We all understand that there i's risk in the world. Put simply, risk is a
possibility of loss, and as investors, we tend to focus solely on market risk. But
there are many different types of risk. We're talking about longevity risk,
inflation risk, there's also sequence of return risk,
interest rate risk, there's liquidity risk, market risk,
opportunity risk, and tax risk. So let's talk about longevity risk, the risk of
running out of money - and that's one of the biggest fears that most retirees
have. Now here are some statistics on life expectancy: so for men, there's about
a one in three chance that you can live to age 90. Now for women, that's gonna be
higher - about a 45% chance of living to age 90. So you need to plan
for a longer retirement. It's saving more, possibly extending when you start
collecting Social Security to get a higher benefit, maybe it's working more
into retirement, or maybe getting a part-time job in retirement. Those are
all things that you might want to consider when trying to manage longevity
risk. So let's talk about inflation risk. Now inflation is the increase of costs
in goods that we'll experience over our lifetime, and it's one of the areas that
gets greatly underestimated when actually planning for retirement. So some
of the things that you want to make sure when you're actually planning your
cash flow or your expenses in retirement is to really understand how inflation
impacts you. If you buy a car every few years and your spending patterns are a
little more in consumption, then you're gonna feel inflation a little more. Now,
let's talk a little about interest rate risk. Now this is an environment that
we're experiencing currently right now. We're seeing interest rates rise across
the board from short-term all the way to long-term types of interest rates and
so think about it like fuel in a car: as credit is getting more expensive
so is, essentially, the cost of fuel so as the environment and the economy, that
overall cost is rising, there is gonna be some interest rate risk across the board
in some different asset classes. Some things that you will experience some
interest rate risk in will be in fixed income, for instance, like bonds. Now
longer-term bonds will have a higher interest rate risk than say short-term
bonds. But you can also position your portfolio to hopefully participate with
rising interest rates by likely going to a shorter duration in
your bond portfolio and having some excess cash reserves invested in some of
the higher savings rates. We're seeing about a 1% increase in most money
markets across the board. So those are some of the things that you want to
consider when you're looking at interest rate risk. Now another type of risk that
investors or retirees might feel and that's liquidity risk. One way you can
look at liquidity risk is your own home - we've all seen the values of our homes
go up. But when you think about the other side of that, what is it gonna cost you
to sell that home? To realize that gain? Well, we're looking at a situation where
if you have an average home of about $500,000, you're paying five to six
percent commissions, that's about a $30,000 cost to get that equity out. And
it's also one of those situations where, in times of market turmoil, liquidity and
credit tends to tighten up and so that means that you may be exposed to some
assets that have no liquidity or may be very costly to get out of. There's some
types of products that have long surrender charges. So you want to make
sure you understand what liquidity risk you have your portfolio and how to
minimize that. Now you're never going to need access to all of your portfolio all
at once. You're usually going to probably have some emergency reserves, that will
help some liquidity risk, but also you don't want to make sure that all of your
assets are tied into certain types of asset classes that are generally hard to
get to, or be costly, or maybe just time onerous to get access to your principal.
Now let's talk a little bit about market risk. Now some of us are experiencing
volatility right now. Volatility is not necessarily a risk in where we're
potentially feeling permanent loss, but if you realize those losses and you
realize your market risk, sometimes that is a bigger concern. So there are ways to
really manage some of that risk and that's avoiding high concentrated
positions in any one asset class or any one stock position or bond - any kind of
investment that you have too much concentration in, you're likely to
assume more market risk than you need. A diversified portfolio is going to help
minimize some of that market risk. Having some bonds in your portfolio that tend
to have a low correlation with the stock market, if the market were in some
serious decline, will help you with some market risks. Now, that doesn't always
move perfectly, but it's going to give you some, I would
say, some flexibility if we do have a downturn in the stock market. So market
risk is something that is, it is manageable, diversification is your
friend, and you want to make sure you have as many asset classes in your
portfolio that don't necessarily correlate with each other to help you
mitigate some of that market risk. Now let's talk a little bit of opportunity
risk. We may actually take this on unknowingly while we're trying to avoid
market risk. And it's a type of risk where we're sitting the market out.
A perfect example right now, the market is volatile, so a lot of people are being,
maybe, more conservative they need to be. And sometimes if you're too conservative
or sitting the market out, you're just going to risk losing money safely
because inflation is going to eat some of that principle away. Some statistics
on that is, if you look at over a 27 year period of time, between 1990
all the way to 2017, and that's roughly about 6,800 trading days, if you were out
for only the best 15 days over that period of time, which is only 0.2%, you
can have about a 39 percent decrease in your overall assets. So if I invested
$1,000 and I stayed invested, I would average right about 9.8%
if I invested in the S&P 500. If I missed those 15 days, I averaged 6.1% .
Again that's a 39% drop. So you want to make
sure that again your portfolio is withstanding a lot of the different
types of risk but you don't want to be too conservative as well, because that's also
risk in itself. And finally let's talk about tax risk. Now most of us will
probably lose more to tax than we will in the actual stock market, and it's very
important to consider how you're concentrating your assets and
accumulation. There's generally three pools of money that you can save into - a
lot of people will concentrate a lot of their assets in tax deferred pools like
401(k)s and IRAs. Now those are dollars that have never been taxed, and when you
pull the money out, whether it's retirement or pre retirement, you're
gonna be taxed in some future uncertain tax environment. So you really need to
understand that tax diversification is very, very important. That means making
sure that you have access to some non retirement accounts, like a joint account,
if maybe you're sharing it with a spouse, or individual account, or dollars that
are invested in a trust brokerage account. There's also the tax-free pool
that's very important. You may want to consider, maybe
if your income drops or you're in a low tax bracket today, to possibly look at doing
some Roth conversions or realizing some capital gains while you're in the lower
tax brackett. Different things to mitigate that. But again, taxes are one of
those things we cannot avoid, but we certainly can manage that, and that's one
of the things that you need to consider. So by focusing on risk management, in
addition to just your returns, will help you sleep better at night and actually
help you get a better portfolio and have a better retirement plan in general. Now
if you want more information or if you have some questions on these types of
risks please contact us at Pure Financial.