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Understanding Risk March 24, 2014

Posted by shaferfinancial in Finance.
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Risk is something that folks do a poor job evaluating. Perhaps it is because we are emotional creatures tied to our emotions through our brain function? Or perhaps, as a generation we didn’t learn how to deal with risk? Whatever it is, facts demonstrate how poorly we deal with it. Because of this, most people have a hard time dealing with their finances, specifically how to deal with developing retirement income.

We fear risks that are extremely unlikely to happen and don’t worry about risks that are almost guaranteed to happen. Its common place for me to talk to people who are worried about economic collapses yet haven’t given much thought to the risk of the stock market they invest in. As regular readers know, I think mutual funds are the worst place to invest for retirement. It is full of obvious risk that is generally ignored especially when we see a 32% return like we did last year. One gentleman I recently conversed with on the internet was bragging about his 12% return over the last 23 years. Indeed, it was pretty impressive considering it beat the S&P 500 return by 20%. But, missing from the discussion is the fact that 1 year ago that return was 9%. What a difference a year makes! I calculated the 22 year return [life of the fund] for a commonly advised, low expense [.17%] fund the Vanguard Total Market Index Fund [VTSMX] and found it to be 9.4%. Not bad. But 1 year ago that return would have been 6.1%. Again, what a difference a year makes. Do people really understand that the sequence of returns make such a huge difference. Take the man above, he started investing at the beginning of the longest bull market in stock market history and now has tripled the value of his investments in the last 5 years. If he was retiring today, he can be considered one of the luckiest people alive. But he is not. He is leaving all that capital at risk for the last 10 years before his retirement. Crazy. Do you know someone like him? Maybe yourself? Do you know you can lock in those gains and guarantee future gains in the 7% range right up to retirement if you are in your 50s?

The peaks and valleys of investing in the stock market appears innocent enough until you start to understand what the real risk is. Those numbers above assume that you have a constant amount of dollars invested over the long haul. But is that realistic? For most people they have the least money invested in the first 10 years and the most in the final years coming up to when they will use it for retirement. How does that effect risk? Common advice is to ratchet down stock ownership and increase bond ownership as you age. Great, except now you don’t get the full advantage of a 32% up year when you have the most money invested. And what about those people that are just starting out. They get a 32% return, but it is on very little money.

Simply put, the final 10 years before retirement have a huge effect on the results. And if you are invested more in bonds than stocks over those years as some would suggest is wise, that decreases significantly the potential gains during the most critical period. And we haven’t even touched the damage down years can do the closer you get to retirement.

We are currently seeing much money going into stock mutual funds. Surprising? No, we just had a +32% year. Do these people have any understanding of what buying at high prices can do to their overall return? Probably not. Do they understand the risks they are assuming? No.

How did we get to a place where millions of nice, smart people are putting their retirements is such peril?
The easy answer is a combination of corporate malfeasance [moving from defined benefit pensions to 401K style retirement plans], government encouragement and Wall Street propaganda. But let’s not be glib here. We are where we are and we can’t change that. Neither can we change human psychology or the way the market works.

And it does critics like myself no good blogging to a couple of hundred people pointing out the obvious when there are tens of millions of folks out there with no idea the trouble they are in. But, what can be done is to reach out, person by person, explaining what is going on, explaining risk, explaining how to avoid it, advocating for folks to take over their retirement.

Not all risk is obvious and preventable. Humans have been dealing with this fact forever. But, there is no reason to assume known risks that are preventable. If you are still thinking that investing in your 401K, buying mutual funds, being fully exposed to stocks, or using strategies that are failing people, are the way to go because it is commonly advised, don’t call me. But, if you are beginning to see the cracks in the wall of using commonly advised strategies, starting to understand how it really works, starting to worry about the risks [both unknown and known] for these strategies, then give me a call. Hopefully, you will be open to how to redesign your retirement income using insurance products and/or real estate and/or dividend producing stocks to fix the fissures in your retirement wall!

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