14% Gains with 60% Short Term Losses: Is Chasing Market Returns Worth the Risk in Retirement?
Several years ago, I had a gentleman call into the radio show that I do here in Houston. Done it for a very long time, and he schedules a visit to come in and see us, and in the first few minutes of sitting down, he tells me, “Troy, I think I’ve made the biggest mistake of my entire life. I don’t know if I have enough. I’m afraid I’m going to run out of income. I’m not sure my spouse will be okay if something happens to me. I want you and your team to look at my situation, tell me if I’m going to be okay, and tell me, did I make the biggest mistake of my life?”
I had to ask, “What is the mistake that you made, of course?” He said, “Troy, I sold all my stocks at the bottom. Everything was going down, and I just couldn’t stand to stay invested anymore. I was losing too much money. Now the market started to go back up, and I’m afraid to get invested because what if it goes down?” He didn’t like the politics, didn’t feel great about the economy. The news was still bad, and he said, “Troy, I’m paralyzed. I really have no idea of what to do.”
In between the first and the second visit, what we do is we do an analysis, exactly what he was asking for with standard. We do that for everyone. When he came back in, we said, “Look, you’re still in a pretty good position here.” Many of you have seen these probability meters that we run on the Monte Carlo simulations, and he was still coming in at around 85% or so. He was still in pretty good shape.
Now, the mistake that he made was not necessarily that he sold at the bottom. The mistake that he made was that his portfolio was far too aggressive for his willingness to stay committed when things go south. One thing that we know, and history proves time and time again, that markets eventually go down. Once you leave the accumulation phase and you enter the distribution phase, psychologically, there’s a shift that takes place. Once the income stops coming in, and then all of a sudden, you start spending your life savings, all of a sudden, the returns that you earn become magnified, whether they’re gains or losses, because they’re far more consequential on how long your portfolio will last.
What I want to do is recreate that situation and show you what we call congruence, or in this particular case, a lack of congruence, between his willingness to stay invested and what the portfolio hypothetically looked like. We’re going to recreate it. It’s not going to be exact, but it’s an educational video. I want to show you what that possibly could look like, what the potential ups and downs are, and then how that ties into an overall retirement income and investment strategy.
Sadly, he never became a client, and I’ve never spoken to him again since. After we went through the entire process, he simply looked me in the eye and he said, “Troy, I’m just too scared to get back invested.” Hopefully, things turned out well. As I said, this was several years ago. I want this story to hopefully resonate with you so you don’t make the same mistakes.
Portfolio Risk Scores and How They Are Determined By Historical Data
Before I get into an analysis of these hypothetical portfolios, I want to walk you through one of the steps that we take on a first visit to help understand your willingness to stay committed to an investment strategy. You’ve all heard, are you high-risk, medium-risk, or low-risk? We found over the years that that’s not a good enough question. There needs to be a deeper dive, because if 10 people tell me they’re medium risk, some of them may only be willing to lose 5% or 10%, and others 20%, 25%, or maybe even 30%. It’s not concise enough.
We need to be more clear when it comes to your willingness to stay committed when a recession hits or some type of unexpected event causes the markets to catastrophically drop. This is also going to set the stage for comparing a portfolio that’s too aggressive versus something that’s more moderate and more in line with someone’s comfort level or willingness to stay invested.
We have many conversations that dive deep into your comfort level with risk, because that’s a critical part of building a successful retirement plan that you can stay committed to. We have this tool that we’re going to walk through with you now, as well as some other tools that we use. Holistically, we bring them all together, combine it with our experience, and help you identify the correct portfolio that you can stay committed to based on all of that information that we gather.
Now, with this particular tool, you can actually do your own self-assessment to identify your very own risk score. I hit the Get Started button, and now we’re just going to point out our goals. This part isn’t tremendously important, because from our end, of course, we have it documented in many other places. We’ll go through the exercise.
Sample Portfolio With a $1 Million Allocation to Highlight Risk Scores and Potential Outcomes
Any notes if you wanted to enter here, of course. We’re going to look at a $1 million portfolio. For this exercise, if you are retired, I want you to think back to when you very first retired and those paychecks stopped and you started to distribute from your savings. If you’re not retired yet, if you can, try to put yourself into that mindset. No more paychecks. Everything you’ve worked your entire life for, now you have to start to draw down and spend while also, obviously, keeping it invested, hoping to generate some positive returns.
We’re going to start with this $1 million example. We’ll just assume age 60. We can skip through that for now. Okay, so what we’re starting to get into here, this is a symmetrical risk versus reward, the very first question. From this point, we’re going to start to get into some asymmetrical decisions. Now, very simple here. Those are big words. All it means is symmetrical is, are we willing to risk $140,000 to gain $140,000? It’s symmetrical. Minus 14%, plus 14%. Important to note that this is over the next six months.
I’m going to do this as the typical person who comes in to see us that’s entering retirement, is soon to enter retirement, or maybe been retired for a few years. Typically, what we’re going to hear is, “No, Troy, this is way too much risk for me over a six-month period.” All we’re going to do here is slide this down. Then we’re going to start to have a conversation.
The way I like to frame this is, are you starting to lose sleep at night? If you have $1 million, and I like to focus on the downside, if you have $1 million, and over the next six months, it’s down to $920,000, roughly, are you starting to lose sleep at night? What we don’t want to do is for our brain to override our gut, because when we get into these particular situations, it’s your gut that most likely is going to cause you to make some rash decisions, not the brain.
What I tell people is, what is your first instinct? When you see this number, what is your first reaction? Don’t spend 5 seconds, 20 seconds, 2 minutes thinking about it. That’s hard for many of our clients, because here in Houston, probably half or more of our clients are engineers. I’ve spent probably 30 minutes on just a couple of these questions with some of them before. Your first initial reaction is what’s most important, I believe.
We’re going to say, you know what? 8% at 16% over the course of 12 months, we’re going to leave it there. Go to the next question. Okay, so now we’re starting to get into some asymmetrical risk versus return. This was our original choice here, so risk 80 to win 80. That’s the symmetry. Now, if we could improve this, would we rather have less risk for the same potential return? Would we rather have the same level of risk, but we’d rather have much higher returns? You can see what the questionnaire is starting to do here. It’s starting to help identify what’s more important to you. Is it reduced risk, or is it increased return? I’m going to say less risk.
Okay, now it’s going to tweak it just a little bit. Here was our original choice. Here was the one we just chose. Now it’s saying, okay, it’s clear that the trend has been established, which direction that the answers are going? Do we want to take even less risk for less return, or are we pretty comfortable here? I’m going to say we’re pretty comfortable right here.
One more question. This was the one that we just chose. Now it’s just asking, okay, well, what if we brought this down a little bit and not so much over here? Minus 4 for plus 6, or minus 5 for plus 8? We’re saying, you know what, I’m pretty comfortable with this last choice here that was the second one that I made. This now helps to identify your risk score. If this doesn’t feel like you, we can simply go back and do it again.
What this means is, based on the answers, over a six-month period, most likely, you would be comfortable losing no more than about 5%, or over a 12-month period, about 10%. Let’s round up to $50,000 over a six-month period, or $100,000 over a 12-month period. If that does sound like the range that your gut is telling you, the outer range of your comfort level, then this is probably a pretty accurate number for you. If you say, “You know what, Troy, actually I feel a little bit low, I’m a little bit more comfortable with some more risk.” Okay, we just simply try again. Pretty straightforward.
Two big takeaways there. First, you can see how that conversation would go over a 5, 10, 15-minute period, where we’re really starting to dive into your comfort level with seeing your portfolio drop. The one thing that we have to ask you to accept is that markets go up over time. We believe that. In the short term, markets can be very volatile. If you have a more aggressive portfolio, then your willingness to stick through it, you have a lack of congruence there. From our experience, that often leads to rash decisions, like you selling at the bottom when your portfolio loses more money than your comfort level.
I’m going to come back to that second point that I wanted to make, because once I go through the portfolio risk score versus your risk score, which is what I’m going to do right now, the second point I want to make, which may not be so obvious at first viewing of that risk score that we just went through, I want to make that after we go through this next part of the video. I believe that’ll make more sense for you.
Okay, so this is something that we would do after a first visit with a prospective client, or something that we do on an ongoing basis with existing clients. What I do is I created this portfolio. Very simple. It’s $1 million. It’s half NVIDIA, half the S&P 500, the SPY. It has a risk score of 92. This is what we call your portfolio risk score.
Now, most times people are going to have a lot more positions inside the portfolio than just two. We’ve seen this though before, because someone will come in and say, “Troy, NVIDIA is up 200% over the past several years. Why would I want to sell it?” This is a good example of when a stock does really, really well, or a group of stocks do really, really well, how your risk could potentially increase over time. Now, we don’t have any bonds in this particular account because they would become a smaller portion of the overall portfolio. Point being, I just want to point out aggressive portfolio and what that portfolio risk score looks like.
Now, I’ve clicked over to the analytics tab for that portfolio, 50% NVIDIA, 50% SPY. What this is telling us is based on the real-world performance of both of those securities combined together, this is a probability of a likely outcome within a 95% historical range over a six-month period. That means this portfolio, $1 million, historically could lose $293,000 over a six-month period, or almost $600,000 over the course of a year, 60%. Also look, when things are going really, really well, it could make $439,000 over a six-month period and over $800,000 over a 12-month period.
The Importance of Stress Testing Portfolios
When we stress test this, and we can now look to see how that particular portfolio would have performed, or did perform, I should say, in various past market instances. Here for 2008 bear market, happened again, we’re looking at abut 50% loss of that portfolio, the S&P was down 36%. That’s January 1 of ’08 to December 31 of ’08. The financial crisis, which was a bit longer period from October ’07 to March of ’09, this portfolio would have been down 72% versus the S&P being down 53% in that timeframe.
Now, the 2013 bull market, 41% for this portfolio versus 32% for the S&P. We have an interest rate spike happening again, not going to impact the S&P 500 or NVIDIA that much. If we had bonds in here, this would be where we would see probably a bigger impact. You can see here, the AGG, the aggregate bond index was down about 5% during that timeframe.
The pandemic, 46% from February to March. Look at that, that’s about 33 days or so, 32 days, 46% with this portfolio. Then 2022, of course, was a really bad year in the market, 25% from January to December. Intra-year, this portfolio, the SPY and the NVIDIA would have been down, I believe it’s two and a half times that roughly, I think it’s about 60%, 65%. It rebounded towards the second half of 2022.
Okay, so now I want to recap because we’ve looked at two very important steps in determining what we call step one of the retirement success plan, but identifying your comfort level with risk or your risk willingness, and then the actual analysis of your portfolio, and are they congruent or are they incongruent?
What I’ve done now is created a proposed portfolio. It’s not based on the risk score that we looked earlier. That was just a hypothetical example to walk through and show you the deep dive of some of the questions and how we really ascertain what your comfort level with risk is, or at least one component of that process of identifying your willingness to stay committed to an investment strategy. Now, I want to show you the comparison between that aggressive portfolio and something that’s going to be more in line with a common risk willingness that we see working with thousands of people over the course of time.
Here, we have a hypothetical portfolio that was constructed simply based on a common risk willingness number that we often see here for working with people in retirement or approaching retirement. 50, anywhere from 40 to 60 is going to be a very common risk score that we see. Of course, that changes over time when the markets are doing really well. When we have conversations, people tend to be a little bit more aggressive. Of course, when things are going bad, a lot of times, we see people like to lower their risk score. That’s we’re really having that conversation and having you either rethink getting more aggressive or rethink getting too conservative at the wrong time.
That’s a lot of what the conversation is like on an ongoing basis. This is fairly common, what we’ll see around a 51. Just to put some securities to it, so we have $400,000 in the Vanguard total bond market, the QQQs, the NASDAQ, $300,000, and then the SPY, which is the S&P 500, $300,000. About a 60-40 portfolio.
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Bond Types, Risk Scores, and Why Bonds Are Often Misunderstood in Portfolios
Bonds are one of the most misunderstood type of security in portfolios. When we have conversations with people, most people really don’t understand the bond market or the various types of bonds. Some of these bond funds could very easily be $35, $40, $45, $50, $60 on a risk score, and some of them could be much, much, much lower, around $1, $2, or $5. This is just the Vanguard total bond market, just randomly selected, so I can do this educational video about these hypothetical portfolios.
This comes into a risk score of 51. Now, if we look at the analytics here, over a six-month period, historically, with a 95% probability, $97,000 is what would fall in. We call it two standard deviations from the mean, or two standard deviations from the average returns expected of that given portfolio. There is a chance. This is not guaranteed. It’s important to point that out. There is a 5% historical probability that your returns will fall outside of this range over a six-month period.
COVID, typically, the pandemic, that would be a really good example of when things fell outside of their probability range. This then leads to the discussion of, is this more in line with your comfort zone? Is this still too much? Then we start tinkering with the portfolios to bring them in line with your willingness to stay committed to a plan. We stress test this portfolio, which is always important, and I think it’s going to maybe open up some eyes here.
We look to see the 2008 bear market, so 18%, not too bad. The financial crisis, 28%. This is your 60-40 typical portfolio that we might see. The 2013 bull market, 16%, almost 17%. Almost flat if we have the interest rate spike from May to September of 2013. Then in the pandemic, minus 19%, and then the 2022 inflation crash, minus 17%. The number underneath that, of course, was just the S&P 500’s return for those various instances.
I want to point out one thing. We actually can see just the pure S&P 500 here. Its risk number is 73 compared to this 60-40 portfolio here is a risk score of 51. Now, again, not all 60-40s are a risk score of 51. I want to make sure that that point is emphasized because there are tons of different types of bonds that you can choose from to comprise what that 40% allocation to bonds looks like. That number can absolutely change depending on that decision. Every single security, publicly traded security, its past returns can be quantified along with its past volatility to identify some type of mathematical output to help us understand how risky a particular security is.
I think more importantly, when you combine various securities together, like ingredients in a recipe, their correlation with one another, so historically, how do some go up and some go down together? If so, that typically reduces risk. Do we have a portfolio that’s very similar in its historical volatility patterns, where this security goes up and this security goes up, and they both go down at the same time? Theoretically, that can increase your risk because you don’t really have any offsetting movements there.
Any combination of publicly traded securities, as long as they have a history, and of course, any individual security, all of this can be quantified. The most important thing that I really want you to take away from this video is risk is not necessarily bad. If you have a 92 or a 98 portfolio, that doesn’t mean it’s bad. I believe it’s only bad when your willingness to stay committed to that plan or that portfolio is so different than how much risk you actually have.
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How to Avoid the Pitfalls of Fear-driven Investing
What happens, and I’ve seen this way too often over the course of my career, market goes down, portfolio’s too aggressive, someone fires their advisor, they come in to work with us, we go through the statements, we look at it, we go through this risk willingness exercise, we run their portfolio that they had through the portfolio risk score, and as clear as day, the portfolio was an 82 and their risk score was a 49.
It’s virtually guaranteed that when the market goes down, that person is going to panic. They’re going to sell probably near the bottom because that just tends to be what happens because it starts to hit that pain threshold, you can’t hold on anymore. Typically, when that pain threshold is hit, that’s usually when the stock market, at least it seems, usually starts to go in the other direction.
The problem, just to add on to this, is when you do sell at the bottom or somewhere near the bottom, that’s not necessarily what gets you. What oftentimes gets you is the fear of having to make that decision to get back in. Once you’ve hit your pain threshold to the bottom and you’ve capitulated, now you have to make a decision of when you get back in. The fear is what drove that decision, and 99% of the times, it is. Fear is not going to subside over the next one, two, three months. You’ve lost so much money, it hurts, it’s painful, it damages your psyche, and the news is typically still bad. The economic reports are typically still bad. The stock market is a forward-looking mechanism.
Historically, the stock market is going to start to rebound and perform better when it believes 9 months from now, 12 months from now, 18 months from now, that things are going to be better. That’s when big money, institutions, everyone starts piling in to buy low. Meanwhile, the average retail person who’s sold, they’re struck with so much fear by the time they actually feel more comfortable to get back in. The news reports and the economic numbers are better. The big money’s already profited on the way up, and typically, it’s too late to get back in.
That’s the damage. That’s what can happen to you and why we want to make sure that there’s congruence between how much risk you actually have in your portfolio and your willingness to stay committed to that investment plan. This is why we call it the Retirement Success Plan here at Oak Harvest, because by utilizing some of these tools to help us ascertain your comfort level of taking risk and how your portfolio is actually constructed. Then I think just as important is, over time, as those two variables change, we can stay connected to the portfolio and help you stay in congruence with the portfolio risk score and also your risk score.
Click here to perform your own self-assessment on your willingness to take risk. I believe you can even do your portfolio. Thank you for tuning in this video, and we look forward to seeing you again soon.
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