The word risk gets thrown around quite a bit by the financial planning industry. Usually they like to talk about risk in terms of diversifying your ownership of assets [in practical terms they are really encouraging you to buy mutual funds]. They like to mention those companies that imploded, like Enron or Global Crossing or AIG to scare folks into buying what they want them to [ironically mutual funds that probably owned all three of those companies].
But there are more critical risks to your retirement goals than some outlying companies that acted fraudulently or at least recklessly. How many of those financial planner types have talked to you specifically about sequence of return risk? Do you even know what that is?
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Sequence of Return Risk
The order in which your investment returns occur.
I hesitate to even call it a risk, because I think of a risk as something that might occur, but probably won’t. To further define SOR, I think it is the risk that a large loss of value will occur within 5 years before or after a planned retirement. If you are investing in an equity or a mixed mutual fund that risk is greater than 90%, or you have a greater than 90% chance of a large loss [greater than 25%]of value during that 10 year time period.
If you are an institution, that risk doesn’t matter as your plan as an institution is to never need to use the institutions endowment. Same with pension funds, which are able to predict payouts using actuarial tables. However, the individual is a different story. Most individuals plan on using those investments to produce retirement income. They don’t have decades to make up for bad market years. Once they start taking income, then they will never have a chance to make up for bad market years with the money they used. So for the individual, bad market years as they approach retirement or in early retirement are a double whammy, which can and will devastate even the most successful saver’s retirement. So I repeat, historic evidence points out to a 90% chance of this occurring.
Financial planners came up with a fix, that they call asset allocation. Really, all they suggest is that you move money from equities and the large variation of return you get from them to other assets like bonds which have lower increases and decreases as you age. The so-called 100 rule where you subtract your age from 100 and invest that percentage in equities. But, what they don’t tell you is that decreases your expected returns significantly. So the equities market might return 10% over a lifetime, but the bond market doesn’t resulting in lower overall returns. And even this idea doesn’t fix sequence of return risk, only dampens the effect.
So, perhaps the majority of folks saving for retirement in the US, are heading straight for that brick wall at 100MPH.
Related: The Truth about RISK
How to AVOID Sequence of Return Risk
Let me tell you a little secret I discovered that led me to sell all my mutual funds. It’s not the total value of your assets that is important, it is how much annual income you can generate that is critical in retirement.
You need to invest in ways that secure the income and forget about what the assets are worth on a year to year basis. For those of you on here who invest in real estate, you are on the bus to a fruitful retirement. Growth of your real estate value is inconsequential to the real metric which is how much cash flow your real estate is throwing off. [Flipping houses is an entirely different model and does not eliminate sequence of return risk]
There are two other ways that complement your real estate investing:
1. Study and become an expert in equities that pay dividends. There are some companies that have paid dividends at an increasing rate for decades. Investing in these large companies can give you an income stream that grows every year. I have an opportunity to meet someone who was a Coca-Cola millionaire when I was 19 years old. His father had bought stock in Coke back in the 1930s. He was raking in several hundred thousand dollars a year [as was his siblings]in dividends in the 1980s all from an investment of less than $4,000. There were folks just like him all over south Georgia. The point is you don’t sell the companies, just spend the dividends which means the change of value in the short term [10 years or less] wouldn’t effect your retirement income.
2. EIUL: By eliminating losses in your cash account you minimize sequence of return risk and can take out as income a higher percentage of your account value. You also realize higher average returns because you eliminate those negative years.
Proper financial planning must include dealing with sequence of return risk. Eliminate as much of that risk as you can as it will destroy your bountiful retirement.