Risky Business: Navigating Risk and Volatility in Investing and Retirement

Picture yourself at an amusement park, staring up at a towering roller coaster. The anticipation builds as you watch the cars climb to dizzying heights, only to plummet back down at breakneck speeds, twisting and turning along the way. In many people’s minds, this thrilling ride is a perfect analogy for the world of investing, where the terms "risk" and "volatility" are often used interchangeably, much like the ups and downs of a roller coaster. However, just as the height of the drops and the speed of the turns are not the same thing, risk and volatility in investing are related but distinct concepts. It is crucial to understand the difference between these two terms to make informed decisions and avoid the common pitfalls that arise from confusing them. It could reduce the worry that you experience with your investments and make your retirement more enjoyable.

Defining Risk and Volatility in Investing

When it comes to investing, the terms "risk" and "volatility" are often used interchangeably, leading to a common misconception that they are one and the same. However, while these concepts are related, they are not synonymous. Understanding the difference between risk and volatility is crucial for making informed investment decisions and achieving your long-term financial goals.

In the context of investing, risk refers to the possibility of losing money or not achieving the expected return on an investment. It encompasses various factors, such as market risk, credit risk, and liquidity risk, among others. Volatility, on the other hand, is a measure of how much an asset's price fluctuates over a given period. It is often used as a proxy for risk because higher volatility is typically associated with greater uncertainty and potential for loss.

The misconception that volatility equals risk can lead investors to make suboptimal decisions, such as avoiding investments that exhibit short-term price fluctuations, even if they have the potential for long-term growth. This is particularly relevant when considering the stock market, which is known for its short-term volatility. Many investors, especially those nearing retirement, may be tempted to avoid stocks altogether, believing that they are too risky. However, this approach fails to recognize the difference between short-term volatility and long-term risk.

As the chart above shows, while stocks can indeed be volatile in the short term, history has shown that they have the potential to deliver higher returns over the long run compared to other asset classes, such as bonds or cash. In fact, over extended periods, the stock market has consistently outperformed other investments, despite experiencing temporary downturns along the way. By focusing too much on short-term volatility, investors may miss out on the long-term growth potential of stocks and hinder their ability to build wealth over time.

Understanding the difference between short-term volatility and long-term risk is essential for creating a diversified investment portfolio that aligns with your financial goals and risk tolerance. While short-term volatility can be unsettling, it is important to maintain a long-term perspective and not let temporary market fluctuations derail a well-thought-out investment strategy. By embracing the potential for short-term volatility and focusing on the long-term growth prospects of your investments, you can position yourself for success and work towards achieving your cherished financial goals.

The Volatility of Stocks

Short-term volatility is a well-known phenomenon in the stock market. Stock prices can fluctuate significantly over short periods due to a variety of factors, including market sentiment, economic news, geopolitical events, and company-specific developments. These fluctuations can be driven by investors' emotions, such as fear or greed, leading to buying or selling frenzies that can cause stock prices to rise or fall sharply.

For example, a company's stock price may plummet in response to a disappointing earnings report or a negative news story, even if the company's long-term prospects remain solid. Similarly, a broader market downturn, such as the one experienced during the COVID-19 pandemic, can lead to widespread selling and significant short-term losses for investors.

However, it is crucial to recognize that short-term volatility does not necessarily equate to long-term risk. In fact, stocks have historically provided higher returns over extended periods than other asset classes, such as bonds or cash. This is because companies have the ability to grow their earnings over time, and as they become more profitable, their stock prices tend to rise. Additionally, many companies pay dividends to their shareholders, providing a steady stream of income that can help offset short-term price fluctuations.

Numerous studies have shown that stocks have outperformed other investments over the long term. For example, according to data from Ibbotson Associates, a leading authority on asset allocation, large-cap stocks have returned an average of 10% per year since 1926, while long-term government bonds have returned an average of 5.5% per year over the same period. This difference in returns can significantly impact an investor's wealth over time, as the power of compounding allows stock market gains to accumulate and grow exponentially.

Of course, this does not mean that you should ignore short-term volatility entirely. It is important to have a well-diversified portfolio that includes a mix of stocks and other assets, as this can help smooth out the ups and downs of the market and provide a more stable return over time. Additionally, you should consider your individual risk tolerance and investment timeline when making decisions about your portfolio allocation. However, for long-term investors who are able to weather short-term market fluctuations, stocks can be a powerful tool for building wealth and achieving your financial goals.

The Risk of Bonds

While bonds are often touted as a "safe" investment option, particularly for those nearing or in retirement, they come with their own set of risks that investors must consider. One of the most significant risks associated with bonds is their inability to keep pace with inflation over the long term. Bonds provide a fixed income stream, which means that the interest payments remain constant throughout the life of the bond. However, as the cost of living increases due to inflation, the purchasing power of that fixed income diminishes over time.

For example, let's say you purchase a 10-year bond with a face value of $10,000 and an annual interest rate of 3%. Each year, you will receive $300 in interest payments. While this may seem like a stable and predictable income stream, the problem arises when inflation is taken into account. If the inflation rate averages 2% per year over the 10-year period, the purchasing power of that $300 will be significantly eroded. In other words, the same $300 will buy fewer goods and services at the end of the 10 years than it did at the beginning.

This erosion of purchasing power can be particularly problematic for retirees who rely on their bond investments to cover living expenses. As the cost of healthcare, housing, and other necessities continue to rise, the fixed income provided by bonds may not be sufficient to maintain your desired standard of living in retirement. Over time, this can lead to a significant shortfall in retirement income, forcing you to make difficult choices about your spending and potentially compromising your financial security.

Furthermore, in a low-interest rate environment, such as the one we have experienced in recent years, the yields on bonds may not pay a meaningful amount of interest to fund your desired lifestyle in retirement. In some cases, you may be better off exploring other investment options, such as dividend-paying stocks or real estate investment trusts (REITs), which have the potential to provide income that grows over time and keeps pace with inflation.

Of course, this is not to say that bonds have no place in a well-diversified investment portfolio. Bonds can still play an important role in managing risk and providing stability, particularly during times of market volatility. However, you must be aware of the long-term risks associated with relying too heavily on fixed-income investments and take steps to mitigate those risks through diversification and careful planning. This may involve incorporating other asset classes into your portfolios, such as stocks and alternative investments, as well as regularly reviewing and adjusting your investment strategy to ensure that it remains aligned with your long-term financial goals.

The Greatest Risk in Retirement

When it comes to retirement planning, many investors focus on mitigating short-term volatility, often at the expense of considering the far greater risk: running out of money in retirement. While short-term market fluctuations can indeed be unsettling, they pale compared to the potential consequences of prematurely exhausting one's retirement savings. This risk is exacerbated by several factors, including inflation, longevity, rising cost of healthcare, and unexpected expenses, all of which can significantly impact a retiree's financial security.

Inflation, as discussed earlier, erodes the purchasing power of money over time. This means that even if you have a substantial nest egg, its value will gradually diminish as the cost of living increases. For example, assuming an average annual inflation rate of 3%, a retiree who requires $50,000 per year to cover their expenses would need approximately $90,000 per year in 20 years to maintain the same standard of living. Failing to account for inflation in retirement income planning can lead to a significant shortfall in retirement income, increasing the risk of running out of money.

Longevity risk is another factor that contributes to the possibility of outliving one's retirement savings. As medical advances continue to improve life expectancy, you must plan for the possibility of living well into your 80s, 90s, or even beyond. While a longer life is undoubtedly a blessing, it also means that retirement savings must stretch further than ever before. Retirees who underestimate their life expectancy may find themselves in a precarious financial situation in their later years, as their savings dwindle and their expenses continue to mount.

Moreover, unexpected expenses, such as healthcare costs or long-term care needs, can quickly deplete your savings. According to a 2021 report by Fidelity Investments, the average 65-year-old couple can expect to spend approximately $300,000 on healthcare expenses throughout their retirement, not including the cost of long-term care. These expenses can be difficult to predict and plan for, making it all the more important to have a robust and well-diversified retirement portfolio.

To mitigate the risk of running out of money in retirement, it is crucial to have a well-diversified portfolio that includes a mix of stocks and other asset classes. While stocks may be more volatile in the short term, they have historically provided the highest long-term returns, making them an essential component of a retirement portfolio. Bonds, despite their potential inflation risk, can still play a role in providing stability and income, particularly in the early years of retirement. Other asset classes, such as real estate, commodities, or alternative investments, can further diversify a portfolio and potentially enhance returns while managing risk. By carefully constructing a portfolio that balances growth, income, and stability, you can improve your chances of maintaining a comfortable standard of living throughout your retirement years.

However, the decision to delay claiming Social Security benefits should not be made in a vacuum. It's important to consider your overall retirement income strategy, including other sources of income such as pensions, savings, and investments. Consulting with a retirement income planning specialist can be invaluable in this process. A professional can help you evaluate your unique circumstances, including health status, life expectancy, and financial needs, to determine the optimal timing for claiming benefits. A personalized retirement income plan will give you confidence and peace of mind as you transition into this new phase of life.

Managing Retirement Risk as a Financial Advisor

At Tapparo Capital Management, our primary goal is to help clients manage the risk of running out of money in retirement. We understand that retirement planning is not just about accumulating wealth, but also about creating a comprehensive strategy to ensure that your money lasts as long as you do. As a financial advisor, I work closely with clients to develop personalized retirement income plans that take into account their unique goals, risk tolerance, and financial situation.

One of the key strategies we employ is managing portfolio withdrawals. We help clients determine a sustainable withdrawal rate that balances their income needs with the long-term growth potential of their investments. By carefully monitoring portfolio performance and adjusting withdrawal rates as needed, we can help ensure that clients' retirement savings last throughout their lifetime. Additionally, we emphasize the importance of maintaining a well-diversified portfolio that includes a mix of stocks and other asset classes, as this can help mitigate risk and provide a more stable income stream over time.

Another critical aspect of our approach is ongoing financial planning and review. We regularly meet with clients to assess their progress toward their retirement goals, discuss any changes in their financial situation, and make adjustments to their plans as needed. This proactive approach allows us to identify potential risks early on and take corrective action before they become significant problems. By staying engaged with our clients and providing ongoing guidance and support, we can help them navigate the complexities of retirement planning with confidence.

At Tapparo Capital Management, we are committed to helping our clients achieve a secure and comfortable retirement. We understand that the greatest risk in retirement is not short-term market volatility, but rather the possibility of outliving one's savings. That's why we work tirelessly to create comprehensive retirement income plans that are designed to stand the test of time. Our goal is to give our clients the peace of mind that comes from knowing that their money will be there for them, no matter what challenges they may face in retirement. With our expertise, guidance, and unwavering commitment to our clients' success, we can help ensure that their retirement years are filled with financial security and the freedom to enjoy all that life has to offer.

About Andy

Andrew Tapparo is a fee-only financial advisor at Tapparo Capital Management, a financial planning firm in Topsfield, MA, helping clients turn their savings into a retirement income that lasts. Inspired by the quote, “Choose a job you love, and you will never work a day in your life”, Andy founded Tapparo Capital Management in 1997 with a passion for helping clients enjoy a truly worry-free and fulfilling retirement and experience financial freedom. As a Retirement Income Certified Professional (RICP?), he designs retirement strategies along with sound money management to help clients retire with confidence.

Andy holds a Bachelor of Science in Industrial Engineering from Rochester Institute of Technology in Rochester, New York, and a Master of Science in Finance from Bentley University in Waltham, Massachusetts. Specializing in retirement income planning, Andy completed a comprehensive financial industry education program at The American College of Financial Services and was awarded the Retirement Income Certified Professional? designation. He is frequently quoted in the media as a financial expert.

Andy and his wife, Susan, live in Topsfield, Massachusetts, and have two beautiful daughters. Outside of work, he is an automobile enthusiast, enjoys taking road trips, and loves the Outer Banks of North Carolina. In his spare time, he volunteers with the local high school varsity girl’s basketball team as the team statistician and runs the team’s website. He is passionate about supporting charities that serve our veterans and their families. To learn more about Andy, connect with him on?LinkedIn.