Over the past 20 years, investing has changed a lot. Back in the 1980's, the biggest decisions investors had to make was whether to buy a 1 year GIC or a 5 year GIC. Double-digit interest rates were the norm and if you were retired, you could easily supplement your pensions and government benefits with interest on your GICs.
Today with much lower interest rates, investors are putting significant amounts of their portfolios into non-guaranteed investments like stocks, mutual funds and real estate. Let's face it, we are all motivated to earn decent return and generally the higher the return, the better. When GICs are paying less than 5%, it seems pretty obvious to look at other higher risk alternatives to enhance returns.
While investing in higher risk investments has become the norm, it is crucially important for retirees and those approaching retirement to be more conservative. It is pretty well known in the investment world that the older you get, the more conservative you should be. Let's look at three risks of having too much risk in your portfolio when you are older.
One of the advantages of guaranteed investments is their predictability. When you buy a 5 year GIC, not only do you know you will get your capital back but you can also calculate exactly how much interest you will earn. This predictability does not exist in the world of markets and mutual funds. You will never be able to consistently predict what markets will do, what return you will get and how much money you will have at any point in time.
In most cases, retirement planning is done using straight-line assumptions. For example you might assume your portfolio is going to get an average return of 7% over the long term. The problem is non-guaranteed investments never move in a straight line. Using oversimplified straight-line assumptions can be extremely dangerous for retirees drawing income from their investments because volatility can be very damaging to income portfolios.
Too much volatility
Markets today are more volatile than we have ever seen. 100-point swings or more are all too common. Volatility has caused a lot of problems for retirees over the past eight years. For example, I've seen many people delay retirement because of the markets. This was especially true from 2000 to 2002, which was one of the worst bear markets in history. It wasn't uncommon to see portfolios drop 25% to 50% during that painful time. The media and professionals urged everyone to hang in there because it would eventually come back up and in fact it did. That's great advice if you didn't need the money. But if you needed the money, that was a different story altogether.
Many retirees drawing income from their portfolios had to stop taking income or reduce withdrawals from their investments because withdrawal rates became too high. For example, if you have $100,000 and you are taking out 6% in income, you would get $6000 per year. But if the $100,000 dropped to $70,000 because of market volatility, continuing with the $6000 income means you are now taking out 8.6%. To make matters worse, the $6000 is all coming out of capital, which means you won't have as much money working for you when the markets do eventually come back. Cutting back the income on your investments may save the portfolio but it may also mean cutting back your lifestyle or even for some going back to work.
The bottom line
Retirement should be about living the best years of your life. To do so, it is better to have more predictability and control over your income. In many cases, it is necessary to diversify your portfolio into riskier investments but at the same time, be careful about taking too much risk when you are drawing income from your portfolio.