section 1 - The American College Online Learning Center

standard deviations of the returns on these securities follows in the same orderwith stocks being substantially more risky than the other two.g. There are other investments that a retiree might consider, and these are referredto as alternative investments. These include such things as REITS (real estateinvestment trusts), nontraded REITS, equipment leases, oil and gas investments,managed futures, and private equity funds.h. Because of the difficulty of collecting large amounts of unbiased data to analyzethese alternative investments, we cannot say as much about them in terms ofhistorical performance but one of the goals in using alternative assets is toimprove portfolio diversification.2. Investment risk involves investing too conservatively, too aggressively, and/orinadequately diversifying assets (called asset allocation risk). There is also market risk,which is the risk from events that cause all security prices to fall. Your clients should beconcerned about losing money in the financial markets for a variety of reasons:a. If realized, these risks can lead to the loss of capital or less-than-planned-forinvestment return.b. Example: Sue is about to retire and she fears a loss of principal on herinvestments and puts all of her assets into safe, but low yielding, certificates ofdeposit. However, these investments will produce a lower return than is neededfor the retirement period.c. Embedded in the issue of losing money in the financial markets is the risk ofreceiving low or negative returns in the early years of retirement (sequence ofreturns risk). For example, Rick retired in 2007 to face a 30 percent drop in hisportfolio shortly thereafter. The timing of this black swan market event had along-term negative effect on the ability of his retirement portfolio to provide him theneeded income.d. Example: Consider the following illustration of sequence risk. In Table A, Peggystarts with a portfolio worth $10,000. She draws out $1,100 at the end of eachperiod. Peggy earns the following returns in years 1 through 5: 40%, 20%, 0%,–20%, –40%. Note that at the end of the five years, she has $4,614 left in theaccount, even though Peggy has achieved a 0% arithmetic average rate of returnand drawn out a total of $5,500. In Table B, Gregg starts with the same amount,makes the same withdrawals, and earns the same rates of return, except inreverse order. Note that Gregg will fall $934 short of his fifth withdrawal. Thisdisparity of outcomes is the result of a bad case of sequence of returns risk.e.Table APeriod BOP ROR Value Withdrawal EOP1 $10,000 40% $14,000 $1,100 $12,9002 $12,900 20% $15,480 $1,100 $14,3803 $14,380 0% $14,380 $1,100 $13,2804 $13,280 –20% $10,624 $1,100 $ 9,5245 $ 9,524 –40% $ 5,714 $1,100 $ 4,614Table BPeriod BOP ROR Value Withdrawal EOP1 $10,000 –40% $6,000 $1,100 $4,9005.22