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Piershale: Protecting money from sequence of return risk

Knowledgeable investors are aware investing in the stock market presents a number of risks. There’s interest rate risk, company risk, market risk and even purchasing power risk.

Risk is just part of investing. Some types of investment risk, such as specific company risk or market risk, can be reduced through diversification, sometimes loosely referred to as not putting all your eggs in one basket.

Risk also can be reduced through a more tactical approach where you use an exit strategy based on good research to get out of the stock market if the risk gets too high.

As an investor, you face another lesser-known risk where not even diversification has provided a consistent track record of protecting your money. This is a risk of investing your money at the wrong time, resulting in the depletion of your assets.

We call this the sequence of return risk. It refers to the unpredictability of the order of returns an investor will receive over an extended period of time.

For example, the stock market, as measured by the S&P 500, has averaged about 10 percent growth per year over the past 100 years. It’s normal to think the market will deliver this historical average return over the long term.

However, you never can know when you will be receiving the positive years and when you’ll be receiving the negative years that make up that average return, and the order in which you receive these returns can make a huge difference.

In the stock market crash of 2008, from the top to the bottom, the market fell 57 percent as measured by the S&P 500. Let’s assume you were unlucky enough to invest $1 million at the top of this market in October 2007 and you needed to generate 5 percent income ($50,000) per year.

The problem you would have ran into is that when your $1 million got to the bottom of that market crash in March 2009, it was worth $432,000, assuming you hadn’t started your withdrawals.

To keep the math simple, let’s assume you didn’t need to take your first $50,000 withdrawal until March 2009.

Taking $50,000 off $432,000 is not a 5 percent withdrawal rate anymore. It is now an 11.5 percent withdrawal rate, greatly increasing the risk of running out of money. This illustrates how important timing is.

The sequence of return risk creates huge hazards if you are in retirement and, especially, if you are taking income on a stock portfolio.

More tactical approaches historically have helped to avoid this hazard. This is sometimes known as buy, hold and sell. With this approach, you still invest in stocks and bonds. However, you have a disciplined exit strategy not based on fear or emotion but on solid research to get out of the stock market when the risk gets too high.

If the research you’re using is good, it will greatly increase the probability of avoiding major stock market declines.

• Mike Piershale, ChFC, is president of Piershale Financial Group. Send any financial questions you wish to have answered in this column to Piershale Financial Group Inc., 407 Congress Parkway, Crystal Lake, IL 60014. Email them to mike.piershale@piershalefinancial.com.

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