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A Retirement Puzzle: Sequence Risk

| June 29, 2016
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Investing

Two investors retire on the same day with the same amount of money. They both average exactly 10% returns for the next 20 years and they both spend exactly the same amount. One doubles her money while the other goes broke.

Why?  If you are going to have peace of mind in retirement, you need to know how to solve this puzzle.

The answer is a little known force all investors face called "Sequence Risk." 

It is like trying to safely cross a stream that averages 3 feet in depth when any one spot could be over your head. Your outcome, if you attempt to cross without a life jacket, could be fatal.

Anyone who has been investing for more than a few years knows that while investment returns tend to average out over time, they can spike up and down wildly over shorter periods of time. These spikes, if not properly planned, like forgetting to wear your life jacket, can leave you "underwater."

Permanent damage is done during bear markets when retirees who depend on their portfolios to “keep the lights on” need to liquidate more shares than originally planned because share prices declined during the bear.

Since your assets would have been prematurely liquidated to meet expenses, they would not be available to enjoy the ultimate market recovery when it arrives. This process can lead to a negative spiral with dire financial consequences.

How can you help protect yourself from "Sequence Risk"?

The best defense is a three-step process that incorporates time sensitive diversification along with a strategic distribution plan.

  1. The first step is determining how long you want to protect yourself against negative returns and how much income you want to have available each year. HCM focuses on protection periods ranging from 3 to 5 years, depending on where we are in the business cycle.
  2. Next we determine what your "dependable" income will be regardless of what happens with the markets. This includes things like interest, dividends, pensions, Social Security etc. We do not include any assumed gains from market appreciation – remember, this is bear market contingency planning. This amount of predictable income is then compared to your income needs estimated in #1 above.  Any shortfalls are identified and protected in step three.
  3. Next, we create a diversification plan that looks like a multi-layer wedding cake with the biggest layer, the base, supporting everything. This bottom layer includes your most conservative holdings with the shortest time horizons. As you move to higher layers in your “time-segmented” portfolio, your investments have different jobs to do including inflation protection and future growth.  As a result, these upper layers should become progressively more aggressive and will be associated with more volatility and longer time horizons. 

In thinking about your portfolio’s structure, it is important to understand that different parts of the portfolio have different jobs to do.  As a result, the various layers should look and behave very differently. Too often investors look at their portfolios as a single homogenous effort which may cause them to make poor decisions during difficult markets.

How Does it Work

In operation, when markets are performing well gains are taken from the upper, more aggressive layers.  These gains are combined with portfolio income such as interest, dividends, social security and any pensions to meet your income needs. When markets are misbehaving, your base-portfolio layer will fund your living needs and protect your lifestyle. 

This process of time segmentation/diversification gives you a portfolio that is appropriate for your risk tolerance, protects your short-term income needs, and creates the opportunity for long-term growth and inflation protection.  Peace of mind at last!

If you’d like help reviewing your investment strategies and saving for retirement, please contact Mike Hengehold via email mike@hengeholdcapital.com or 513-598-5120.

Date Posted: 06/29/2016 Advice provided in this article is meant for educational purposes only and financial education is important to us. Before making decisions regarding your personal financial situation, please consult an advisor or conduct your own due diligence. If you would like to discuss your Retirement Income Plan with an HCM Wealth Advisor, please give us a call – 513-598-5120. Located in Cincinnati, Ohio, we serve clients in 28 states, and we’d love to help.

 

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