After many years of working, saving and investing for the future, many households eventually arrive at a point where they have accumulated significant assets, both in terms of number and value. I am talking not just about real assets such as houses, property, vehicles, collectibles and more, but also financial assets including holdings in investment and retirement accounts like 401(k)s and 403(b)s.
For many people, especially those who are further along in their careers and nearing retirement, their financial holdings may represent their largest asset. For a good number of them, these assets are bigger than the equity value they have built up in their primary residence.
These assets are also the most at-risk from a loss in value. While individuals can insure property and belongings against loss (for example, home insurance protecting against loss from a fire), there really is no insurance available for financial holdings. At least not in the traditional sense.
What high net worth households can do is use risk-management strategies for their financial holdings that can help protect against losses, especially catastrophic losses. When framed as a kind of “insurance” for their largest asset, clients may be more willing to consider a risk management strategy for their retirement savings.
Where’s the Wealth?
We’ve all heard and read the stories about Americans’ retirement shortfall. For many individuals and households, the problem is real—the average 401(k) account balance in 2015 was just over $73,000, according to the Employee Benefit Research Institute, while the median balance was much lower at just under $17,000.
But those numbers are counting all 401(k) participants—from younger workers who just started saving for the future, to older workers who have been making contributions for years if not decades. In fact, the retirement savings picture is much different among older workers; for those in their 50s who have been working for more than 20 years, the average 401(k) balance in 2015 was over $223,000. That’s three times as much.
Perhaps more significantly, the value of these financial assets also exceeds the value many older people have in their homes, usually what many households consider their most valuable asset. According to Census Bureau, the median home equity value for people age 55-64 is just $97,000. In fact, it never rises above $130,000 for any age cohort, from age 35 to over age 75.
Of course, there will be wide variances in these figures among different clients, depending on age, region, occupation and a host of other factors. For some clients, it may be true that their home equity is more valuable than the cumulative value of their retirement investments, but the most important takeaway is this—people protect their homes against risk but do little to protect their financial assets from risk. And many people may not realize how big their financial assets are relative to their total wealth, and how much at-risk thesve assets are.
The “Worst” Risks
1. Bad investment menus
For clients with most of their assets in a 401(k) or 403(b) plan, their investment choices are often severely limited by the number of options included in the plan menu. This limitation can hamstring investors who want to protect their biggest asset against the risk of loss.
Perhaps the biggest risk in 401(k) and 403(b) investment menus is from correlation. This is the tendency for different asset classes to move in the same direction at the same time. When correlations among asset classes are high, any risk-management benefit from diversification is essentially nullified. This is what happened at the height of the financial crisis downturn in 2008, especially among equity funds—many asset classes experienced sharp losses, from the merely-bad 30% drop in small-caps to the catastrophic 55% fall in emerging market stocks. For many retirement plan investors, their plans’ limited menus left them with few if any places to hide to avoid these significant losses.
2. Bad investor behavior
Investors can unfortunately be their own worst enemy when it comes to investment decisions. Part of this is inherent in human nature—we are vulnerable to behavioral biases that cloud our judgement. That can lead us to take on more risk than we are truly comfortable with, or we may not even be aware of how much risk we are taking on.
This is an acute problem for those investors who have most of their wealth tied up in financial assets. Many tend to follow a “buy-and-hold” mentality where they accept their fate at the hands of the markets, including catastrophic losses. For those who are close to retirement, this behavior can leave them facing a shortfall at a critical time and potentially derail their plan for building greater wealth for retirement.
3. Bad market performance
Investors can largely control the first two risks, but the third—market risk—is out of their hands. Individual investors cannot control what the markets will do from day to day or year to year, and they really shouldn’t worry about it either.
What investors can control is how they react to increasing market risk. Avoiding catastrophic losses is critical so investors don’t have to play the “catch-up game”. That’s where an investor who has sustained a significant loss needs to achieve a return that is greater than the amount lost to fully recover.
If clients don’t want to play the “catch-up game”, then they need to employ strategies that helps them manage the risk of catastrophic losses. That’s what Potomac’s strategies seek to do.
Breaking the “Worst” Risks
It is our belief that many investors can’t handle excessive stock market risk and really shouldn’t. To find out, all we must do is ask a potential client how much of a loss they are willing to accept on their investments. In our experience, most clients say, “not much”, which is not surprising—humans are hard-wired by nature to avoid the pain of losses. In fact, we tend to place a higher value on avoiding pain over seeking pleasure.
The philosophy behind Potomac’s strategies are built around avoiding pain, or risk as we call it in the investment business. By identifying the “worst” risks investors face with their largest asset, we seek to give clients greater peace of mind, knowing their investments are being managed against the risk of catastrophic loss.
We’ve created a guide to understanding the “worst” risks and why it’s important for investors to break them using risk management strategies. Request a copy of our latest guide to use with your clients below.