Many people have told me over the years that they find the financial world far too complex. After attending the recent Lions-Chiefs game, I would argue that it’s easier to understand the financial world and all its lingo, than it is to understand what the National Football League considers a catch.
So I’d like to simplify some of the mathematical aspects of investing. Since the Great Recession of 2008, many investors have realized some pretty good returns on their investments. As a result of their more sizable nest eggs, many have elected to retire.
Based on demographics, it’s estimated that, over the next two decades, about 10,000 people will be retiring every day. That’s a whole lot of people who will be changing their financial mindset from accumulation to distribution.
After being in the savings mode for most of their lives, many people will struggle with this adjustment. In retirement, mathematics dictates that investors need to exercise extreme caution during the distribution phase of their lives. After all, they don’t want to re-enter the workforce because they made a poor financial decision after they retired.
When I make a financial presentation to a group, I often ask, if an investor loses 20 percent on an investment, what return would be needed to get back to even?
The most common response is 20 percent, which of course, is wrong. If an investment dropped by 20 percent, you need to earn 25 percent to recoup the loss. Climbing up the ladder after a fall is much more difficult than climbing from level ground.
And it could be worse. Suppose you determined you needed to supplement retirement income by tapping into your nest egg and withdrawing five percent per year.
What happens if, during the year you withdraw 5 percent, your investment value declines 10 percent? Mathematically, you now have a significant hurdle to get back to even. Using a technical phrase, your investment was just hit by a “double whammy.” To get back to even from the total of minus 15 percent you need an uptick of 17.6 percent. Not impossible, but certainly challenging.
My intent is not to frighten investors, but in this volatile world and based on history, a 20 percent market decline is never out of the question. And if that 20 percent drop were to happen in conjunction with a five percent annual withdrawal, you’d need just over a thirty three percent return to get back to square one. Much more than the 25 percent required without a withdrawal.
This is where nerves and emotions come into play and when investors tend to make mistakes. But the mathematics of loss dictates that people need to be mentally and financially prepared for a downturn, especially during their retirement years.
Retirees should be able to put themselves in a position to receive reliable and predictable income regardless of the market’s direction.
Investment firms offer a number of programs, but they tend to be somewhat complicated and require proper research and due diligence. At the end of the day, I think it’s worth the time to become well educated in the mathematics of investing.
It may be complex, but I think it’s probably a bit easier than studying to become a referee in the National Football League.