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Risk of ruin in finance can mean the probability of bankruptcy or, in the case of a retiree, outliving one's assets. A retiree who can generate all the annual income he needs from a cash/fixed income portfolio doesn't have to worry about risk of ruin. But even a bond portfolio faces reinvestment risk if a higher interest-paying bond matures when interest rates are lower. At that point, buying a new bond won't generate the same income. That may pinch the retiree, but it won't ruin him.
However, a retiree's real risk of ruin comes from stock market volatility and the retiree's need to liquidate assets periodically for income. Withdrawals taken during down or flat market cycles create a risk of ruin just like a string of losing trades for an active trader.
The way to avoid risk of ruin is the same for the retiree and the trader: start with enough capital to withstand a string of losses. To do so, you have to estimate the probability of future returns and the rate of inflation. Read on to find how. The Sequence Of Returns
The greatest danger for someone in or planning on retirement is the rosy scenario - using one period of market performance as a guide. For anyone liquidating assets periodically, what's important isn't just the rate of return, it's the sequence of returns. (For more insight, see Common Concerns For Retirees.)
For 17 years, beginning in 1966, the market was flat and had the highest inflation on record. Few if any financial advisors or stockbrokers use that period for their illustrations. According to William Bernstein's book "Four Pillars of Investing" (2002) the reason is simple: No asset allocation avoids bankruptcy when a 4% withdrawal rate is applied to a $1 million portfolio using returns from that time period. (For more insight, read Asset Allocation Within Fixed Income.) The 4% withdrawal rate used by many financial advisors is no guarantee. Illustrations using an average annual return, even for a long period of time, are especially dangerous. Actual annual returns are hardly ever average. In 54 of the 82 years between 1926 and 2007, the Standard & Poor's 500 Index (S&P 500) performance was either a loss or a gain of more than 20%. In other words, almost 66% of the time, the index returned better or worse than a return of between 0% and 20%. Only one-third of the time did the index performance fall within the range of an "average" 10% return (0% to 20%). (To learn more, read All Returns Are Not Created Equal.)An average annual return is irrelevant. It's the sequence of returns that's important.
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