 30 days.