Probably the biggest risk a retirement portfolio faces is the risk of loss. The corollary risk is the risk of missed opportunity (such as a big gain), but I think I can show you the risk of loss is far worse. It all comes down to simple math.
Let’s say you are in or near retirement with a retirement portfolio worth $80,000 at the start of last year, and you experienced a 50% drop in value due to market losses. So you start this year with retirement savings worth $40,000. To get back to your original value of $80,000, how much do you need to earn in percentage terms? You might think, “A 50% loss means I just need a 50% gain to offset my loss.”
But you actually now need a 100% gain. A 50% gain on $40,000 is just $20,000, giving you a total value of $60,000. Instead you need a 100% gain on $40,000 (so another $40,000) to get back to $80,000. It’s just the way the math works, and it’s a key learning point to realize why losses can be so devastating to a retirement portfolio. And why you need to do all you can to avoid them, especially if you are, say, age 55 or older.
To use a tennis analogy, you’re playing “not to lose.” In other words, you want to play solid tennis and minimize any errors on your part. You want your opponent to make the mistakes, and in so doing, you win. Rather than “playing to win,” which means taking bigger risks, you want to minimize your chance of losses with your retirement money.
So how do you avoid losses with your retirement savings? There are a couple approaches, and they all involve having a system or a process that you stick to, no matter what your emotions tell you to do. One approach is to avoid being “forced” to sell in down markets. While you may still experience a loss on paper with part of your savings in the markets, you have enough “safe money” (in CDs or money market funds) that will hold you for a few years, giving your other savings time to recover.
Or another approach is to have a system that tells you when to get in and out of the markets. This “market timing” approach is much tougher to execute successfully over time, and can be more expensive than buying-and-holding (because when you trade more often, you pay more in commissions and taxes). But emotionally, you at least feel like you’re “doing something” in response to market meltdowns. Again, the key is to have a system that you believe works and that you will stick to, no matter what your emotions (and friends and the media) are telling you.
Look back to 2008 and see how you responded to the drops in nearly all types of financial markets. What if you went through 2008 without either of the above approaches? Make a change in your retirement plans now. Develop a long-term strategy you can really live with, in good times and bad. Or talk to your current financial advisor to make a new plan (or fire your current financial advisor if they did nothing to help you avoid these problems in the past).
There are a lot of options to consider. Talk your approach over with someone you trust. And be sure to play good defense with your retirement savings. Don’t worry about making a big win. But do all you can to minimize your losses, and the math will work in your favor every time.