An old joke says that if you keep one foot on a hot stove and your other foot in an ice bucket, on average you should be comfortable.
That line always makes me smile. It underscores a reality in the world of markets and investing—averages can be both mathematically accurate and experientially awful.
Case in point? Lucky Lenny. He retired in 1973 with a cool $1,000,000 in assets. His good fortune increased the night he got a visit from an economic angel who informed him, “The stock market is going to average a 10% return over the next twenty years.”
Thrilled with this news, Lenny bought a new leisure suit and a puka bead shell necklace and started planning a luxurious future. He reasoned, ”I’ll withdraw $80,000 a year from my account. After all, if the market is going to average a 10% gain, withdrawing only 8% annually will leave room for growth.”
That angel wasn’t lying. The stock market did average a return of slightly more than 10% over the ensuing 20 years.
But something else happened too. Lenny ran out of money fifteen years into his retirement! To make ends meet he found himself working as a greeter for a new company called Wal-Mart, which was opening stores in small towns all over the south.
How could this have happened? If the markets averaged a 10% return per year, how did Lenny run out of money?
Lenny learned the painful lesson that too many retirees learn too late: averages are not actual.
Even a well-known celebrity financial expert glosses over this reality. He’s fond of telling his millions of radio listeners that “a good mutual fund averages 12% per year, so if you put your money in one of those and take out no more than 8%, you’ll be fine.”
He and Lenny both need to get acquainted with an investing concept known as the “sequence of returns” risk.
Think of the sequence of returns risk the same way a pilot thinks about turbulence. When you are already flying low to the ground, a turbulent shock can cause a devastating crash.
Here’s how market turbulence got poor Lenny. Yes, over the twenty years following 1973, the stock market averaged a slightly better than a 10% return. But along the way, there were annual returns as high as 37% and as low as negative 26%. And that negative 26% year came on the heels of a negative 14% year!
This is why, when the stock market drops, you often hear, “Sit tight. Don’t do anything. It’ll bounce back.” However, if, like Lenny, you continue withdrawing big sums of money from your account for living expenses, that money won’t be there to “bounce back.” You will have locked in that loss forever.
So what to do? Market history suggests that when you’re a long way away from retirement it’s good to tilt your investment accounts and retirement accounts heavily towards stocks. As you near retirement (certainly within five years) it’s wise to tap the brakes so that you don’t suffer a nasty surprise at the very end of your career.
The best solution? Don’t do what Lenny did and treat your investment portfolio like a checking account. Instead, put those assets to work generating a predictable amount of retirement income for you. That’s how to worry less (about money) and live more (of the kind of life you want to live in retirement).
If you aren’t sure how to make that happen, I’d be glad to assist. Every day I help individuals and couples get on the road to a better financial future. In fact, if you’d like to see the “Financial Freedom Roadmap” I use with clients, email me at email@example.com. I’ll send you my new e-book “How to Put Money Worries in Your Rear View Mirror” for free.
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