Decoding retirement finance: the interplay of sequence of returns, drawdowns, emotional trading, and your personality
Kitco Commentaries | Opinions, Ideas and Markets Talk
Featuring views and opinions written by market professionals, not staff journalists.
The golden years of retirement are eagerly anticipated by many as a well-deserved reprieve after decades of hard work. However, ensuring these years are as golden as you hope, demands more than just diligent saving. It requires a nuanced understanding of investment intricacies, particularly sequence of returns risk, value drawdowns, time drawdowns, emotional trading, and the subtle influence of your personality on investment choices.
The Hidden Pitfall: Sequence of Returns Risk
One commonly held belief is that an average return on investments over time is enough to ensure a comfortable retirement. But the sequence, or order, in which these returns occur, especially during the early years of retirement, can dramatically alter your financial landscape.
Consider the scenario of Bob, who enters retirement with savings of $500,000. With his calculations, an annual withdrawal of $20,000, coupled with a specific average return, should suffice. But markets are unpredictable. If the initial years of his retirement are marked by poor returns, the combined effect of his withdrawals and these losses can significantly erode his savings. Even if the market bounces back later, his diminished principal may not fully benefit from these positive returns, affecting his long-term financial health and sequence of returns risk is the cause for this.
Demystifying Two Types of Drawdowns - Value and Time
Central to understanding the sequence of returns risk are the concepts of value and time drawdowns.
Value Drawdown: This describes the percentage reduction from an asset's peak value to its lowest point. In Bob’s context, if his savings dwindle from $500,000 to $400,000, he's encountered a 20% value drawdown. Such a dip doesn't just represent a numerical loss; it fundamentally alters the foundation upon which future returns can be built.
Time Drawdown: This concept revolves around the duration it takes for an asset to rebound from a value drawdown. If Bob’s portfolio, after its decline, takes five years to ascend back to its original value, that represents a five-year time drawdown. For retirees consistently withdrawing funds, prolonged time drawdowns can be especially perilous, accelerating the depletion of their savings.
These drawdowns, while sounding technical, have tangible repercussions. They can translate to longer recovery periods for investments, and is the number one cause of retirees to outlive their savings.
The Emotional Quagmire of Trading
Financial markets are a roller-coaster of highs and lows. While experienced traders are more accustomed to this ride, retirees can find the dips stomach-churning, especially when their life's savings are at stake.
Imagine Bob, observing a consistent downward trend in his portfolio, succumbs to fear. Anxious about further losses, he might hastily reposition his assets into ultra-conservative options or even cash out a significant portion near market lows. Such decisions, dictated by emotions rather than rational analysis, can generate losses, hindering his portfolio's chances of recovery during future market rallies.
Do You Know Your Personality Type? An Overlooked Connection
In the realm of investments, technical know-how is undeniably valuable. But equally vital is the introspective understanding of one's own personality and emotional propensities.
Investors differ in their risk appetite. Some are thrill-seekers, unfazed by market turbulence, while others are more risk-averse, seeking stability. Recognizing how your brain perceives and reacts to situations can profoundly influence your investment decisions and success.
Had Bob undertaken a deep dive into his own risk tolerance, he could have sculpted a portfolio that resonated with his personality. Such congruence between one's investment choices and inherent risk tolerance can act as a buffer against impulsive, emotion-driven decisions during market volatility.
The Ground Realities for Retirees
Without a firm grasp of the sequence of returns risk, the implications of value and time drawdowns, and the dangers lurking in emotional trading, retirees might find themselves on shaky financial ground. Bob’s journey, though hypothetical, echoes the experiences of many retirees. They enter retirement armed with calculations, only to find their plans derailed by market realities and their own emotional responses.
When the ominous prospect of outliving their savings becomes apparent, retirees are faced with undesirable choices. They might have to drastically cut back on their planned lifestyle, contemplate rejoining the workforce, lean heavily on governmental support, or even seek financial assistance from family. Beyond the palpable financial strain, such scenarios can also inflict emotional stress, shatter confidence, and diminish retirees' sense of autonomy.
Using Wealth Math on the Journey to Retirement
If you read the article Shockingly Different Results Of How Two Pilots Invested $1,000,000 earlier this year, or if you have attended one of my presentations, you may already be familiar with the story of John and Mike who each invested $1,000,000 using different strategies. Now that retirement had begun, both men withdrew $50,000 annually.
Just before his retirement, John realized that he needed to shift his focus from higher risk strategies to one that would protect and grow his money in a more conservative manner. He no longer had the luxury of unlimited recovery time should a downturn in the market occur. John was ready to settle into consistent returns, even if that meant he missed out on the adrenaline and excitement that only a big winning trade can provide.
Mike, on the other hand, loved the ability to call himself an active and successful trader. With some yearly returns coming in at 35% and 43%, he saw no reason to change tactics. Sure, he’d had a few bad years, but so had everyone else, so he continued on as always. What Mike failed to really appreciate was that he was now playing with his future with no other income streams to insulate or support him during the not so good years.
Looking at the image below, it becomes easy to see that while John is off living the retirement he always envisioned, Mike is by turns getting lots of high fives at the golf club or sitting hunched over his computer, desperately trying to stem the flow of lost money.
Retirement, while representing the culmination of a life's work, also introduces a new phase of financial management. Ensuring that this phase is stable and prosperous isn't just about amassing significant savings. It's about navigating the intricate web of investment dynamics, being cognizant of one's emotional triggers, and aligning one's investment strategy with their personality traits.
Bob and Mike’s narratives serve as cautionary tales. They underscore the importance of holistic financial education and the value of seeking expert counsel. With the right knowledge and a strategy tailored to one's unique profile, retirees can pave the path to a truly golden retirement. It's not just about safeguarding finances; it's about preserving peace of mind and ensuring a legacy of financial prudence for future generations.