One of the most important aspects of retirement planning is ensuring that your nest egg is protected from market downturns. As you approach and enter retirement, the stakes get even higher, and the margin for error diminishes.
The pursuit of financial security demands a plan with risk management. As disciplined savers, your well-earned nest egg – having surpassed the million-dollar mark – is both a testament to your financial acumen and a call to safeguard the fruits of your labor.
This article discusses how to reduce risk in a portfolio and includes insights on diversifying your portfolio, correctly allocating assets, and improving your decision-making.
While proper diversification doesn’t guarantee against loss, our hope is that these tips can help steer you toward a prosperous retirement.
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Avoid Timing the Market
There’s an old investment adage that says, “Time in the market is more important than timing the market.” Like most cliches, this one rings true.
Trying to time the market is akin to trying to guess the physical factors of the roulette ball so that you can accurately predict its landing point on the table. In a perfect world, you’d be able to accomplish this. But, in reality, there are just too many factors at play and the margin for error is too small to be continuously successful.
Let’s meet two hypothetical investors, Lisa and John.
Lisa invested $1,000 into the S&P 500 index (Excludes fees and taxes. Not available for investment.) on January 1st, 2009 after experiencing a tumultuous market crash. Nearly every headline she reads is negative and there appears to be no end in sight. However, she realizes that trying to time the stock market is a fool’s errand. Instead, she trusts in markets long-term and prefers to avoid timing the market.
John, on the other hand, takes a different approach. He believes that it’s possible to get in and out of the stock market at the right time over the long-term. John invests $1,000 on January 1st of 2009, but decides to move his money to cash for three months after each of the 20 worst days since 2009. After the three month period, John reinvests into the S&P 500 index.
How did both investors turn out? Just take a look at the chart above.
Lisa’s $1,000 grew to $6,323 and John’s $1,000 grew to only $4,403 due to his market timing strategy.
Why?
Market timing hinges on accurately predicting market moves based on macroeconomic issues, a feat that eludes even the most seasoned experts. Even worse – just like the roulette table – the allure of predicting the perfect time to buy or sell assets is a siren song that has lured many astray.
In the pursuit of long-term financial well-being, we believe a better approach involves staying the course with a well-crafted investment strategy. In the short term, it’s impossible to predict what the market will do. But, over the long run, the market has always trended up and to the right. While not guaranteed, if you keep your money invested long enough, your nest egg has a better chance to accomplish the same goal.
Diversify, Diversify, Diversify
Diversification is the cornerstone of a robust retirement portfolio. If your goal is to learn how to reduce risk in a portfolio, this is a key topic. Here are some tips to help you navigate diversification in your portfolio:
Asset Class Variety:
Spread your investments across different asset classes such as stocks, bonds, real estate, and possibly alternative investments. And yes, we believe that bonds are still a powerful component of a diversified portfolio.
Each asset class responds differently to economic conditions, providing a potential buffer against market volatility. For example, when your stocks are down, bonds might be up.
Global Allocation:
Consider international diversification to reduce risk with any single country's economic performance.
Global exposure can add a layer of resilience to your portfolio. You can gain some exposure through large U.S. companies, but there are also many funds that focus on different markets.
Size and Style Diversification:
Include a mix of large-cap, mid-cap, and small-cap stocks to balance growth potential and risk.
Diversify between growth and value stocks to capture different market trends. For example, value stocks often provide income by paying dividends.
Real Assets and Real Estate:
Consider investing in real assets like commodities to hedge against inflation.
You can also buy and manage different properties. And for a more hands-off approach, real estate investment trusts (REITs) can offer exposure to the real estate market.
Professional Guidance:
Consider consulting with a financial advisor to tailor your portfolio to your financial situation and goals.
As illustrated in the chart above, the significant outperformance of U.S. stocks represented by the S&P 500 index in recent years had led some investors to avoid other areas of the market.
But, as you can see, there have been many historical periods in recent years when other asset classes such as international (ex: Europe Asia Far East (EAFE) and Emerging Markets (EM)) and small cap companies outperformed.
While diversification cannot guarantee against a loss, diversification takes advantage of these trends.
With cheaper valuations and global growth, it may be best to not overlook other regions for investment.
Remember, the key is not just to diversify for the sake of it but to create a well-balanced mix of assets. Your portfolio should align with your long-term goals and risk tolerance.
How to Reduce Risk in a Portfolio: Stocks vs. Fixed Income
Balancing stocks and fixed-income assets goes hand in hand with diversification. Here are some guidelines to help you strike the right balance:
Risk Tolerance:
Assess your comfort level with market fluctuations. If you're averse to big ups and downs, a higher allocation to fixed income may be suitable. Taking a proper risk tolerance test can help.
Fixed Income Variety:
Diversify your bond holdings by including government, corporate, and possibly municipal bonds.
Varying maturities can provide a balance between income and interest rate risk.
Sleep Factor Rule:
A little known rule of thumb that we often discuss with clients is the sleep factor rule. To determine the amount of stocks and fixed income you may want in your portfolio, ask yourself how much your portfolio could decline during a turbulent stock market before you would abandon your investments. Then, double that percentage to come up with the amount of stocks you should own.
For example, Tom is a long-term investor, but he and his wife Mary would become very uncomfortable if their portfolio dropped by more than -30% or $600,000 on a $2 million portfolio. Tom multiplies 30% by two to come up with his target stock percentage of 60% stocks. He then subtracts 60% from 100% to calculate his target fixed income exposure. Tom and Mary end up with a portfolio that is 60% stocks and 40% bonds.
Focus on Long-Term Wealth Building
Similar to staying physically healthy, building wealth is all about letting small decisions play out over the long run. For example, eating just one salad won’t be enough to make you healthy. But, if you eat a salad every day for decades (paired with ample exercise) then you’ll undoubtedly be in great shape.
We believe that the same rings true for your investments.
Try to avoid constantly buying/selling different stocks or assets in hopes of chasing a slightly higher return. Instead, commit to your investment strategy and embrace a patient mindset. In doing so, you’ll enjoy the magic of compound interest as you can see in the chart above.
Couple this with reinvested dividends and consistent contributions and you’re well on your way to building a golden nest egg to fund your retirement.
Hedge With Options for Concentrated Stock
Hedging with options can be a strategy to mitigate risk. If you have a large portion of your wealth tied to a single stock, options can provide a safeguard against a downturn. This is because you can buy options on your stock that will rise in value should your stock decrease in price. Thus, offsetting your loss.
A protective put strategy allows you to purchase put options on the stock, setting a predetermined selling price to shield against potential downturns. This insurance-like approach ensures a floor for the stock's value, limiting potential losses while allowing you to participate in any upside gains on the stock.
Also, covered call options can lower risk by generating extra income. This works by selling the right to buy your stock at a specified price. However, these strategies are not suitable for everyone, can get much more complex, and can be expensive.
If you’re interested in learning more, be sure to schedule a consultation with one of our wealth advisors.
Short-Term, High-Quality Bonds
Short-term, high-quality bonds offer advantages that align with the needs of many retirees.
First and foremost, these bonds generally have lower risk compared to longer-term bonds. With shorter maturities, they are less sensitive to fluctuations in interest rates, providing more stability in the face of market volatility.
Moreover, high-quality bonds, often issued by stable entities such as governments, present a lower risk of default. This increased level of safety aligns with the conservative goals of many retirees. It can offer a more stable foundation for a portion of your portfolio.
For example, in the chart below we illustrate the returns of the S&P 500 index vs. the Bloomberg U.S. Aggregate Total Return index since 1990. As you can see, in all years where returns for the stock market were negative, the bond index performed better thus illustrating the power of diversification with bonds.
The shorter time to maturity also improves liquidity, providing retirees with the flexibility to access their funds quickly if needed. This liquidity can act as a cushion during financial emergencies.
Short-term, high-quality bonds in your retirement portfolio can serve as a stabilizing force. While not guaranteed, this approach may offer lower interest rate risk, increased safety, liquidity, and a reliable income stream.
Avoid Concentration Risk
This step can be crucial for safeguarding your financial well-being. Here are some tips to help you mitigate concentration risk:
Diversify Across Asset Classes:
Spread your investments across asset classes, including stocks, bonds, real estate, and potentially alternative investments. This diversification helps reduce the impact of poor performance in any single asset class.
Diversify Within Asset Classes:
Within each asset class, diversify further. For stocks, consider a mix of industries and sectors. For bonds, diversify across different issuers and maturities.
Limit Exposure to Individual Stocks:
If you have a large portion of your portfolio invested in individual stocks, consider reducing exposure. You can diversify into a broader range of equities or investment vehicles. If you need help building a strategy to diversify your portfolio away from concentrated stock, contact us for a free assessment.
Mutual Funds or Exchange-Traded Funds (ETFs):
Consider investing in funds that provide exposure to a basket of securities, offering instant diversification. Professionals manage these funds and can help lower the impact of a single stock's poor performance.
Limit Leverage
One key strategy to reduce risk in a portfolio is to avoid using margin, which is money that you borrow against the value of your investments. While margin trading can amplify returns, it also magnifies losses, posing a significant risk to your retirement savings.
Focus on a disciplined investment strategy that aligns with your risk tolerance and long-term goals. Resist the temptation to chase quick gains through leveraged products, as they can expose you to more risk. Prioritize a diversified portfolio with a mix of asset classes, and regularly review and rebalance to maintain a prudent level of exposure.
Liquidity Management
Market downturns call for financial resilience. In times of market turbulence, liquidity acts as a financial buffer, allowing you to cover expenses without being forced to sell investments at depressed values.
Consider having three to twelve months worth of living expenses in easily accessible, low-risk assets, and avoid tying up all your funds in long-term, illiquid investments. Liquidity not only provides peace of mind during a market downturn but also positions you to seize investment opportunities that arise when asset prices are low.
Here’s more on where to invest emergency funds in retirement.
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Stay Loyal to Your Investment Principles
With the insight above, you’ve learned how to reduce risk in a portfolio. A commitment to your long-term goals and resilience against the fluctuations of the market can help you stay on track with your retirement goals. Begin by building a clear and realistic investment strategy that aligns with your risk tolerance, financial goals, and retirement timeline.
Once set, resist the allure of short-term market noise and remain unwavering in the face of volatility. Regularly review your portfolio's performance, but let your main goals guide decisions rather than fleeting market trends. Diversification, rebalancing, and a focus on quality investments are pillars of a sound retirement—stay true to them.
If you’re interested in learning more about how to build wealth to and through retirement, contact us today for a free retirement assessment.
We hope that you’ve found this article valuable in learning how to reduce risk in a portfolio.
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Author: Mark Fonville, CFP®
Mark is a fiduciary, fee-only financial advisor at Covenant Wealth Advisors specializing in helping individuals aged 50 plus plan, invest, and enjoy retirement without the stress of money.
Forbes nominated Mark as a Best-In-State Wealth Advisor* and he has been featured in the New York Times, Barron's, Forbes, and Kiplinger Magazine.
Disclosure: Covenant Wealth Advisors is a registered investment advisor with offices in Richmond and Williamsburg, VA. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. The views and opinions expressed in this content are as of the date of the posting, are subject to change based on market and other conditions. This content contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Please note that nothing in this content should be construed as an offer to sell or the solicitation of an offer to purchase an interest in any security or separate account. Nothing is intended to be, and you should not consider anything to be, investment, accounting, tax, or legal advice. If you would like accounting, tax, or legal advice, you should consult with your own accountants or attorneys regarding your individual circumstances and needs. No advice may be rendered by Covenant Wealth Advisors unless a client service agreement is in place. Hypothetical examples are fictitious and are only used to illustrate a specific point of view. Diversification does not guarantee against risk of loss. While this guide attempts to be as comprehensive as possible but no article can cover all aspects of retirement planning. Be sure to consult an advisor for comprehensive advice.
Registration of an investment advisor does not imply a certain level of skill or training.