Key points:
– Retirees cannot eliminate all financial risk; reducing one type often increases exposure to another.
– To maintain purchasing power in retirement, investments need to outpace both inflation and taxes.
– A diversified portfolio of stocks and stable holdings is often best for balancing growth and risk.
Q. As I approach retirement, I am wrestling a bit with how much risk I should be taking with my retirement funds. How should I think about risk as I near the time when I have no paycheck? — Carol in Indialantic
A. Carol, over the years I have noticed that the people who are most comfortable with their investments understand the risks they face and consider risk from several angles.
The first dimension is the need to take risk. You cannot eliminate all risk. If you reduce one kind, you increase exposure to other types of risk.
For example, most people see an investment that does not fluctuate in value as safe and one that does fluctuate as risky, but there is more to it. Many people would love to “live off interest and not touch principal.” It is an attractive idea, but if you require stable principal, you become fully exposed to the risk of fluctuating interest rates. We just went through an extended period when interest rates on stable holdings were a fraction of 1%, falling far behind inflation and taxes.
There have been times when stable instruments yielded enough to overcome inflation and taxes, but those periods usually did not last long, and the returns over inflation and taxes were low.
A newly retired 65-year-old has, hopefully, at least 20 years of retirement to fund. It is nearly certain that food, clothing, and many everyday expenses will cost more in 20 years. Taxes could be higher too. To maintain your current financial position, you need to stay ahead of taxes and inflation.
Historically, diversified stock holdings have been the best asset for staying ahead of inflation and taxes over 20-year periods. But loading up on stocks brings substantial risk of principal fluctuation. For most people, some balance between stable holdings and growth-oriented holdings is best. That balance should be based on several factors, particularly how much cash flow you need from the portfolio beyond other income sources, such as Social Security or a pension.
What is ‘risk capacity’ and why does it matter?
A second dimension is risk capacity: a measure of how much you can afford to lose before your standard of living is at risk. We see many people get burned because they never make this assessment. One common example is holding an outsized position in the stock of one company.
On average, individual stocks are about twice as volatile as the market as a whole. Even good businesses can see their stock price collapse and stay down for a long time. At some point, the decline can be so severe that recovery is unrealistic. The market has always recovered from its drops and reached new highs, but many individual stocks that fall never recover. According to research by Heaton, Bessembinder, and others, four out of seven of the 26,000 stocks that traded on major U.S. exchanges from 1926 to 2016 underperformed U.S. Treasury bills, a reasonable proxy for cash.
The last dimensions I’ll mention are risk composure and risk perception. I find it helpful to explore how people reacted during tough financial periods. As someone approaching retirement, Carol, you have been through good times and bad. When were you most afraid financially? What was happening? What did you do? What would you do differently and why? Was your perception of the danger worsened by certain people or by the news?
In my experience, people have a much better chance of succeeding financially with a well-thought-out plan than by moving money around based on short-term forecasts. Resilience is more reliable than nimbleness.
You can’t avoid risk, but you can take it on thoughtfully and manage it intelligently.
Dan Moisand, CFP® has been featured as one of America’s top independent fee-only financial planners for retirees and near retirees by at least 10 financial planning publications and practices at one of America’s most decorated independent firms. For more info, e-mail him atdan@moisandfitzgerald.com, visit moisandfitzgerald.com, or call Dan at 321-253-5400, ext. 101.
Originally published on FloridaToday. Read the original article here.