By Mike Bergen, CIMA®
From time to time, we use this column to discuss the different types of risk investors face in managing their portfolios. Often, we are more geared toward talking about risk on a theoretical level. Today we will explore risk on a more practical level, and how to address those risks in your retirement investment portfolio.
Investors face many types of risk in their portfolios, but the one we commonly focus on is the risk of loss of principal. This is the risk that the money you invest will be worth less when you take it out of an investment than it was when you put it in. Risk of loss of principal can be divided into two types: Systematic and Unsystematic. Systematic risk is the risk inherent in an economy, like recession and inflation. These risks affect all investments, and diversification is not an effective tool to mitigate these risks. Another systematic type of risk is political. This is the risk that the government will do something that will hurt all investments, such as raising taxes. Unsystematic risk is the risk of any particular investment. For example, if you invest in a company and the management of the company makes poor decisions, those decisions may have a negative impact on your investment. This is risk that is limited to that one company – in fact, bad decisions by one company may have a positive effect on its competitors. This type of risk may be mitigated by diversification.
If you are retired, and drawing income for your portfolio, you are also subject to liquidity risk. This is the risk that you won’t be able to sell your investments when you need to, or that you will have to sell at an inopportune time, like when the market is down. You may be able to address this risk by having a certain amount of your assets in things like cash and short-term fixed income investments. To determine how much, start with your monthly expenses. Subtract regular monthly income like Social Security and pension payments. The remainder is what you need to have liquid in your retirement portfolio each month. Multiply that number by the number of months’ expenses you want to keep in cash. For example, if you want to have six months’ worth of expenses liquid, you should multiply by six.
However, liquidity comes at a cost. Short-term investments usually pay less than long-term investments, although that is not necessarily true right now. Just to maintain your purchasing power, you must earn at least as much as inflation. As inflation has been higher lately, chances are you will need a higher return than you can get with cash and short-term fixed-income investments to keep pace over time. Historically, many investors have looked to stocks to bridge the gap.
Stock investments come with their own set of risks, including the risk of loss of principal covered above. In addition, if you have poor returns in the early years of a portfolio, you may have lower returns overall than if the bad returns came later. This is called sequence of returns risk.
Another potential risk to your retirement portfolio is withdrawal rate risk. This is the risk that you will withdraw more than the account can generate and you will run out of money. For many years, 4% was considered to be the highest sustainable withdrawal rate. New research suggests that 4% is too high. (Source: TheBalance.com, Fidelity Investments) Of course, market conditions and the returns you actually earn will ultimately determine what the sustainable withdrawal rate is.
Finally, you will need to address succession planning. Who will run your portfolio and make investment decisions if you are unable to. A written plan or set of instructions will make it easier for a spouse or adult child to manage your portfolio according to your wishes.
This is certainly not an exhaustive list of all the risks your retirement portfolio faces. However, addressing these may help in your pursuit of your financial goals.
To hear the podcast of the Smart Money Management radio show on this topic, or others, go to our website at alderferbergen.com.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
All investing involves risk including loss of principal. No strategy assures success or protects against loss.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.
Asset allocation does not ensure a profit or protect against loss.
Securities and financial planning offered through LPL Financial, a registered investment advisor. Member FINRA/SIPC.