Hidden Dangers in your Portfolio: Creating a Risk Management Plan for Your Retirement

In today’s video, I want to go through what I call a hidden risk inside your portfolio, and it may not even be there yet. As a matter of fact, you may do nothing at all, make no changes to your portfolio, and then this hidden risk can all of a sudden show-up. Now, there are also various different considerations that need to be taken into account if you have IRA versus non-qualified money or non-IRA money, and also the impact that it could have on your security, whether you’re pre-retirement or post-retirement. We’re going to dive down, understand what this hidden risk is, and some of the considerations that you should look into to make decisions to lessen this risk.

Revisiting Risk Tolerance and Portfolio Congruence

The video we did last week looked at what could possibly happen when there’s a difference between your willingness to take risk and the actual risk that you have in your portfolio. It’s important to identify if there’s congruence there, meaning they’re in line, or if there’s some incongruence because that’s when people often get into trouble. That video looked at what we call step one of the retirement success plan.

When someone comes in to see us, one of the first things that we’re doing is we’re trying to identify if there’s incongruence between your willingness to take risk and the actual risk in your portfolio. This one we’re going to look at what happens when you make no changes at all, but over time, because of the success of the stocks inside your portfolio, that now you have a lot more risk in that portfolio, and this is why it’s hidden.

In that video, we had a hypothetical person here with a million dollars in the portfolio. Your standard 60-40, I just picked the QQQ here, the NASDAQ ETF, the SPY, the S&P 500 ETF, and then just a Vanguard Total Bond Market ETF. 400, three in three, so that’s a million bucks, 60-40, and what we see is this comes out to a risk score of about 51. When we look at the risk-reward here, now this is based on two standard deviations from the mean, which looks at the historical performance of the combination of these financial tools inside your portfolio, and looking at the real-world results over time.

Within a 95% probability, over a six-month period, you should expect to, 95% of the time, have a rate of return or have a range of outcome that is possibly almost down $100,000 to up about $181,000. Now this is 95% of the time, so it is important to understand that there is that 5%, the outlier of possibilities that could be outside that range of expected outcome.

The impact of inflation on future purchasing power

Now it’s important to point out that this is, again, over a six-month period, so that means over a 12-month period. If we extrapolate this out, that’s about $200,000 to the downside and about $360,000 to the upside. Those would be your guardrails, right? When we talk about your risk willingness and making sure there’s congruence with how much risk is actually in your portfolio, when we use the term guardrails, this is what we’re referring to.

Hypothetical Portfolio Analysis (Initial Parameters)

My question to you would be, is this a comfortable range for you to stay committed if we have a probable outcome within this range of expected return? If it’s not, that means the portfolio is probably too risky and we should make some adjustments. Again, there is that 5% that could fall outside the range of expected outcomes. When we go back and we look at the max drawdown of this portfolio–

This was back in ’07 to ’09, the financial crisis here, this 60-40, if we had these ETFs, over a 12-month period, we’re looking at about a 34% drawdown. That’s outside the range of expected outcome, but it is something that could possibly happen. Now historically, markets go up over time, and what tends to happen when markets go up is you get more risk inside your portfolio because the stocks tend to outperform the bonds.

We have that same portfolio here, but now it’s grown to 1.3 million. When we dive down into what the composition of that account looks like now– Again, this is just hypothetical. I’m trying to fast-forward a few years into the future and show you how this could impact your risk, and then there are considerations, of course, pre-retirement, if you’re getting close to that retirement date, and then again, post-retirement when you’re depending on this portfolio to generate income.

Now we have $500,000 in the NASDAQ, $500,000 in the S&P 500, that’s the equity portion that has grown, and $300,000 over here in the Vanguard bond market. This has come down a little bit, these have come up a little bit. Again, this is just for example purposes to show how over time growth in capital markets, the stock market, equity indexes, how they can increase the overall value of your portfolio to simultaneously increase the risk that you have.

Risks of Market Growth Without Rebalancing

When we look at the analytics here, now our 95% probable range of outcome based on historical performance of these indices and also the combination of them together in this percentage. Now, over a six-month period, we’re looking at possibly $160,000. You need to be comfortable with about $320,000 decline in value over a 12-month period with a 95% guardrail probability as far as expected outcome. That’s your lower-end guardrail.

Of course, risk versus reward now, but look at our upside. Because we have this much more risk in the portfolio, historically capital markets go up and they reward investors for risk. We’re looking at about $580,000 of potential upside over a one-year period. Now, the previous portfolio, it started out with $1 million, 60-40 stock bond, but a few years later, because the equities have grown and the bonds have actually gone down a little bit here, now we have much larger guardrails.

This is where rebalancing comes in. Not just rebalancing. Most importantly, you need to be able to identify that there is a possible need for rebalancing. It’s back to that same question. What is your risk willingness? Everyone likes to see the portfolio grow in value. We started with $1 million. Now we’re up to $1.3. But the biggest risk we often have in retirement is our own decision-making. When we have much larger guardrails, first, are we aware of it? We need to identify it.

Then secondly, are we comfortable with this, or do we need to make some changes to bring those guardrails back in to a place that we’re comfortable with? Because we should expect something on the lower end of this range to happen. As a matter of fact, when we look at the max drawdown now, we’re looking at minus 43%. That’s almost half. That’s almost half of that entire portfolio.

Whether we have the max drawdown scenario or maybe just $320,000 over a 12-month period because this $160,000 is over six months, is that something that you’re willing to stick with? Is that something that when you go to sleep at night, are you comfortable? Are you panicking? Are you afraid if the markets continue to go down further, are you going to want to sell and get out of everything? That’s when a lot of long-term damage occurs.

The Importance of Rebalancing

Now, most of you have watched a lot of the videos here on this channel, you’re familiar with the tax software that we use. You’re familiar with the probability of success software. This all ties together. We use all these different tools to help build a retirement plan that fits you, that’s custom to you, and what you’re trying to accomplish. The conversation, the way that goes is, okay, we’re going to help you identify this because we have someone overlooking all portfolios to see if they’re within the risk willingness.

If you come back here, this is a sample portfolio here. 52 is the risk willingness. That’s always what this big one is up here. That’s how much risk you’re willing to take. We have the ability to overlook all of our clients’ portfolios, and when someone’s portfolio gets to be a 60 and we see them, we can compare that high level to their risk willingness, an email goes out to the advisor and we reach out and have a conversation to let you know, hey, this is what’s going on. Do we need to make some adjustments? That’s important because that’s an internal control. That’s something that from a compliance perspective, we’re looking down to making sure that your portfolio is within the range of acceptable outcomes that we’ve had multiple discussions over time about.

Normally when someone starts out over here at a 51, we’ve put that in place because that’s within your risk willingness and the expected return of that portfolio is enough to accomplish the goals that you said are important to you. Once it gets out of whack, one of the conversations we like to have is, we have a couple of choices. One, we can just simply rebalance the more aggressive portfolio and include more bonds, more low-risk items.

Risk Management in Retirement

Something that we also like to do is to encourage you to spend the money. This is how when we’re connected to how much risk you actually have, understand your risk willingness, and then tie that into the retirement plan that has all your income and other goals, and we understand the probability of success. Now what we can look to do is say, “Okay, Mr. Client, we have this go-go income plan in place where we were going to spend an extra $25,000 a year for 10 years.”

We can plug it into that other software and say, “What happens if we bump that up to $40,000? Maybe you want to give more to the kids or to your grandkids, help out with the future, the college fund. Maybe you want to give more to the church or to your favorite charities. We can incorporate all of those things in there without increasing the risk of you running out of money”

We have multiple different risks in retirement. The one most people are concerned with is, do I have enough? Am I going to run out? One of the biggest risks that I see happen often isn’t a risk that you’re going to run out necessarily. It’s the risk that you don’t enjoy the money that you’ve saved your entire life, and you could have done things, created memories with your kids or grandkids that they’ll have with them way after you’re gone. Tying all these different pieces together is really important.

Integrated Retirement Planning

Back to the portfolio where the equity component has grown to a large amount beyond your risk willingness. If you remember from the original one, we started out 60-40 and we see these bonds are down because this is something that I often see over the years. Typically, when someone’s stocks are doing well, it’s not uncommon when they come in to see us for the first time and we see this and we do the risk analysis and we ask them because step two of the retirement success plan, of course, is income planning. Where are you drawing income from? Are you taking it from your IRAs, from your non-IRA accounts, assuming you’re in retirement?

A lot of times what we’ll hear is, Troy, the stocks have been doing really well so I’ve been taking it from my bonds. I’ve been taking it maybe from the dividends and also from the bonds. That’s another factor that could contribute to all of a sudden your portfolio becoming much more risky than you had originally thought because when you take income out of your portfolio, where you take it from matters. We usually talk about on this channel the impact of taxes, but now we’re focusing on the impact of risk.

From an academic standpoint, we should probably take 60% from the stocks, 40% from the bonds and we’ve rebalanced that portfolio and that’s academically sound, assuming your willingness to take risk is still in line with what that remaining portfolio looks like. In the real world, especially when we have someone come in for the first time, it’s rarely what’s happening, whether you’re doing it yourself or you’re working with another advisor. The big takeaway there is that your income withdrawals can impact how much risk you have in your portfolio depending on which investments you sell to generate that income.

Spending Strategies and Risk Willingness

The other component, what if you’re pre-retirement and not taking income out? Oftentimes what can happen is when this gets out of whack, the worst case scenario would be you’re six months from retirement, this big recession hits and then all of a sudden we get something on the lower end of this outcome or hopefully not something near this max drawdown, historically speaking, because now this is impacting your security. You’re probably going to continue to work. You’re going to have to put off the plans that you had with your family because a lot of times you’re just simply not going to retire.

Understanding this hidden risk, one, it’s just vitally important to understand that this can happen without you doing anything. We all like to see our accounts go up in value, but when that happens, typically the risk increases. If you’re pre-retirement, that brings other risks into the picture that maybe you’ll have to keep working. You won’t be able to retire when you were planning if something bad happens.

Then of course, if you’re in retirement and taking income distributions, then it can jeopardize your long-term security because when you have more risk, you don’t identify it, you don’t make adjustments, you have a bigger magnitude of potential loss and that of course is no bueno. Understand that you can spend the money, you can rebalance, but most importantly, we need to be connected to a retirement plan so we see how adjusting the portfolio, bringing the risk down, spending more money, extending that spending out over a series of years. How many years? How much can we spend? How does that impact our long-term security?

Everything I’m going through with you here is what I call visibility. This is why we use these different softwares. We have conversations. We go in-depth. Ultimately, you make the decisions, but we’re the CFO. Hopefully, this has been insightful. If you’re a client, this is what we’re doing for you on a daily basis. If you do it all yourself, hopefully this helps you make better decisions, but glad to share this with you and we look forward to seeing you on the next video.

➡️ Do you need a Retirement Success Plan that goes beyond allocating funds to truly fit your needs? We can help you create a retirement life plan customized for your retirement vision and legacy. Call us at (877) 404-0177 or fill out this form for a free consultation: https://click2retire.com/7-hidden-dangers