It can be exhilarating.
The market goes on a tear, your portfolio’s value soars, and, perhaps, a part of you thinks it will always be so.
Unfortunately, if we aren’t careful, the market has a way of catching us off guard, and one day that marvelous portfolio balance isn’t so marvelous anymore.
And in such situations, many people discover — much too late — that they had even more of their money at risk than they realized. This is because that longlasting, upward-trending market, with equities gaining in value, threw their investments out of balance.
Here is why that is so.
Let’s say you chose a traditional 60-40 balance for your investments, with 60% of your money in stocks and 40% in bonds. Over the last three years, the S&P 500 saw average gains of about 20% annually, while annual gains for bonds were more like 3%.
As a result, at the end of those three years, more than 70% of your portfolio is in stocks and a little under 30% is in bonds — far from that original 60-40 balance you carefully chose. Without you realizing it, a much larger portion of your money is at risk than you might prefer.
For someone who is a good 20 years away from retirement, this might not be so consequential, since there is time to recover in the event of a market downturn. But if you are approaching retirement — and the market takes a sudden dramatic dip — your retirement plans may be upended.
Taking Control of Risk
How much could they be upended?
Based on history, the answer is: quite a bit. On average, during the last three or four recessions, the market saw declines in the realm of 40%. That would be an extreme hit to any portfolio — but even more so if you are blindsided because you are taking more risk than you thought.
This is why you need to regularly check to make sure your risk is what you think. If the balance you seek is 60-40, 50-50, or whatever it might be, then you must ask whether events have conspired against you to throw that balance off kilter and you need to take steps to bring it back to where you want.
When the market is performing well, though — as it has in recent years — people can become complacent, happy with their gains and preferring not to think about those good times coming to an end.
History teaches us that eventually the good times are interrupted by some down years. The question is when will that happen and how much of a correction to the market will there be?
Sadly, no one has the crystal ball that will give us a definitive answer.
But the positive news is that one of the best ways to control risk is to take advantage when times are good. Make the appropriate adjustments to your portfolio now instead of waiting until something unsettling happens (another war, another pandemic, you fill in the crisis) and the market reacts negatively.
Rate of Return vs. Range of Return
As someone nears retirement, the rate of return on their investment continues to be important, but even more important is the range of return — that is, the highest and lowest points caused by volatility in the market over time.
Let me explain what I mean.
These days, because of longevity, a typical person could have a retirement lasting 20 years or longer. Over that amount of time, the market likely would experience plenty of ups and downs. Let’s say overall the market gains 9% during those 20 years. That might sound good, but for someone to have enjoyed that return, they probably had to endure several periods of minus 20% losses or more. Maybe during that same 20 years a more conservative investor saw a return closer to 6%. On the surface, that makes the conservative investment sound like a bad idea.
But that’s not necessarily the case when it comes to retirement. A retiree is often making withdrawals from their portfolio even as their money continues to be invested. The combination of a down market with withdrawals can quickly deplete a portfolio. This is why thinking about range of return is just as important as thinking about rate of return. That person who gained a 9% return over the 20 years saw a high year of 21% over that time but also a low year of minus 31%. The person with the 6% return saw a high year of 11% and a low year of minus 12%.
Reducing your risk will increase the odds your portfolio can withstand the market volatility that’s almost certain to happen over a long period of time — volatility that could be devastating to your retirement.
Don’t let risk creep up on you. Keep tabs on your investment allocation and make adjustments when necessary. Taking a certain amount of risk is necessary if you want your investment to grow. Just be sure you are in control and well aware of how much that risk is.