Where to Find Them and How to Eliminate Them
All financial portfolios have at least some amount of risk inherent. As an example, even though a basket of CDs won’t technically lose their value in a falling stock market, they can reduce your future purchasing power. This is due in large part to their extremely low rate of return.
Likewise, CDs and bonds, as well as annuities and life insurance, all typically include early withdrawal or surrender penalties if you access some or all of the funds in the account prior to a certain time period.
But, while these risks are easy to detect, what about those that can’t be seen as easily? Worse yet, what if you notice the risk after it is too late?
What Risk Is and Isn’t
Risk – at least as it pertains to the financial world – is defined as being “the possibility of losing money on an investment or business venture. Some of the more common and distinct financial risks can include credit risk, liquidity risk, and operational risk.”
Risks to your portfolio – and in turn, to your future retirement income – can include:
- Stock market volatility
- Low interest rates
- Early withdrawal/surrender penalties
While investors and financial advisors alike work to reduce these dangers, there are some other areas that could also creep up on you. So, they need to be considered when designing your short and long-term financial plan.
Sequence of Returns Risk
One common “hidden” financial risk is the sequence, or order, of returns. This has to do with WHEN you actually attain certain positive or negative returns. For instance, even though two investors may have the same “average” return on their investments, one could run out of money much sooner than the other.
As an example, if two investors start out with $100,000 a piece, and they both withdraw 9% from their portfolio per year, how is it that Investor #1 runs out of money six years before Investor #2?
The reason is because Investor #1 received the negative 13 percent a year earlier than Investor #2 did. Because of that, it was enough to deplete his funds far earlier than Investor #2 runs out. With that in mind, the timing of your returns can often be just as important, if not more so, than the amount of your average return.
Sequence of Returns
|Year 1||Year 2||Year 3||Ave. Return||Years Until Depleted|
Source: Government Accountability Office, June 2011.
Another financial risk – often referred to as shortfall risk – can occur if you don’t have enough money to reach your goals. Shortfall risk may be caused in a variety of ways, such as by being too aggressive or too conservative with your investing.
Special Situation Risk
Special situation risk is more of a specialized danger that pertains to individuals, based on your own unique financial goals. For example, many parents opt to set aside money for their children’s college education. Doing that, however, can lead to you having less money saved for your own retirement.
You’ve likely heard financial advisors warning investors that they can’t time the market – and they are correct! But in this case, timing risk has more to do with your own personal needs and goals.
One example of timing risk is the likelihood of stocks producing a positive return over the next 20 years. But if you need to withdraw your money in the next two years, you could face a loss of your principal.
Longevity Risk/The Risk of Living “Too Long”
Living longer life spans today has also become a common financial risk. One reason for this is because assets – and the income that is produced from them – need to be stretched out much further than they did in the past.
In addition, living longer can also mean that your portfolio is subject to all of the other financial risks for a longer period of time. These include market volatility, inflation, sequence of returns, and low interest rates.
How Should You Protect Your Portfolio?
Everyone’s situation is different – and because of that, there is no single strategy that is best for all investors across the board. Therefore, the best way to protect your portfolio is to discuss your situation, time frame, and objectives with a financial professional.
At Annuity Gator, our mission is to educate consumers and financial professionals on the various ways that principal can be protected, and income can be generated using annuities. If you would like to determine whether or not an annuity is right for you, feel free to contact us at (888) 440-2468, or via email through our secure online contact form. We look forward to hearing from you.