As you approach and ultimately enter retirement, you’ll need to reduce the risk of your investment portfolio gradually. But what exactly does that mean? And what steps should you take to make your portfolio less risky?
The Basics of Investment Risk
In the investing world, risk is simply a measurement of the chances that the outcome of a given investment will differ from the expected outcome. For example, when most people buy stock shares, they anticipate their prices going up over time. If the price remains the same or drops, it will result in losses and/or missed opportunities.
Risk is important for all investors to consider — but it’s essential for retirees. That’s because retirees are typically dependent on consistent income generated by their investments and because they have less time and fewer opportunities to make up for losses instigated by excessive risk. They may be out of the workforce, making it difficult to compensate for any catastrophic losses.
Generally, investors reduce the risk of their portfolios as they approach retirement and then continue to minimize the risk as they age, ultimately making their portfolios safer and safer.
Personal Risk Tolerance
In this discussion, it’s important to acknowledge that risk tolerance varies even among retirees. Personal risk tolerance is essentially a measure of how much risk you can easily withstand. Two people with different risk tolerances, despite having similar financial positioning, should have two different portfolio balances.
Suppose you’re absurdly wealthy, with hundreds of millions or even billions of dollars to your name. In that case, you likely have much more risk tolerance than someone shakily retiring with less than a million dollars. Similarly, if you’re still young enough to work and confident enough to find work, you can tolerate risk better than someone with no practical way to return to the workforce.
The Dangers of Excessive Risk Reduction
As we’ve established, reducing risk in a retirement portfolio is generally a good thing, especially as you get older. However, you shouldn’t take this to mean that you should eliminate all risks or that risk reduction is always good.
Frequently, risk is a byproduct of potential upside. Stocks are somewhat risky, especially compared to investments like bonds, but they offer much higher returns. Optimizing a portfolio to be less risky typically means optimizing away from gains and profitability. If your portfolio is sufficiently robust and you no longer have a pressing need to continue making massive gains, this isn’t much of an issue. However, if you’re concerned about inflation, if you want your portfolio to continue growing, or if you’re barely scraping by on the income generated by your portfolio, reducing risk may not be in your best interests – or at the very least, there will be an upper threshold of risk reduction that you should not cross.
These thresholds and limitations vary among people, so making a universal recommendation is impossible. The most important takeaway is that you can’t or should not pursue pure risk reduction ad infinitum.
Your Golden Strategy: Diversification
The most important strategy for reducing risk in a retirement portfolio is diversification. Essentially, that means investing in many different types of assets simultaneously. Proper diversification means including many other asset classes in your investment portfolio and diversifying the types of investments held within each of those classes.
The purpose of this is to balance out potential risks and rewards. Every conceivable investment carries at least some risk of failure. If you have a portfolio with a diverse mix of different types of investments, no single investment failure can bankrupt you.
This is perhaps best understood with an example. Index trading is a strategy that allows you to incorporate diversification into your investment portfolio naturally. With a single purchase, you can invest in various equities; for example, you can invest in the S&P 500 index, thereby getting exposure to 500 different companies simultaneously. If any of these companies fail, it will have an almost negligible impact on the index’s overall performance. Even if 100 companies catastrophically fail, it would still only account for 20 percent of the index’s total value.
It’s important to consider diversification both broadly and narrowly. In other words, you should diversify the types of assets you hold in your portfolio and your strategic picks within each of those classes.
These are some of the most common types of asset classes to include:
Stocks
Stocks are among the most popular investment types because they offer a relatively high rate of return for relatively low risk and literally thousands of equities to choose from. Younger investors can afford to allocate most of their portfolios to stocks, but as you approach and enter retirement, most people gradually shift away from stocks. There’s nothing wrong with having a significant portion of your portfolio in stocks, but you should be wary that they present higher risks than many other assets on this list. You can diversify your stock holdings by investing in indices, as well as investing in different industries, investing in businesses of different sizes, and investing in businesses within different countries.
Bonds
Many retirees hold bonds as a foundational investment portfolio anchor. Unlike stocks and equities, bonds don’t represent an ownership stake within an organization. Instead, buying bonds is a way of buying debt. Whoever is offering the bond will pay back your principal with interest, usually at a fixed rate based on the risk associated with that debt. Bonds provide a much lower rate of return than stocks on average, but they also have a much smaller risk profile. Like with stocks, you can diversify your bond holdings with indices, as well as buying bonds from a variety of different sources.
Real Estate
Retirement portfolios also benefit from holdings in real estate. Real estate is historically one of the best asset classes in terms of overall returns, but it definitely presents some risks of its own. You can own and manage rental properties by yourself or with the help of a property management company, or you can invest in real estate indirectly with the help of real estate investment trusts (REITs). Either way, it’s a good idea to diversify your real estate holdings by investing in real estate in different areas, as well as both commercial and residential properties. If done properly, real estate can adequately balance stock and bond holdings and function as a relatively low-risk entry into your investment portfolio.
Cryptocurrency
It’s tempting to perceive cryptocurrency as a risky asset, and in some ways, it is. Historically, cryptocurrencies like Bitcoin have been very volatile, fluctuating in price as public sentiment shifts on a dime. And, of course, lesser-known and newer cryptocurrencies have been known to implode – and some have even been revealed as total scams. Still, cryptocurrency is an attractive alternative investment that can help flesh out your overall portfolio – if you know what you’re doing. The learning curve is a bit steep, but because digital, decentralized currencies have incredible potential, crypto is more than worth learning about – and potentially investing in.
Commodities
Commodities are fungible units of various items that can be readily interchanged with each other; they’re also typically useful from a practical perspective. Oil, sugar, and even precious metals are considered types of commodities. Commodities can be volatile, introducing significant risk into your portfolio. However, they also tend to perform well in inflationary environments and economically uncertain times; accordingly, they may serve a niche role in balancing the risks associated with more mainstream asset classes like stocks.
Other Currencies
You may also choose to invest in alternative currencies, especially currencies of countries you feel optimistic about. The United States, despite being an economic powerhouse, isn’t totally immune to high-level, large-scale economic risk. If our country experiences economic hardship or the dollar loses its status as a world reserve currency, anyone holding currencies of other developed nations stands to strongly benefit.
Alternative Investments
There are many types of alternative investments worth considering as well. These investments come in many shapes and sizes and typically fall outside the mainstream, giving you many different options. Hedge funds, private equity, art, and collectibles are just a handful of examples of alternative investments that could help you reduce or balance your retirement portfolio risk.
The exact allocation and balance of your portfolio is going to depend on your net worth and your personal goals. If you want to be as conservative as possible, with as much consistent income as possible, you should focus on bonds, safe blue-chip stocks, and appropriately balanced REITs. If you want to pursue greater returns a bit more aggressively, you should shift in favor of stocks and include potentially more volatile assets like cryptocurrency.
No matter what, it’s important that your retirement portfolio has a diverse mix of different assets. This way, no single risk or type of risk can seriously impact you.
Cash and Cash Equivalents
It’s also a good idea to hold more cash and cash equivalents. Cash is arguably the least risky asset to hold, as it’s not susceptible to losses and is backed by FDIC insurance if held in a qualified financial institution. Cash equivalents are about as safe but offer at least some marginal returns.
High-Yield Savings Accounts (HYSAs)
HYSAs are savings accounts that are designed to have higher yields. They may not help you see massive gains over the years, but they can at least mitigate the effects of inflation and give you a much better return than you could get with a typical bank account.
T-bills
A Treasury Bill, or T-bill, is a debt obligation from the U.S. government, officially backed by the U.S. Treasury Department. It’s an incredibly safe investment, available with different terms so that you can balance your holdings according to your needs.
CDs
Certificate of Deposit (CD) accounts are similar to savings accounts but with some important differences. Most notably, you will not be able to access your money throughout the course of the account’s maturity.
Annuities
An annuity is a financial product that practically guarantees you a fixed amount of income, typically at annual or monthly intervals, in exchange for your initial purchase of the annuity. There are many different types of annuities that are available — and they’re available from a wide range of financial institutions as well. Accordingly, you’ll need to do your due diligence before you decide on any annuity product.
That said, annuities from established, robust financial institutions are generally very safe. The rate of return is lower than what you might find with other investments and financial products, but that might be worth it, depending on your personal risk tolerance.
Evaluating and Rebalancing Risk
It’s important that you’re able to accurately evaluate the risk of your investment portfolio so you can rebalance it as needed over time. As you enter retirement, you may be perfectly satisfied with your portfolio’s performance and risk balance – but that will likely change. After just a few years, you may find that your assets are performing differently than you expected; some assets will overperform, disrupting the balance of your holdings, while others will underperform. You may also be introduced to new investment opportunities, or your income needs may change.
In any case, it’s vital to reevaluate your portfolio and rebalance it as necessary. For many retirees, it’s advisable to do this at least once a year. At the very least, you should do a health checkup on your investment portfolio to ensure it’s performing in line with your expectations.
Reducing risk in a retirement portfolio isn’t always easy, especially if you’re also optimizing for higher returns in the face of risks like inflation. However, with some careful rebalancing and attention to your personal level of risk tolerance, you should be able to maintain a portfolio that’s perfectly aligned with your goals.
The post How to Reduce Risk in a Retirement Portfolio appeared first on Due.
