After the tumult of last year, volatility is again on investor’s minds. But it’s not something that’s likely to go away, even if markets calm down. Using the S&P500 as a proxy for the equity market, Bloomberg data shows that median volatility has increased steadily since the 1950s.
Retiring into a volatile market can be stressful, but there are tactics that can help keep your investments on track. The principles of sound portfolio management don’t change when you’re in retirement, but the way you implement them might, based on changes to your situation. We break down three things you need to know to successfully navigate volatile markets in retirement.
Your Risk Profile May Have Changed
Retirement brings about new changes in many different areas of your life, and this can change your risk profile. You’ve probably already considered making some changes to your asset allocation, but thinking about risk more holistically, across your entire situation, can give you a greater understanding of how to craft a retirement portfolio that meets your needs.
Risk has two dimensions for the retirement portfolio. The first is personal risk tolerance, or the amount of risk you can take in your portfolio and still sleep at night. The second is the amount – or composition – of risk that allows your portfolio to meet both your current income and future growth needs. Since you no longer have a source of employment income to make up for market downturns, you may find that market ups and downs have more impact on your peace of mind than before.
Even if you feel confident that over the course of a two decade (or longer) retirement your portfolio will recover from market drops, you should give some thought to your overall picture. Evaluating your retirement risk profile provides an opportunity to think about what you want to do in retirement. If you plan to scratch an entrepreneurial itch and start a business, it may make sense to take on less portfolio risk. You’ll be investing time and money in a new business which has the potential for capital appreciation, so you may want to dial up capital protection in your investment portfolio.
When determining the balance between income producing assets that are generally lower risk and growth investments that are usually higher risk, you should consider how risky your other sources of income are. Besides social security, will you be drawing a pension? Do you have other assets, such as a home or a valuable collection that you may sell in the future?
Overall, the goal of knowing your risk profile is to create a portfolio that allows you to stay invested while still accommodating the amount of growth and income needed for retirement.
The Dual Role of Income Investments
Income investments throw off cash through some type of payment to the investor, whether it’s a dividend or a coupon payment. It’s usually one of the main sources of income for investors in retirement, as it can be fairly stable. However, particularly when the income comes from bonds or bond alternatives, the more conservative nature of these investments can lower the overall risk profile of a portfolio. The addition of a consistent cash cushion also helps to smooth volatility.
AARP estimates that income in retirement will need to be approximately 80% of your pre-retirement income. Fortunately, investors today don’t have to just rely on bonds to get to that number. There are many different sources of income available to the modern portfolio and one way to find the yield you need while combating volatility is to add different income-producing assets to your portfolio. Alternative assets such as private equity, private credit and real estate can often be sources of income and offer lower correlations to stocks and bonds. Whichever direction you take, adding different assets to your portfolio can require a little more planning which leads us into our next topic — diversification.
Using Diversification to Curb Risk
A well-diversified portfolio not only consists of different asset classes, but captures the benefits of investing in non-correlated asset classes. In theory, if one asset class is experiencing negative returns, another non-correlated asset class is like to be positive, which provides balance and stability to your investments.
A common goal amongst all investors is trying to capture the highest returns with the lowest amount of risk. When this is accomplished, the portfolio is considered to be “efficient”. An “efficient frontier” is the elegant curve that models the expected risk and return of portfolios comprising different asset allocations. The set of portfolios (specific to each investor) are expected to provide the highest returns for a certain level of risk. This efficiency can be accomplished through proper diversification amongst asset classes, which reduces the overall amount of risk.
Source: Bond returns are based on data from the Merrill Lynch 7-10 year U.S. Treasuries Index. Stock returns are based on the total returns of S&P500 index from 1977-2011.
The efficient frontier displays the impact that diversification has on a portfolio’s returns, as well as its overall risk.
It’s important to periodically revisit your investments and allocations to ensure they’re aligned with your risk profile and time horizon. Without proper rebalancing from time -to- time, you may be taking on too much or too little risk, which creates a new set of problems to address. Overall, having a well-diversified portfolio plays an important role when investing in an unpredictable market.
Bottom Line
Retiring into a volatile market can be stressful. It’s important to take all the right steps and precautions to protect your years of hard work and saving. While no investment strategy can provide guaranteed returns, approaching retirement with a well thought out strategy can remove some of the worry that typically takes place during volatile markets.