KEY TAKEWAYS:

• Without a clear understanding of risk, investors fall into behavioral traps like panic selling, overreacting to recent events, or trying to time the market.
• Having a broadly diversified portfolio shifts risk toward ups and downs in value, not total loss as is possible with a single stock, making long-term recovery far more likely.
• Short-term declines don’t cause permanent damage unless you sell at the wrong time; having a plan to avoid forced selling can help protect long-term outcomes. 

Most people seem to have a good grasp on the idea that they can control the level of investment risk in their portfolio by altering the amount of exposure to stocks versus bonds. As retirement planning specialists, we repeatedly find that people tend to have a much poorer understanding of what investment risk actually means to their retirement plan and how to apply it to their investment decision making.  

Having a solid understanding of the risk being accepted makes an investor more informed and therefore a better investor.  Absent this understanding, investors are more likely to fall susceptible to behavioral biases that tend to lead to irreparable harm, such as:

• Loss aversion -- when an investor sells just to stop the emotional pain
• Recency Bias – when an investor overweighs what just happened and assumes markets will keep falling
• Overconfidence – when an investor believes they can exit now and get back in later, but often miss the recovery
• Regret Aversion – when selling feels safer than risking another drop, even if staying invested is wiser

Making investment decisions based on these and other behavioral biases could lead your retirement plan off track and cause unnecessary stress. 

So, what exactly is investment risk in the context of retirement planning?

When Investment Risk Could Lead to Permanent Loss

A single share of stock represents a small share of equity ownership in a firm.  Buying just a single share of stock makes you an owner in that firm.  One chooses to invest in the stock of a firm because they feel that company has a good chance of continuing to earn a profit and grow its business, making its stock worth more in the future.

Most businesses face many dynamic ongoing risks in their pursuit of continued growth and profitability, such as the following just to name a few:

• Economic Risk: Recessions, inflation, rates, and consumer weakness can hurt demand and margins.
• Legal and Regulatory Risk:  Taxes, labor rules, licensing, privacy, and industry regulation can create costs or penalties.
• Liability Risk:  Lawsuits, product failures, errors, cyber incidents, and reputational harm can be expensive.
• Competitive Risk: Competitors can lower prices, improve products, or take market share.

Sometimes risks materialize that overwhelm a business and force that business to close their doors, or file for Bankruptcy.

As an example, General Motors (GM) was founded in 1908 and grew into the most powerful automaker in the world during the 20th century. By owning multiple brands, dominating U.S. market share, and pioneering consumer auto financing, GM became a symbol of American industrial success. Its scale, manufacturing power, and broad product lineup made it the industry leader for decades.

By the 2000s, GM was burdened by legacy pension and healthcare costs, declining market share, and weak profitability.  When the 2008 financial crisis hit and auto sales collapsed, the company ran out of room to recover.  In 2009, GM filed for Chapter 11 bankruptcy.  Equity shareholders were wiped out and the value of their stock hit $0, never to rebound. Imagine what this meant for the people who had invested all of their money into GM stock and didn’t have anything left.

Why Diversification Matters in Retirement Planning

It is risk of loss that leads investors to want to diversify, so that not all their eggs are in one basket.  When an investor diversifies effectively, risk should no longer be thought of as the potential for permanent loss but rather as the potential for fluctuation in value at any point in time.

For instance, Vanguard’s Total Stock Market ETF (VTI) holds approximately 3,600 individual stock holdings and is designed to track the return of the entire U.S. Stock Market.  During the 2008-2009 Financial Crisis, VTI experienced a peak-to-trough loss of 55% (from 10/9/2007 to 3/9/2009).  We know during this time, some companies, like GM, were lost, but the odds of all 3,600 individual companies going bankrupt at the same time is extremely improbable.  Unlike with GM, an investor could have held VTI through this very difficult time with the knowledge that it would eventually rebound as the tough times receded and that the companies left standing would thrive.  Unlike the GM investor left with $0, the investor that held VTI had experienced a return over 1,200% since the 3/9/2009 trough.

As retirement planning specialists, ensuring that a client is well diversified is one of the first things we do as we seek to mitigate the big five retirement risks to help them achieve their retirement goals.

Investment Risk in a Diversified Portfolio? It’s called Standard Deviation

When you have a portfolio of well diversified assets, risk is better defined by how much a portfolio can fluctuate in value at any point in time.  The statistical measure used is known as standard deviation.  Standard deviation tells us how much returns can potentially move away from the average (or expected return).  The higher the standard deviation, the wider the potential range of fluctuation in value, and the higher the risk.

Using VTI as an example again, the 10-year standard deviation was 15.49% as of 2/28/2026.  The average annual return over the same 10-year period was 13.67%.  Also recall from your statistics class that under a normal probability distribution:

• 68% of observations fall within -1 and +1 standard deviation
• 95% of observations fall within -2 and +2 standard deviations
• 99.7% of observations fall within -3 and +3 standard deviations

This means:

• About 68% of annual returns would be expected to fall between -1.82% and 29.16%
• About 95% would fall between -17.31% and 44.65%
• About 99.7% would fall between -31.80% and 60.14% 

These ranges of value fluctuation are quite large, reflecting the considerable risk involved in investing in a single asset class like U.S. stocks.  This is why properly constructed portfolios are built using several asset classes with differing risk factors and low correlation that lead to greater diversification.

It’s Not the Fluctuation in Value that Hurts You, it’s the Capitulation

Aside from the psychological impact a large drop in the value of your portfolio can have, it does not hurt you economically speaking.  

As long as you can ride an investment portfolio up, and then down, and then back up again without having to sell, no economic harm will come to you and your retirement plan.  

What can hurt you economically is succumbing psychologically and selling (or capitulating) when the market is down or falling.  Even if you miss some of the bottom, you will most likely miss the point to get back in and will miss out on the inevitable recovery.  This causes an irreparable gap in performance that you cannot regain, especially if you’re nearing retirement

But Don’t Retirees Have To Sell To Fund Retirement Expenses? 

Retirees are particularly exposed to investment risk because they generally need money every month from their portfolios to support their living expenses.  This need for regular withdrawals means they will likely be faced with having to sell assets even if they are down in value leading to a negative sequence of return decay effect on the portfolio, one of the biggest retirement risks that we discuss below.  Lowering the stock exposure in the portfolio’s asset allocation to reduce the magnitude of fluctuation is one way to help, but you also lower the portfolio’s expected return potential, which may not be desirable. 

Management of Sequence of Returns Risk is Critical

So how do you protect against sequence of returns risk in your portfolio? Sequence of returns risk management is about planning in advance for inevitable downturns and ensuring you’re positioned to be able to withstand difficult market environments without being forced to sell investment assets at depressed values to meet income needs. 

As retirement planning specialists, we design customized strategies for each client that help create this flexibility, allowing them to cover spending needs while their portfolios have an opportunity to recover. These strategies help separate the asset allocation decision from the practical need to manage near-term market risk, allowing portfolios to retain a more proper growth potential. 

While market risk can never be eliminated, thoughtful planning and the right combination of tools can provide retirees with valuable time to navigate downturns more confidently and avoid unnecessary liquidation during unfavorable conditions without being relegated to maintaining an ultra-conservative asset allocation lacking proper stock growth potential. 

If you’d like our guidance in reviewing your investments or retirement portfolio, you can schedule a complimentary Thrive Assessment analysis with our retirement planning specialists here.