Nov
07

Retirement Security? The Name of the Investment Game is Controlling Risk
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As an investment manager, I learned a long time ago that I do not have much control over the rate of return on an investment that is the markets role. The extent of my control over return is setting up the basic parameters of your portfolio – how much will go into stocks and how much into bonds and cash?

The expectation is that if we hold your positions through market downturns you will eventually be rewarded with a market upturn. This follows from my belief that in the long term taking risk must be rewarded or the market for that asset will disappear. Holding onto a losing position waiting for an upturn is easier said than done. No real magic here other than a disciplined approach.

I do, however, have a much greater ability to control for risk. And controlling for risk is essential in a retiree’s portfolio. Through risk control you can moderate the ups and downs in the market. Why is this important for the average retiree?

Most retirees make periodic withdrawals from their portfolio to meet basic living expenses or to meet large, sometimes unexpected expenses. But it is those periodic withdrawals that can decimate your portfolio. Think of these withdrawals as “losses” in your portfolio. But unlike investment losses that may rebound, these are permanent losses to your retirement nest egg.

During a market downturn these withdrawals compound the problem – making a withdrawal during a moderate or severe market downturn reduces the value of your portfolio even further. The practical impact on you is shortening the expected life of your portfolio. If at retirement, the expectation was that your portfolio would provide an inflation adjusted stream of income for 30 years, the combination of a severe downturn in the market plus the periodic withdrawals may reduce the life of the portfolio by 5 years.

How do I reduce that risk? One way is to moderate the downturns. Each portfolio I build for my clients has what I refer to as “low market correlation” (LMC) investments. In other words, when the market zags the LMC investments zigs – moderating any downturn. But this comes at a cost – when the market does recover, the upturn in your portfolio will not be as large. Risk control always comes at a price after all you are buying insurance. But for a retiree this cost is well worth it. Retirees, unlike those still in the paid labor force, do not have a long timeline to “recover” and the withdrawals increase the “loss” within the portfolio.

Retirement portfolios must be built around reducing risk and moderating downturns even at the cost of reducing the future rate of return. In other words, think controlling risk first, and investing for return, second.

Written by Wealth Management.