Lessons on Losses

#Lifestyle Wealth
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Hopefully the viral and economic concerns dominating our daily lives will soon recede, and the plummeting asset prices in March 2020 will eventually be nothing but a distant and unpleasant memory.

However, if/when the next wave of pandemic or financial destruction occurs, you can help protect your clients from a painful education in losses, via some instruction in these academic topics and truths.

History

The majority of the typical advisor’s ideal clients are “middle class millionaires” who are either retiring or retired, and in an age range of their late 50s to late 70s.

These baby boomer clients have benefitted from having a huge proverbial (and profitable) wind at their backs, in the form of a stock market that skyrocketed during most or all the years in which they were working, saving and investing.

For example, in January 1983, the Dow Jones Industrial Average (DJIA) was around 1,000, and these Boomers were between the ages of 19 and 39.

Most of them were entering the “adult” full time workforce for the first time, and once they had earned enough to eat, buy a car, and maybe a house, they started putting a portion of their paychecks into a relatively-new investment vehicle called a “401k”.

Over the next 37 years (1983 to 2020), the DJIA rose to over 29,000—an annualized rate of return of about 9.5%. At that rate, someone who started with nothing in 1983 in their 401k and contributed about $5,000 per year would have accumulated about $1.5 million 37 years later.

There were several scary market declines during that time frame, most notably in 1987, 1990, 2002, 2008 and 2020. But although those slides were usually steep and sudden, they were often so short-lived and V-shaped that if the clients didn’t open a newspaper or their account statements for the worst of the quarters, they might not have even been aware that the losses occurred.

The rise in stock prices over those decades was due in part to increased productivity, globalization and technological advances. But, a primary propulsion also came from interest rates that dropped from almost 15% on the 30-year Treasury bond, to barely over 1% right now.

That phenomenon is virtually impossible to repeat going forward, which may mean that Boomers are likely to endure not only much-lower stock returns in retirement than they received while working, but the declines may be steeper and/or longer-lasting.

Those drops could help those who are systematically adding savings to their portfolios, but they could destroy clients who are the “decumulation” phase of their lives.

Math

“Average” annual historical returns always sound nice and smooth, but the pain of actually seeing the lost dollars on the roller coaster’s downturn might make clients jump out before it turns back up again.

For instance, many (but fewer clients) advisors are aware that suffering a 50% loss means that you have to have a 100% gain just to get back to where you were before the loss.

Another illustrative example of what losses can do to overall returns is the “tortoise and hare” comparison.

Say you have a five year time frame, and two different hypothetical investment portfolios. Portfolio A (the tortoise) nets an annual return of 2% each and every year of the five years. Portfolio B (the hare) has a net annual return of 8% in four out of the five years, but in one of the five years loses 30% (the end result is the same regardless of which year this loss occurs).

After five years, the average annual return of the tortoise is 2%. $100,000 invested in this portfolio would be worth $110,408. The average annual return of the hare is -0.97%, and the ending value after five years is $95,234. And again, that amount is only available to those investors who hang on after the 30% decline, to ride up any subsequent increases.

Last, but certainly not least, say a client with a $1,000,000 portfolio experiences that 30% loss. He won’t say “Oh well, I still have $700,000!”. He is more likely to scream (at you), “OH MY GOD I LOST THREE HUNDRED THOUSAND DOLLARS!”

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Psychology

Even when clients are retiring by their own volition, it’s a very stressful time. The landmark Holmes-Rahe Life Stress Inventory study ranked “retirement from work” as the 10th most-stressful life event—more so than “pregnancy,” “major health problems of a family member” and “foreclosure of a mortgage”.

Losses are even harder to endure in the first year or two of retirement, when the client has just given up a healthy income and many benefits (such as health insurance) that the clients now have to pay for themselves.

The news surrounding those prospective investment losses won’t make the clients feel any better—unemployment rising, increasing defaults by borrowers, the relative reliability of Medicare and Social Security is jeopardized.

Besides, for better or worse, we are “linear” beings—when we see a chart with the line heading in one direction, we can easily convince ourselves that the line will continue in the same direction. If the line is going down, the clients might feel that the only thing that will stop the decline is when it hits the floor.

Kevin McKinley is principal/owner of McKinley Money LLC, an independent registered investment advisor. He is also the author of Make Your Kid a Millionaire (Simon & Schuster). 

https://www.wealthmanagement.com/retirement-planning/lessons-losses

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