In the recent weeks we’ve seen the tumultuous return of stock market volatility. In might be causing panic, but it’s important to keep things in perspective. While they’re a nuisance, Hurricanes to begin forming in the Atlantic at the end of every summer in the United States. In fact, it’s been happening for a long time – at least since about the year 830, when a presumed Category 4 or 5 hurricane struck Alabama. The same goes for stock market volatility – it’s been happening forever, and now it’s back.
What Does It Mean For Me?
Your stage in life and taste for investments will dictate what it means for you. For our purposes here and now, I want to focus on what it means for the individual that depends on their investments for income. Not that there isn’t any opportunity for you to take advantage of savers – but skip this article, because it’s more important for your parents.
What Goes Down
Walter has a retirement account worth about $100,000, and decides to start using it. He’s saved all these years, why not? He does some research, talks to some friends, and decides that he’s comfortable taking $5,000 per year, or about 5%. (Don’t nod off just yet, these numbers matter.) One year later, he’s satisfied (not thrilled) with his decision: he’s taken five thousand dollars as income as planned, and managed to maintain his principal investment of $100,000. Not bad, he thinks. He fancies himself a good stock picker and congratulates himself.
Two years after retirement, Walter nearly has a panic attack when he checks his account online. His account has plummeted to $60,000 including withdrawals. He remembers hearing on the news that the stock market dropped. He decides to stay the course knowing that the media blowing things out of proportion probably has something to do with this.
Did Walter make the right decision?
Let’s look at Jean, who, like Walter, wanted $5,000 per year from a $100,000 account, beginning at the exact same time he did. Unlike Walker, she decides to split her investments: one half, or $50,000, will be invested in a stock market portfolio, and the other half, $50,000, will be invested in an account that is guaranteed (either by an insurance company or the FDIC) not to lose principal, no matter what. As a trade-off for taking less risk, her “guaranteed” account earns a low interest rate. She decides she won’t touch this account unless the stock market does really bad, and will take her $5,000 from the stocks only.
Okay, let’s recap Jean’s situation: she has a guaranteed account worth $50,000, and a stock account worth $50,000. For the next year, her income comes from the stock account only. At the end of the year, her stock account is worth $48,000, and her guaranteed account is worth $51,500, for a grand total of $98,500.
I know what you’re thinking – in this situation, I’d rather be Walter, $1,500 richer. But the story’s not over, and I’m about to tell you why there’s a serious flaw in that thinking that can spell disaster for any retirement plan.
When the stock market course corrects, Jean decides to switch at the end of the year to let her stock account recover. She’s not happy that the stock market has done serious damage to her account, but this was her plan all along. She leaves her stock account (now worth $28,800) alone and starts drawing her $5,000 from her guaranteed account (now worth over $53,000.)
Recovering from the Storm
It’s much easier to rebuild the city that had planned for an emergency than one that didn’t. Recovering a loss on investments is no different.
When we last left Walter, his investments were squashed, leaving him with $60,000. He’s excited that his misfortunes have turned around when he hears the market recovered by an astonishing 50%. Great! He logs on to check his account balance and feels his heart sink into his stomach.
His balance? $82,500.
What a disaster! He thinks to himself, proceeding to blame (insert unrelated external force/politician.) I’ve taken $10,000 from this account and now it’s only come back to $82,500. I’ll never make back what I lost!
And you know what? He’s probably right.
Let’s revisit Jean, who decided to go the much wiser route of splitting her investments between stocks and a guaranteed account. The stock market recovery is welcome news to her too. A 50% surge has pulled her account all the way back up to just over $43,000. Her guaranteed account is now worth about $49,500, putting her at $92,500. Still less? Factor in the $10,000 she took in income, and Jean is now the one in the black.
Walter took a gamble. He decided that he was prepared to take on the risk of loss without doing the math. Because the market had a negative year early on his retirement, his account balance didn’t balloon like he had expected it to. And it cost him.
How about Jean? By splitting up her investments, the pull back in the stock market didn’t affect her nearly as much as it affected Walter. Did she still suffer from some loss when the market abruptly about-faced? Sure. But the net loss in her stocks after the recovery was only 4%. Compare that to Walter’s 17.5%. Not bad, Jean.
The Bottom Line
This isn’t just a case for diversification. It’s a case for understanding how having a retirement income plan can (and likely will) make a difference to retirees. And with interest rates on the rebound, there’s a stronger case than in the last 10 years for including some guarantees in your income strategy.