Baby Boomers Seriously Underestimating Investment Risk

Downside Investment Risk Seriously Underestimated

The Report “Tail Risk: About 5x Worse Than You May Think” is a realistic assessment of the frequency and depth of the downside investment risk based on actual results. It discusses the actual frequency and size of a loss vs. expected loss on returns on the S&P 500 over 50 years from 1960 to 2010. Tail Risk is the risk of large losses.

I read an article in a John Maudlin “Outside the Box” newsletter entitled, “Confessions of an Investor”. As I read it I kept nodding my head in agreement with what was being said. It isn’t that I am really smart about this. It is because I have always been uneasy about marketing hype surrounding the investment “story” and about the minimising of investment risk.

It is said you make money on the slow escalator up and lose it in the fast lift down. Picture yourself in the lift going down 5.3x faster and further than your financial planner told you to expect long term and you’d be about right. That’s downside investment risk feeling when it happens. Butterflies anyone Disappointed smile

Investment Risk 5x Worse Than You May Think

It’s about getting stuck in the lift 5.3 times more than the financial wallies tell you, you should be. And being in “free fall” in the lift through far more floors than expected too.

5.3x More Likley to experience Investment losses than expected

If the chart is to be believed then what they are saying is there is no way to predict what will happen, when it will happen, how frequently it will happen and how bad it will be.

That statement tells me there is a good case for taking a really big interest in your portfolio and trying to find ways to minimise the downside risk. Don’t leave it to your financial adviser steeped in the Modern Portfolio Theory, or it may not be there when you need it.

The report does talk about this. But it is financial-speak and if you are to consider it, an appointment with your financial adviser is recommended. Shifty

You can get lucky depending when you were born

Even given this increased risk, Niels Jensen writes in the “Confession of an Investor” that, “your birthday determines your ability to retire in relative prosperity”. He has included some charts in his article going from 1952 to 2000 to show this would have been the case.

The End of Modern Portfolio Theory Maybe?

He goes on to state the case against Markowitz’s Modern Portfolio Theory. It is well worth reading this section alone so you are prepared when your financial advisor tries to tell you different. Like Climate Change whether your are a sceptic or believer is irrelevant if you are a cautious person. Such a person might want to take some precautions either way. A sort of belts and braces to protect your retirement nest egg against the downside investment risk if you will.

Tail Risk explains the Serious Investment Risk Problem

To me this is perhaps the take-away paragraph for Baby Boomers near or in retirement,

“Looking back over 50-years of data stretching back to 1960 through June 2010, our analysis suggests that the average investor encountered severe rolling quarterly losses 5.3x more frequently on average than they would have expected. Viewed over the course of an average decade, investors would have expected about 6.5 such tail events, whereas actual S&P 500 performance consisted of 34. These results suggest that the average investor, or the software code embedded within their asset allocation software, may be harboring
unrealistically favorable expectations about the true nature of equity market tail risk probability
.”

The underlining is mine. Over a ten year period instead of an expected 6.5 events entailing a large loss, there were 34. I wanted to emphasise the last two sentences. Seriously, it could be the death sentence for your retirement nest egg. Can you recall your financial advisor telling you to expect 7-9% returns on average, as far as the eye can see?

If you had my experience in my first and only year to November 2007 in a fund manager, my return was zero, zilch, nada, nothing. What does that do to those flawed average returns these guys talk about? It completely screws them up. But if you were unlucky and took the financial crisis head on with your MPT investment, then you lost big-time. If your returns that year were –10%, or –20%, or –50% what will that do to your averages.

Your financial planner will talk in terms of percentages. They will try to mitigate the losses which you now know based on actual results may be up to 5.3x what he told you they might be. See my post yesterday on my friend’s portfolio, “Baby Boomers Retirement Nest Egg Saga”.

You must make them talk to you in terms of dollars left. Its the dollars that do the work to recover your losses. Its the dollars that you take out to live on. Its the dollars your financial adviser takes out in fees. It’s the dollars our governments inflate to reduce their purchasing power.

Losing 20% of a $1Mn portfolio doesn’t sound too bad. It is actually $200,000 in real dollars  that has gone down the gurgler, which may represent several years of investing.  You were going to live off that money for maybe four years. So where does that leave you?

My friend is still down 30% on the risk-based assets and though I think he is fine as he has other investments, it has made him ultra-cautious, to the point of not wanting to spend any of his retirement money, in case it happens again. This is not the way it was meant to be after a lifetime of saving and investing for reitrement.

It is well worth taking the time to read both the article and the report and printing them off to take along on your next meeting with your financial advisor. And being aware of  Tail Risk and how it relates to investment risk may help you protect your nest egg in future.

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