Investment Basics: Drawdown Risks
The last couple of weeks we’ve been doing an article series on the different types of investment risk and why it’s important to be aware of them. Our first article covered the risk of losing money, while our second article discussed the risk of inflation. This week we’ll be diving into something called drawdown risk or maximum drawdown. In financial terms, drawdown risk is measured by how long it takes for a fund to recoup its losses, but for our purposes, we’ll be looking at drawdown risk as the risk that you will draw down your portfolio during a downturn giving it less of a base to recover from.
For younger investors who are in the accumulation phase, drawdown risk is almost non-existent (unless of course, you are in need of funds for a large purchase such as a home or educational expenses in the near future). This is because younger investors are usually contributing money to their portfolio such that when a downturn occurs, instead of pulling funds from their portfolio, they’re actually contributing funds. This actually turns out to be a really great play for accumulating investors because it allows them to get in at a low point, if they’re making contributions during the downturn, and take advantage of the upside when the fund or market recovers. For retirees, however, drawdown risk is a big deal. This is because retirees are in the “decumulation” phase. For most retirees, they rely on their monthly draw regardless of what the market is doing. If the market drops 10%, they still need to buy food and pay their monthly bills, forcing them to sell out at a low point. As they continue to “draw down” their funds, they leave less and less of a base for their portfolio to recover from as the market recovers. For some retirees, this can be a make it or break it scenario in retirement. That’s why this risk is so incredibly important for retired investors to be aware of. Luckily, there are a couple things you can do to counter this risk.
The first thing you should do is to try to plan your unusual large expenses around the market. The best time to pull extra money out is when the market is at a high, but it’s not a great idea to do a home remodel or buy a new car when the market has hit a low point. If you can, try to spend less when the market has taken a dip and save those extra expenses until the market has had a chance to recover. Secondly, unless a large portion of your living expenses is provided by fixed sources (such as pension payments and social security), it’s a good idea not to invest your portfolio aggressively. The more you rely on your portfolio to live off of, the less you can afford for it to take huge dips. In addition to your emotional tolerance for risk, your situational tolerance for risk should play a huge role in determining how you invest your retirement savings.
If you’d like to speak with one of our expert advisors about relevant risks to your situation, or would like a complimentary financial plan done, please give us a call. We’re always happy to help.