Why Volatility is a Retirement Killer

Volatility is a fact of life when investing in the stock market.

As indicated in the chart below, the Chicago Board Options Exchange volatility index has had six meaningful spikes (index levels exceeding 30) since 1990, with by far and away the most extreme spike occurring over the past couple of years.

Each of the high volatility periods below is correlated with a swoon in stock prices.

Although periods of high volatility produce gut-wrenching headlines and loads of anxiety, one might ask why volatility really matters.  After all, things seem to work-out relatively well for those who are able to stick with their equity investments over very long time horizons.

The reality is that when it comes to volatility, timing is everything and there is enormous risk if one is forced to start making withdrawals from a portfolio during a period of when asset prices are fluctuating wildly.  Portfolios and retirement spending plans are simply unlikely to recover from the effects of sequence of returns risk or a blow delivered at the wrong time.

Sequence of returns risk describes a situation in which poor investment returns at the general time of retirement (e.g. plus or minus 5 – 10 years before or after retirement) jeopardize the likelihood that a planned level of spending will be sustainable throughout one’s entire retirement.

In other words, as millions of Baby Boomers have experienced over the past couple of years, longevity risk and the likelihood of ruin in retirement increase significantly if: a) one has meaningful, un-hedged equity exposure in an investment portfolio, and; b) equity market volatility happens to roughly coincide with the onset of retirement.

Future additions to this post will provide specific examples of the relationship between sequence of returns risk and planned levels of retirement spending.