If you’re like most people, investing in stocks during your working years offers one of your best opportunities for growing a nest egg large enough for a comfortable retirement. And when retirement is still years away, any volatility that comes from stock ownership can be waited out by patiently holding a diversified portfolio.
For most of your life, the advice to ignore short-term market fluctuations and continue investing for retirement is great advice. But when you retire, every withdrawal reduces the amount of money you have to recover with. If you have a $500,000 portfolio, for example, and withdraw $50,000 per year, with no gains or losses, you have enough money for 10 years. If you have the same portfolio and lose 20% the first year, however, then you only have enough for 8 years (assuming no more gains or losses). Of course, markets have a history of recovering over time. But because you’ve withdrawn $50,000 after taking a 20% hit, a market recovery will provide gains on $350,000 rather than $400,000. The math only gets grimmer for bigger losses or losses in more than one year.
The chance that the market will dip just before you need to start making withdrawals is known as sequence of return risk. And it’s why investors often reduce their stock exposure as retirement approaches to reduce volatility and prevent a major downturn from wiping out needed capital.
Should Stocks be Avoided Altogether in Retirement?
As you may have noticed in the example above, even 10 years of income isn’t necessarily a very comfortable retirement plan.
There are two major difficulties in retirement planning. One is the uncertainty surrounding any individual’s lifespan, and the other is the difficulty in having enough money in the first place. In the example above, if you knew for sure you would only live 9 or 10 years, then your best option would be to not invest at all and put your entire nest egg in insured savings accounts.
Unfortunately, no one knows exactly how long to plan for in retirement. Continuing to invest in a diversified portfolio that includes stocks, albeit a more conservative one than pre-retirement, is one way some investors allow their retirement funds to continue to grow and support a longer retirement. Because retirement funds are withdrawn incrementally, a 15 or 20 year retirement may be enough time to let the market swings of a well-designed portfolio to work themselves out.
The key is to match your need for growth to the right amount of safety, which is why even in retirement you need to keep reviewing your investment portfolio to provide the right ratio of risk and reward.