I have been advising expats and high-net-worth individuals on investments and retirement planning for close to a decade and a half, and have written about it for Forbes and other publications.
Most people assume that retirement success depends mainly on how much money they have when they stop working.
What they overlook is that the first few years after they retire can have a disproportionate impact on how long their money lasts.
Let's compare two retirees. At first glance, their situations were almost identical:
Yet today, one has almost $10 million remaining, whilst the other is close to running out of money.
The answer becomes obvious once you look at when each person retired.
One investor retired in 1996; the other retired in 2000.
Everything else remained exactly the same.
At first glance, this doesn't seem possible. After all, both people invested in exactly the same portfolio. The only difference was the year they retired.
The person who retired in 1996 enjoyed four excellent years for the stock market. By the time the dot-com crash began in 2000, their portfolio had already increased significantly in value.
When markets subsequently fell between 2000 and 2002, they were withdrawing money from a much larger portfolio.
The retiree who started in 2000 never had that opportunity.
Instead, they began withdrawing money almost immediately after one of the biggest stock market declines of recent decades.
That made a huge difference to the outcome.
Many people focus on average returns. In reality, the order in which those returns occur can be even more important.
If markets perform well during the first few years of retirement, your portfolio has time to grow before you begin taking larger withdrawals.
If markets fall sharply during those early years, you are withdrawing money from a portfolio that is already shrinking.
That makes it much harder to recover later, even when markets eventually rebound.
This is called sequence risk.
It is one of the biggest risks retirees face, yet it is also one of the least understood.
The difference was neither the investment nor the withdrawal rate.
The difference was that one retiree began taking withdrawals after several excellent years for the stock market, whilst the other retired just before one of the biggest market declines of recent decades.
When you are still working, market falls are often an opportunity because you continue investing and buying at lower prices.
Retirement is different. Instead of adding money, you are taking it out.
Every withdrawal during a falling market leaves fewer assets invested when markets eventually recover. That is why sequence risk matters so much.
No. Stocks remain one of the best long-term investments available.
The issue isn't investing in stocks but relying entirely on one asset class once you begin making withdrawals.
If you happened to retire during a period like 1996, a 100% stock portfolio would have worked extremely well.
If you retired during a period like 2000, exactly the same strategy would have produced a completely different outcome.
The difficulty is that none of us knows which environment we will retire into.
People were already saying that markets looked expensive during the late 1990s.
The crash didn't actually arrive until several years later.
Trying to predict those turning points consistently is extremely difficult.
If we can't predict whether we will retire during a period like 1996 or 2000, it makes sense to prepare for both.
That is where diversification comes in.
Holding a mixture of assets reduces the risk of relying entirely on one market.
When different retirement portfolios are compared over difficult market periods, diversified portfolios consistently perform better than portfolios invested entirely in stocks.
A traditional portfolio split between stocks and bonds reduced the damage considerably.
Even better results came from combining stocks, bonds and hedge funds.
No investment is risk-free, but spreading your money across different asset classes reduces the likelihood that one bad period for the stock market will permanently damage your retirement plans.
Hedge funds aren't suitable for everybody, and there are significant differences between managers.
However, some hedge fund strategies are designed to produce returns that are less dependent on stock markets continually rising.
That is one reason they can improve diversification when combined with stocks and bonds.
Historically, many hedge funds have only been available through wealth managers, private banks and advisory firms, although there are now some exceptions.
For many investors, that still means accessing these strategies through advisers like ourselves rather than investing in them directly.
In my own comparisons of retirement portfolios, combinations of stocks, bonds and hedge funds produced some of the strongest results during challenging market periods.
This isn't an argument against stocks, nor is it an argument that everybody should invest in hedge funds.
If you retire during a period like 1996 and the stock market performs very well during your first few years of retirement, being 100% invested in stocks can produce excellent results.
If you retire during a period like 2000, exactly the same strategy can leave you close to running out of money.
The problem is that none of us knows which type of market we will retire into.
That uncertainty is exactly why diversification makes sense in retirement.
Being 100% in stocks might make perfect sense while you are accumulating wealth.
Once you start drawing an income, having your eggs in different baskets is often the safer approach.
A diversified portfolio won't necessarily produce the highest return in every market.
However, it can significantly reduce the chances that bad timing rather than bad investing determines the success of your retirement.