As great as it feels to take income from an appreciating account, it feels terrible to take income from the same account when the value is declining. From a mathematical perspective, taking income from an account with a declining value might be harmful in terms of retirement planning. The reason is simple - whatever the percentage of investment loss, it takes a larger percentage of gain to make up the loss as the discussion below outlines.
Let's look at an example.
If I have an investment worth $1,000,000 and lose 20% in a given year, I have a year-end account balance of $800,000.
Now, let's assume the following year my investment makes a 20% gain. I now have an account balance of $960,000. A 20% loss followed by a 20% gain still results in an investment loss!!
It takes an investment gain of 25% to recoup the losses experienced from a 20% investment decline.
The relationship existing between losses and subsequent gains is absolute - meaning it always exists, regardless of the percentage. The greater the investment loss, the larger the subsequent gain needs to be in order to recoup all investment losses. It's this simple mathematical fact that makes not losing money in investments so important for so many retirees.
That's why it's important to invest at least a percentage of your assets conservatively, in a vehicle where account values are as stable as possible. A large investment loss makes it more difficult to receive a level, consistent income stream. And, for those individuals in retirement or nearing retirement, receiving consistent income is an essential component of living a traditional retirement.
Avoiding losses in retirement may be every bit as important as making gains, some would argue more important. One of Warren Buffett's best known quotes is "Rule number one: Never lose money. Rule #2: Never forget rule number one."
-Tom
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