Understanding the Risks of Wall Street Investing
As individuals, we have little to no control over the investments made with our money on Wall Street. That said, when we do have the opportunity, wouldn't we like to make the best choices and decisions as to how it is invested?
Understanding that there's no such thing as a perfect investment, I think you'd agree that it's only prudent to learn about some fundamental strategies to improve your odds of winning on Wall Street. Let's consider three key concepts: drawdown, decumulation and sequence of withdrawal.
Drawdown is the historical loss of an investment that's calculated by subtracting that investment's lowest value from its highest value over a market cycle. (It's important to note that the recovery from drawdown isn't linear, which is why the average rate of return of an investment can be markedly different from the real rate of return.)
As the definition states, recovering from a loss isn't linear -- it's exponential. So if I lose 50 percent and then earn 50 percent, I am not whole. I need to earn 2 x 50 percent, or 100 percent, to make up for a 50 percent loss.
The other thing that's important to note is why it's more reasonable to accept more risk when you're younger. With more time to recover, your returns can be much smaller but will still grow your investments. For instance, let's say you were about to retire in 2008 and the market crashed. You could have lost 50 percent of your retirement nest egg right before you planned to access that money. Many people did find themselves in that exact situation and had to postpone their retirement as a result, hoping the market would recover in the next five years and the value of their accounts would be restored. But, that would take a 20 percent return every year for each of those five years. Do you know how many times the stock market earned 20 percent for five years in a row? Never! What if you don't have time? What if you're going to retire and need to spend down your nest egg?
To illustrate the reality of the stock market, Wall Street uses the expression "No tree grows to the sky," meaning the stock market doesn't go up forever. Eventually, it goes down, referred to as a "correction," and what that means is you lose money. Drawdown has a profound impact on earnings. The problem is only exacerbated if you make withdrawals. This situation is referred to as "decumulation."
Decumulation is a condition whereby investment withdrawals occur while, simultaneously, the principal remains invested. Therefore, as withdrawals are made, there's still potential for ongoing gains. There's also the risk of ongoing losses.
Decumulation is what every retiree faces with their retirement nest egg. After all, one has to take some risk. With no risk, there are no earnings, no rate of return. We need to invest with Wall Street. It's almost impossible to avoid it. Yet, even modest losses at the wrong time can blow up a retirement plan completely over a short period time.
Can I paint a bleaker picture? Of course I can. Let's talk about one last concept: the "sequence of withdrawal" risk.
Sequence of Withdrawal Risk
If an investment isn't protected from losses while withdrawals are made during a down market, that investment is subjected to profound negative effects, which are exacerbated by those withdrawals. If one takes withdrawals and simultaneously experiences serious losses, then there's very little chance of recovery and the investment will likely be depleted entirely over a relatively short period. That's the sequence of withdrawal risk.
The solution to this problem is simple. Simply, never choose to retire immediately prior to a market downturn. As long as you can predict the future accurately, then you can avoid the sequence of withdrawal risk altogether.
But, unless you're a fortune-teller, there's no way you can correctly predict just what will happen in the market. So now you're probably asking yourself, "What the heck should I do about investing in Wall Street?"
- Be smart and do your homework. Understand the true risks involved with your investment options.
- Be realistic and understand that there's no such thing as the perfect investment.
- Plan ahead, creating a long-term financial plan to better understand your financial needs and the time horizon you face.
- Do something, because doing nothing will guarantee failure. Get involved, learn and be willing to take an appropriate amount of risk.