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Why you should risk manage your nest egg

By Bruno Giordano, MBA, CFP

Everywhere I turn I see and hear the same type of expression over and over: “Invest for the long term”, “Buy and hold”, “Stay the course”, etc.

That may be (note I said may) well and good for an individual in the accumulation phase of his/her life but I believe it is entirely inappropriate for an individual nearing retirement, or in retirement, that depends on income in the range of 5% to 7% or more, from a lump sum to augment a retired lifestyle.

Why do I make such a bold statement? Because I don’t know what the future holds. Not only that, but I’ve been around long enough not to trust averages.

Virtually every financial planner and investment advisor I know and am aware of, and certainly all the TV talking heads and pornographic financial magazines tout the assertion that withholding 7% per year adjusted for inflation can be safely achieved without disturbing inflation adjusted principal.

They base this on the fact that, from 1972-1996, the S&P 500 averaged about 13% per year, while inflation averaged about 6% per year.

They say that, if the lump sum grows at 13% and you withdraw 7%, the remaining 6% will cause the lump sum to grow by 6%. Therefore, when you take out 7% the next year, it will be from a lump sum that’s 6% larger, and therefore you have kept up with inflation.

Since I can’t predict the future, I decided to rely on the past to test this assertion. I assumed our hero retired in 1972.

I further decided to give our retiring hero $1 million invested in the S&P 500 index with a withdrawal of 7% per year or $70,000 per year to augment a retired life style.

Not only did I do that, but I was bold enough to use actual results on a year-by-year basis instead of averages.

He was dead broke in 13 years!!!

Why? Because I used actual numbers, not averages. The back-to-back double digit losses in the S&P 500 in 1973-1974, combined with the high inflation of the late 1970’s, diminished our hero’s lump sum while at the same time increasing the amount to be withdrawn at a rate greater than 6%.

In other words, he was taking an ever increasing amount from an ever decreasing sum. Shesanoworka!

Well, you say, what if he diversified his portfolio with some Government and Corporate Bonds. Great! Then our hero’s assets lasted for 14 years!

In summary, if you are dependent on your lump sum in retirement to augment lifestyle, then you absolutely, unequivocably cannot afford to lose large amounts of money!

Who knows what the future holds? Why take the chance of another bad stretch like we had from 1966-1982?

Many people think that the key to successful investing is to spend time finding and investing in the top performing stocks or mutual funds. Since to become the top performing fund or stock there had to be a sharp run-up in share price, this pattern assures that they buy most heavily at above-average prices, which mathematically guarantees below-average returns. Carried to its logical conclusion, a sharp run-up in share price normally will be followed by a lagging in price and or a market correction. At that point, the investor, having bought a great record only after it had been amassed, panics out at or near previous lows. Having bought high, he sells low.

Here are some interesting facts:

Stocks recommended the most by newsletters since 1980 did not out-perform the Wilshire 5000.

Stocks that were most popular, seriously under performed the neglected stocks 16% versus 9%.

Investors who at the start of 1993 purchased the 100 stock funds with the best records over the last 10 years would have under performed a portfolio consisting of the 100 funds with the worst 10 year performance.

The same exercise for each of the last six years produced the same result. Buying funds that had five year track records among the top quartile of the investment universe, produced inferior results to buying those funds ranked in the bottom quartile.

In each of the prior four years, equity funds that had been awarded MorningStar’s five star rating under-performed their respective asset class’ average return over the ensuing 12 months.

In order to procure investment not investor returns one must be the record not buy the record.

To set matters straight, I’m not a proponent of the buy and hold philosophy. The market is replete with examples of severe corrections, crashes, losing years and prolonged secular Bear Markets, emphasis on prolonged and secular. Benjamin Graham, the father of value investing, when referring to his investment philosophy, said it the best when he said, “Rule #1: Don’t Lose Money. Rule #2: Never Forget Rule #1.”

Can you imagine working your entire life to build your nest egg and then, just after retiring and investing in a “properly diversified portfolio,” watching it plunge 30% to 70% like it would have in the 1973-1974 Bear Market? No way! The average investor will sell near the bottom, suffer a huge loss, and reinvest in “guaranteed” issues and be guaranteed of having inflation slowly devour the purchasing power of their remaining assets over time.

Don’t just dismiss that past thought. Be honest with yourself: if you had $1,000,000 in the market today and it was down 40% and still falling, would you stick with it? Did you just tell yourself that that couldn’t or wouldn’t happen again? Don’t forget the Japanese Stock Market is down 60% since 1989 and holding.

How can an investor avoid the potential disaster of exposing herself to enormous downside risk inherent to the market, and still earn investment returns? Hello, “Risk Management.” The Risk Management investment creed is to earn near investment or market returns while reducing the risk. The intent is to avoid major loss, and if the investor does not experience major loss, she is much more likely to “stay the course and achieve investment returns.”

We are currently in the 17th year of a Bull Market, the longest sustained advance ever. It is interesting to note that two other similar Bull Markets that sustained themselves much longer than the average ended in the crashes of 1929 and 1987. Far be it from me to suggest that is what we have in store. The only true response has to be “we don’t know.”

If you recall, many investment pundits called for a Bear Market in 1997. If you had listened to them and got out you would have missed out on double digit returns (S&P 500 returned 31%). A risk manager rides a rising market and cuts his losses quickly on the down side, thereby avoiding major loss and reducing the propensity to “bail out” at the wrong time.

Please don’t tell me you won’t bail out. All you need do is check buying volume versus selling volume in 1974. That, plus my own personal experience over twenty years with many hundreds of investors, tells me that real people buy high and sell low!

Earn investment returns, avoid major loss and enhance your returns now by managing the risk in your equity portfolio. I say manage the risk by taking small losses quickly. If the market continues to be great…wonderful. If it goes bad, risk management can save the day.

Bruno A. Giordano, MBA, CFP, is president of Dorset Financial Services in Devon, Pa.

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