|
Note: The examples and case studies in this article are hypothetical but represent real situations I have encountered in my practice working with Washington State public employees. I was re-reading one of my favorite pieces of financial writing last week. It’s an essay by Morgan Housel called “The Three Sides of Risk.” Housel is a bestselling financial author, and the piece tells a deeply personal story about a ski trip that ended in tragedy. Two of his closest friends were killed in an avalanche when they were seventeen years old. He survived only because he declined, on a whim, to join them on a second run. He uses that story to make a point about investing. Not about volatility. Not about routine market corrections. About something far more serious. About the kind of risk that can end everything. The three sides you need to know Housel argues that most people think about risk in two ways.1 First, the odds of something going wrong. Second, the average consequences if it does. Those two feel manageable. You can wrap your head around them. A 10% chance of losing 15% of your portfolio in a bad year is uncomfortable, but it’s survivable. You run the math. You plan around it. You move on. But there’s a third side of risk most people never think about until it’s too late. The tail end consequences. The low-probability, high-impact events that don’t make daily financial headlines but make the pages of history books.1 Pandemics. Depressions. A market crash that wipes out half your portfolio the year you planned to retire. These are called “tail risks.” And in my experience working with Washington State public employees planning for retirement, this is the risk that almost nobody has a real plan for. Why this matters more if you’re retiring early Consider a hypothetical situation I encounter often in my work. A PERS 2 member, let’s call her Karen, a budget analyst with 28 years of service, is planning to retire at 57. She’s done everything right. She has her DRS pension lined up, a healthy DCP account, and a solid portfolio of personal savings. She’s run the numbers. She feels confident. But here’s the problem. Karen is looking at the average risk. The likely scenarios. A normal market correction she could ride out. A healthcare expense she could absorb. Average consequences. Survivable ones. What she hasn’t thought through are the tail end consequences. What happens if she retires in 2008, and her portfolio drops by half in the first eighteen months? She’s 57. Medicare is still eight years away.5 The sequence of withdrawals during a crash that early in retirement can permanently damage a portfolio in ways that average market returns alone cannot fix. This is sometimes called “sequence of returns risk.” But it’s really just tail risk wearing a different hat. Your pension helps, but it doesn’t solve everything Here’s something I genuinely appreciate about working with Washington State employees. Your DRS pension is a real buffer against tail risk in ways that most retirees don’t have.6 A guaranteed monthly benefit that doesn’t depend on market performance means you aren’t starting from zero during a crash. That matters enormously. But the pension doesn’t cover everything. Most of my clients rely on a combination of their DRS pension, Social Security, and a portfolio of personal savings. The pension handles the floor. The portfolio is supposed to handle the rest. And it’s the portfolio that’s exposed to tail risk. What actually works The good news is there are practical, proven ways to reduce the damage a tail event can do to your retirement. Keep a war chest I build every retirement income plan around what I call a “war chest.” This is typically four to five years of expected withdrawals held in high-quality, short-duration bonds. When a market crash hits, you pull from the war chest instead of selling equities at the bottom. This gives your portfolio time to recover without forcing you to crystallize losses at the worst possible moment. It sounds simple. It is simple. But simple works. Own the whole market We use broadly diversified, low-cost investments for client portfolios. The reason comes back to tail risk, but actually the positive side of it. In any given year, market returns are not evenly distributed. Morgan Housel’s colleague at Collaborative Fund documented this pattern clearly: in 2017, a handful of companies accounted for half of the S&P 500’s total return. Apple alone contributed more to the index than the bottom 321 companies combined.2 Recent data confirms the pattern continues: in 2023 and 2024, only about 27–28% of S&P 500 stocks outperformed the index itself, the narrowest market concentration in nearly three decades.3 If you’re picking individual stocks, you have to be right about which companies will be the outliers. Almost nobody is consistently right. If you own the whole market, you automatically own the outperformers without having to predict them. Broad diversification is how ordinary investors capture extraordinary results over time, including the tail events with positive outcomes. Don’t try to hedge your way out of it. Every few years, a new financial product gets marketed as a way to have all the upside of the market with protection from the downside. Usually it involves options strategies or complex insurance-wrapped products. I’ll be direct: the research on these tail-hedging strategies is not encouraging. AQR Capital Management published a paper on this topic that makes the point plainly: the long-term cost of explicit tail-risk insurance strategies tends to exceed the payouts.4 You pay premiums continuously for protection that pays off rarely. Most of the time, an investor purchasing put options to hedge against tail events ends up with options that simply expire worthless, representing a total loss on that investment. Even when they’re rolled over time, they become a constant drag on portfolio performance.7 The expected return for perpetual insurance buyers is negative. The sellers of that insurance are counting on it.4 The better path is owning the right portfolio structure in the first place: broad diversification, a war chest, and the discipline to leave it alone when things get scary. Have a written plan for the bad scenario. One insight from the research is this: the investors who get hurt the worst aren’t the ones who experience the crash. It’s the ones who experience the crash without a plan, panic at the bottom, sell everything, and then miss the recovery.4 Before you retire, write down what you will do if your portfolio drops 30% in the first year. Not what you might do. What you will do. Having a predetermined response to a crisis is the difference between riding it out and making a permanent mistake. The question to sit with Most retirement planning conversations focus on the average outcome. Will you have enough? At what rate can you withdraw? What’s the right pension option? Those questions matter. But they’re not the only ones. The question that often goes unasked is: what happens in the worst case? Have you accounted for a tail event hitting in your first year of retirement? Is there a plan that holds together even then? As Housel wrote, tail-end events are all that matter. Once you experience one, you’ll never think otherwise.1 If you’re a Washington State public employee within five years of retirement, now is the time to think through these scenarios carefully. Not because disaster is likely. But because the consequences of being unprepared for it are permanent. Sources
-Seth Deal
0 Comments
Leave a Reply. |
AuthorsBob Deal is a CPA with over 30 years of experience and been a financial planner for 25 years. Archives
April 2026
Categories |
