Learn how to balance risk and return
When you’re still decades away from retirement, your portfolio has time to recover from a market downturn. But as you approach the date when you leave the traditional nine-to-five behind, your window for recovery shrinks. As a result, your ability to take risks will likely diminish. Your investment mix needs to be able to support your portfolio throughout retirement while maintaining stability during periods of volatility.
Let’s explore what it takes to manage risk and return as retirement nears.
Understanding Risk and Return
A general investment principle called the risk-return tradeoff states that as risk rises, so does the potential return. Certain investments, like stocks and other equities, are considered higher risk than assets like bonds and cash equivalents. That’s because stocks and equities have higher levels of uncertainty regarding how they’ll perform in the future. In exchange for assuming this risk, investors benefit from a higher return potential.
In terms of retirement, managing the right levels of risk and return becomes an increasingly important balancing act.
“When approaching retirement, you don’t have the same time frame to make up losses as you do when you’re younger,” says Aaron Terwedo, ChFC®, ChSNC®, FPQP®, NSSA®, and vice president of TFS Advisors in Edmonds, Washington. “Risk is your friend when you’re in the accumulation phase, but it’s your enemy in the decumulation or distribution phase of your life. With that being said, some level of risk often needs to be taken to at least keep pace with inflation.”
If you are either fast approaching or already in retirement, you need to consider how experiencing too much risk during a market downturn could impact your portfolio’s longevity once you begin relying on it for income.
The Importance of Asset Allocation
Asset allocation refers to how your capital is divided among different asset types in your portfolio. The three most common asset classes are equities (stocks), fixed income (bonds), and cash or cash equivalents (certificates of deposit).
Ideally, as you age or your financial circumstances change, your portfolio’s asset allocation should change as well. In your 20s and 30s, when you’re decades away from retirement, you have an opportunity to be aggressive with your investment choices. With more time to recover from losses or downturns, your portfolio can handle a larger share of equities.
But as your priorities shift or near-term goals emerge (like home buying or college planning), your investment needs may change. Because you anticipate accessing some of your portfolio’s funds sooner, a more balanced asset allocation may work better for you.
Generally, once retirement comes into view, that’s when your portfolio’s asset allocation should shift to a more conservative make-up. Rather than prioritize higher-risk assets in the pursuit of growth, you should focus on preservation and longevity. These goals align more closely with cash equivalents and fixed-income assets.
Assessing Your Risk Tolerance
Risk tolerance refers to how much risk you are comfortable taking on within your portfolio. While it does depend on certain quantitative factors like age, cash flow, and spending goals, there are some more qualitative considerations to keep in mind when determining your portfolio’s asset allocation.
“I believe that risk tolerance, at all phases of life, is a balance between people’s financial capacity to take on risk and their emotional capacity to stay the course during periods of volatility,” says Lauren Hunt, CFP®, owner, and wealth manager of Daybreak Wealth.
“It’s important for people in transition, like moving from full-time employment to retirement, to determine if either of these factors has changed and adjust their portfolio allocation to reflect their new circumstances,” she continues.
To determine your risk tolerance, consider how comfortable you are with the possibility of losing money. Will you be okay financially and emotionally if you experience a substantial loss? Or are you better off moving to a more conservative investment and reducing some risk? Some people prefer to minimize risk at all costs and are willing to forego the opportunity to achieve higher returns for it. Others are more comfortable with the level of risk involved and want to pursue bigger growth opportunities.
Strategies for Managing Risk Near Retirement
Because of the established correlation between risk and return, investors typically pursue a portfolio that has an adequate level of diversification based on their age and general tolerance for risk. This concept becomes increasingly important as retirement draws nearer.
Assets with varying risk levels (and by association, growth potential) play different roles in an investor’s portfolio. While assets with higher levels of risk are used to pursue growth more aggressively, more conservative assets help level out volatility and offer stability and protection. Both asset types are necessary for anyone nearing retirement because they help you accomplish two things: Build a long-lasting portfolio and mitigate market downside risk along the way.
“The key to managing risk as you near retirement is twofold: diversification and adaptability,” says Jennifer Kirby, CIMA®, CSRIC®, managing partner, and senior wealth advisor of Talisman Wealth Advisors. “Diversification means spreading assets across a risk spectrum: Cash for short-term needs, bonds and dividend stocks for mid-term stability, and equities for long-term growth. Adaptability comes from active monitoring, rebalancing, and a disciplined yet flexible withdrawal strategy to navigate market changes.”
Balancing Growth and Safety
While your priorities in retirement tend to shift towards portfolio preservation and stability, maintaining some opportunities for growth is still important. Equities can help your portfolio continue to grow throughout retirement, even as you make regular withdrawals, mitigating the risk that you’ll outlast your assets. They can also help your portfolio maintain its purchasing power as inflation rises year after year.
Yet, as we’ve established, these opportunities for greater growth come with higher risk. This is where a balanced portfolio comes into play. Fixed-income assets, like bonds, offer investors steady payments over a certain period of time, plus the principal amount returned at the end. While there’s still risk involved in the bond market, it’s generally less volatile than the stock market. You can also opt for bond issuers with high ratings or greater credibility, like the U.S. Treasury or local governments. Even within the world of bonds, the level of risk still impacts the potential returns.
Rebalancing Your Portfolio
As your portfolio experiences growth and losses, its asset allocation will shift over time. Say you have a portfolio comprising 60% equities and 40% bonds. In a period of positive stock market performance, your equities will likely grow. As a result, your asset allocation may shift away from the benchmark you’ve been using based on your risk tolerance and time horizon to retirement. To get your portfolio back to your intended asset allocation, you would need to rebalance it.
“Rebalancing is important because it can keep the portfolio in line with an investor’s long-term goals and objectives,” Hunt explains.
Rebalancing can also help you realign your portfolio as your priorities shift. The closer you get to retirement, for example, the more often you may want to reassess and potentially rebalance your portfolio in an effort to manage risk and return.
But if you rebalance too often, you may rack up unnecessary transaction fees. Wait too long, and your portfolio could stay exposed to more risk than you’re comfortable with.
Considerations for Tax Efficiency
Just as diversification applies to your portfolio, it should be considered in terms of your tax obligations in retirement as well. Taxes, when left unmanaged, have the potential to diminish returns, especially when you pay more over time than is necessary.
You may want to consider incorporating tax-focused strategies into your retirement portfolio, especially if you’ve concentrated your efforts on growing one type of account, like a 401(k) or IRA. While these are effective tax-saving tools, any withdrawals you take in retirement will be subject to ordinary income tax.
Consider what other sources of income you’ll be able to draw from in retirement and how they’ll impact your annual tax bill as well. A Roth conversion, for example, could be used to convert a portion of your existing 401(k) or traditional IRA into future tax-free income.
What Are the Most Common Mistakes People Make When Managing Risk Near Retirement?
People near retirement have fewer years to recover from market volatility or downturn than those who are younger, and their portfolio’s asset allocation should consider this risk. Anyone who has never experienced the effects of a major market downturn on their portfolio may underestimate the risk or feel overconfident in their ability to predict future market movements. Taking on too much risk as you near or enter retirement can impact its sustainability and longevity.
What Is Sequence of Return Risk?
When market volatility occurs early in your retirement and you make required withdrawals from an impacted portfolio, this can create what’s called sequence of return risk. If a portfolio experiences negative returns right when withdrawals are happening, it can have a lasting and adverse effect on the portfolio’s value. This is because there are fewer assets left to benefit from potential market recoveries in subsequent periods.
Thus, the unfavorable timing of a major loss can cause your portfolio’s resources to be rapidly depleted. The earlier in retirement this happens, the worse it is for your portfolio. Losses that occur later on in retirement can still be difficult to endure, but they’ll typically have less impact in the long run on your retirement resources.
What Investment Vehicle Is Best for Retirees?
You’ll likely want to include a mix of investment vehicles in your portfolio as you prepare for and transition into retirement. Different investment vehicles offer varying levels of risk and potential return, and you’ll need to consider how much to prioritize each within your portfolio.
Common investment vehicles include stocks, bonds, and cash equivalents.
The Bottom Line
All investments come with risk, but as you near retirement, the key is to consider how much risk is worth including in your portfolio. Your asset allocation should evolve to accommodate your need for protection and stability as your goals change or your time horizon to retirement shortens. By leveraging a mix of investment vehicles with different levels of risk and growth potential, you can better address your need for future retirement income with your desire to protect your portfolio from unexpected market movements.
