Friday, 15 June 2018 15:59

Risk Management: Part 3 Behavioral Risk and Sequence Risk

By Stephen Kyne, Partner, Sterling Manor Financial | Business

IN THE FIRST two installments of this piece we discussed Market Risk, Interest Rate Risk, Inflation Risk, and Longevity Risk. Riveting stuff, I know. Our final installment is going to include Behavioral Risk, and Sequence Risk, and how to help minimize them.

Behavioral Risk is the risk that you do the wrong thing with your portfolio at the wrong time, because you become motivated more by emotions than by logic.

We all know the phrase “buy low, sell high,” but very few individual investors have the discipline to actually follow through and implement on what they know to be a sound strategy. 

It’s often said that stocks are the one thing that nobody wants to buy on-sale. As professional investment advisors, we look at dips in the markets as incredible buying opportunities, whereas most individual investors view them as reasons to be afraid, and they let that fear of loss dictate their actions. 

Similarly, as professionals, when the fundamentals in the markets lead us to believe they may be overvalued, we use the opportunity to realize gains, and redeploy funds in areas of their market which may still have potential. Most individual investors get caught up chasing returns, and end up buying over-valued investments, only to ride them back down. 

The S&P has returned an average 11 percent/year, historically, whereas the average individual investor earns returns averaging about 4 percent, primarily because of their inability to separate their investments from their emotions.

Because almost all investors lack the ability to be objective about their own assets, the best way to help eliminate Behavior Risk is to hire a professional independent investment advisor who understands your goals and ability to accept market risk, but is removed enough to be able to advise you objectively and keep you from overextending in boom times or panicking during downturns. 

Sequence Risk is the risk that your investments are subject to a major downturn immediately prior to, or immediately after a major life change, like retirement. 

Imagine your investment portfolio decreased by 25 percent in the year prior to your retirement. You might be forced to decide to delay retirement until the value rebounded. In this instance, would you be willing to be invested aggressively enough to earn the 33 percent that would be required in order to attain the balance you had previously? 

A large decline prior to retirement sounds bad enough, but at least you’d have the option to work longer to recoup the loss. If a large decline happens just after retirement, you may not have that option. How will your ability to support yourself in retirement be affected?

Market downturns are inevitable. When you’re working and not depending on your assets to support your lifestyle, you may handle them differently. When you are retired, and depend on those assets, it may pay to be a bit more proactive, and put a plan in place to insulate your lifestyle.

Most retirees will find a great deal of comfort in having enough of their investments in cash and cash equivalents (CD, notes, etc) at all times to supplement their income and support their lifestyle while markets sort themselves out. 

Retirees will want to consider keeping 1-3 years’ worth of supplemental cash and cash equivalents available. This will help ensure that, when markets do inevitably adjust, they won’t have to sell positions in a down market to make ends meet. Knowing they are not affected by short-term movements in the markets will allow them to remain properly invested for the long term, which reduces their exposure to both Sequence and Behavioral risk. 

You should work with your independent financial advisor to create a plan to objectively manage your investments toward your individual goals, while protecting your cash flow in retirement from the ups and downs that come with the various economic cycles. Your advisor will tailor your plan to your needs, counsel you against making any knee-jerk changes in turbulent markets, and adjust the plan as your needs and the economy dictate.

Stephen Kyne is a Partner at Sterling Manor Financial in Saratoga Springs and Rhinebeck.

Securities offered through Cadaret, Grant & Co., Inc. Member FINRA/SIPC. Advisory services offered through Sterling Manor Financial, LLC, an SEC registered investment advisor or Cadaret Grant & Co., Inc. Sterling Manor Financial and Cadaret, Grant are separate entities.

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