Many investors regard risk and volatility as “one-and-the-same,” but they are two different animals. Losing one’s principal investment is the risk most average investors fear, but many other risks must be considered before just parking funds in “safe” investments. Risks such as inflation (a daily news topic the prior few years), liquidity, credit, interest rate, business, market, and regulatory risk can be just as damaging to a person’s retirement savings and financial endgame.
Good investment strategies acknowledge these risks based on an investor’s time horizon (When is the money needed?), risk tolerance (Can you sleep soundly with your current portfolio?), and risk capacity (Will you be able to keep your standard of living if things go south?).
Volatility can represent a risk depending on where investors are in their financial journey, but really it simply represents how smooth or bumpy the investor’s journey is. Market volatility itself is not inherently bad, but its impact depends on the context and the perspective of the investor.
For someone in the accumulation phase of finance who is actively saving, volatility is a welcome opportunity to buy positions at potentially lower prices, a strategy known as dollar cost averaging. This investor’s time horizon for these funds is longer and can withstand the ups and downs of funds that are not currently needed.
For those in the distribution phase of finance, volatility can certainly have a negative impact on their financial journey and needs to be managed accordingly. The order in which returns occur will significantly impact the longevity of a portfolio. High volatility can lead to periods of negative returns in your life after work, which can deplete a portfolio faster when combined with regular withdrawals. This is known as “sequence of returns risk.” We like to refer to this as the evil twin of dollar cost averaging.
Beware of focusing on the average rate of return as you distribute money. Dollars removed for lifestyle are no longer in the market to see any potential recovery. A smoother journey in distribution negates withdrawing funds in depressed markets.
So how can we help smooth the journey for investors ready to start using their hard-earned dollars?
1. Diversification: Maintaining a well-diversified portfolio can help reduce the impact of volatility by spreading risk across different asset classes. This includes your standard players such as stocks, bonds, and cash, but also can include alternative investments such as real estate, private equity, and credit.
2. Bucket Strategy: This involves segmenting investments into different “buckets” based on when the funds will be needed. Short-term buckets that you will use for living expenses can hold more stable, liquid assets to cover immediate needs, while longer-term buckets for later retirement and future gifting or inheritance can potentially hold more volatile assets that have time to recover.
3. Dynamic Withdrawal Strategies: Adjusting withdrawal rates based on market performance can help preserve the portfolio during downturns. For example, reducing withdrawals during bad market years can help maintain the portfolio’s longevity. We like this strategy less, as we believe a properly bucketed and diversified strategy can help us weather storms long enough to avoid making these changes.
In short, wise investors will carefully consider critical factors as they traverse their financial journey. Risk and volatility, fees and expenses, taxes both today and tomorrow, and real return represent what we at the Financial Enhancement Group call the Fiduciary Focus. If you are not working with a fiduciary, make sure these key factors are constantly top of mind as you consider investment decisions.
Financial Enhancement Group is an SEC Registered Investment Advisor.
