Do You Understand Risk? You Should!

A really nice guy from Marston Mills came to see Jen and I a week or so ago, let’s call him Sam.  He is 60 years old and a retired school teacher from upstate New York.  He has been married to the same gal, Ellen, for 35 years, has three grown daughters, and has a couple of grand kids.  He has a pretty good pension from the school system but that does not cover his expenses, so he is taking income from his investments at a rate of 4-5% per year.  While Sam hopes to have a long and healthy retirement,  his biggest concern is running out of money.  

The first thing Sam said to Jen and I was, “Before you even look at my investment plan, I know what you are going to tell me.”  Sam went on to explain that he does not like risk and believes that he is risk free with his current investments.  He told me that he previously had a Buy and Hold strategy and got killed in 2002 and 2008. I looked at Sam’s statements and saw that he now has his $500,000 in CDs at the local bank.

Hmmm . . .  we have a problem here!

You see, from our discovery we found that Sam’s income strategy is comprised of two components, his pension and his investments.  But Sam’s pension has come under attack since the cost of living increase has been somewhere around 1.5-2% per year.  I gave him an article I read that explains the real cost of inflation to a senior is 2-3 times that.  So, what does that mean for Sam?  It puts more pressure on his investment plan.  Folks, there has never been more pressure on a senior’s investment plan than there is right now.  Since pensions and Social Security are not keeping up with inflation, we need to grow our investable assets so they produce an inflation hedged income stream to supplement our shrinking fixed benefits.

I find that many retail financial advisors will have people think that to achieve that growth, they should invest in the market and they are relatively safe with a broad stock market allocation that ties to an index, such as the S&P 500.  Well, as Cutter Family Finance readers have learned over the years, that may not be the best approach, since historically, the market has had a major correction every 6-8 years.  

In fact, if you were to look at the S&P 500 from January of 2000 to the end of December of 2010, it actually lost ground by about 12% or so, thanks to the corrections in 2001, 2002 and 2008.  Heck, even as recently as the 4th quarter of 2018 we saw the markets swing over 24%.  Unfortunately, Jen and I see it all the time, folks are taught that to build wealth over time, investors need to accept a significant amount of unmanaged risk.

In our opinion, that simply is not true.

Jen went on to explain that there is no investment without some type of risk.  But we want managed risk. So we took some time with Sam to explain a few of the different types of risk and to see if we cannot design a solution to help him mitigate some of that risk.

One type of investment risk is Sequence of Returns Risk, also called Sequence Risk.  Timing is everything, right? Sequence Risk is the risk of receiving lower or negative returns early in a period when taking distributions from the underlying investments.  It is not just the long-term average returns that impact financial health, but it is the timing of returns.  For example, let’s say you have a $100,000 investment and you lose 50% in year one but in subsequent years you gain 25, 25, 25 and then 10% respectively.  If you are drawing income from that investment, the loss in year one is much more damaging than it would be if the loss was sustained in year five.  Managing this risk becomes critical to one’s retirement system.

Another risk is market risk. Market risk is the potential for losses due to broader economic conditions, both domestically and internationally.  A market crash can crush an investment’s performance, even if the quality of that investment remains the same.

On the other hand, default risk is risk related to the quality of an investment.  This risk gets magnified if we are investing in a single company, whether it be stocks or bonds.  Think of General Motors in 2008 and 2009.  No one ever thought that the bell-weather of the car industry would go under.  But that is exactly what happened. GM filed for bankruptcy on June 1, 2009, and all the existing equity owners and bondholders got crushed.

Inflation Risk is Sam’s biggest risk.  Inflation Risk is the risk that inflation will erode purchasing power of an investment if the nominal return of that investment does not at least equal the inflation rate.  I explained to Sam that inflation runs somewhere between 3-5% a year over time. So leaving money in investments such as CDs or high yield savings accounts that pay virtually no interest really is not “risk-free.”  In fact, this strategy practically guarantees a loss in purchasing power over the long term due to the rising cost of goods.  The math works like this, if inflation is at 3% and you are earning 1%, then your loss is 2% per year.  

But what is even more troubling than the Inflation Risk that Sam is absorbing, is the rate at which Sam is withdrawing income.  As mentioned above, Sam has $500,000 earning virtually no interest and he is pulling out $25,000 a year.  If Sam lives more than 20 years, he is out of money.  Sam will only be 80 years old when that happens, pretty young by today’s standards.

So, what should Sam do?  Sam needs to reduce his inflation risk and take on slightly more market risk with limited Drawdown.  We explained to Sam that Drawdown, the amount by which a portfolio declines from its peak to its lowest value, before attaining a new peak, is one of the truer measures of risk related to an investment strategy. 

Jen and I finished our meeting with Sam explaining investment strategies that focus on minimizing Drawdowns, which subsequently lowers volatility.  By focusing on strategies that use risk adjusted rates of return that can help to lower volatility, he likely will experience higher rates of return than he would with all of his money in CDs.  At the same time, he should experience less Drawdown than he would with an outdated, retail Buy and Hold strategy.  

Sam now understands risk.  He also now understands how to manage it by implementing an investment strategy that incorporates risk adjusted rates of returns designed specifically for his distribution or retirement years.  This should allow him a much greater probability of retirement financial success.

Folks, do you understand your risk?  If not . . . why not.

Be vigilant and stay alert, because you deserve more.  

All of us at Cutter Financial Group hope that you had a wonderful and safe July 4^th. Have a great week!  

Jeff Cutter, CPA/PFS is President of Cutter Financial Group, LLC, an SEC 
Registered Investment Advisor with offices in Falmouth, Duxbury, Mansfield & Southlake, TX. Jeff can be reached at jeff@cutterfinancialgroup.com.

This article is intended to provide general information. It is not intended to offer or deliver investment advice in any way. Information regarding investment services is provided solely to gain a better understanding of the subject or the article. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy will be profitable. Market data and other cited or linked-to content in this article is based on generally-available information and is believed to be reliable. Cutter Financial does not guarantee the performance of any investment or the accuracy of the information contained in this article. Insurance instruments offered through CutterInsure, Inc.

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