Retirement Planning? Volatility Isn’t Your Enemy

With a lot of talk about negative volatility in the media, it’s important not to forget the real risk in retirement planning.

With 2016 having seen its fair share of volatility, the personal-finance pages are chock-full of advice on how a new retiree should deal with what is often presumed to be the biggest risk they face: negative volatility early in retirement. However, this thinking views markets from an unbalanced perspective, and it ignores a big risk that can negatively affect the health of your portfolio late in your retirement years.

The idea that volatility is particularly trying early in retirement is tied to this line of thinking:

  1. You need to withdraw from your portfolio, because you are retired.
  2. Negative volatility means each withdrawal you take is a higher percentage of your assets, increasing the risk you will run out of money.
  3. Hence, there are a series of prescriptions--some ok and some awful--that the media will dole out to you for free, which mostly center on carrying a huge amount of cash, employing an odd strategy where you ratchet down equity exposure dramatically early in retirement and up it later--or even worse.

Much of the free advice and “logic” shared around this issue isn’t logical at all. It seems like an extreme case of myopic loss aversion—the human tendency to feel losses more than twice as much as we appreciate gains—being rationalized into a “strategy.”

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The trouble with this line of illogic is that it ignores why retirees own stocks in the first place: compound interest. A positive return earned early in your retirement is vastly more important to your long-run finances than a return earned late. If you presume early retirement is the time to dial back equity exposure, you disregard this truth. The simple fact is, volatility doesn’t know direction and often comes--irregularly--in bunches.

For the same reason, you must be extremely careful about target-date funds (those with names such as “Retirement 2020” or the like). These alleged set-it-and-forget-it options gradually dial back exposure to stocks over time. Some aim to slash stocks by retirement, while others gradually reduce stock exposure in retirement--and the difference is important. This trajectoryis called the fund’s glide path. A fund that dials down by retirement takes on a ton of longevity risk. Funds that reduce stock holdings throughout retirement take that risk, too, but not quite as much.

Volatility is clearly uncomfortable and can be even more so for a new retiree. And we thoroughly agree with the notion an investor is well served to have a plan for bear markets. For example, you should know what your expenses are and how you can reduce them if needed. You should have an emergency fund (though don’t get carried away by loading up on low-returning cash).

Taking radical action early in retirement risks your later years, presuming you have a long time horizon. A 60-year-old American in good health can expect to live at least 20 years in retirement—a conservative estimate would be even longer, considering nonagenarians (folks over 90) are the fastest-growing age demographic in America today. Over that long span of time, volatility doesn’t pose much of a threat. What does threaten your retirement is not earning a sufficient longer-term return to offset inflation’s impact and fund your later years. It may be bad to suffer through volatility early in retirement but, we’d argue it is much worse to suffer late in life from failing to earn a sufficient return early in retirement.

Equity markets’ higher returns are a result of volatility. It isn’t your enemy. As legendary investor Benjamin Graham put it, “The investor’s chief problem—and even his worst enemy—is likely to be himself.” Not volatility.

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