Risk management for retirement portfolios

I’ve been thinking a lot about risk management lately. A retiree faces a lot of risks but not the ones that are usually talked about. The biggest two, in my opinion, are suffering a very large portfolio decline and retirement income not keeping up with inflation and taxes. This is mainly a thought post on these risks and what are the options an investor has to manage them.

To start, I want to separate the concept of risk and volatility. Standard finance theory defines risk as volatility, plain and simple. The more the price of an asset varies the riskier it is. First of all, volatility has two sides, upside volatility and downside volatility. I think all investors would consider higher upside volatility as less risky, not more. Also, with income producing assets, like dividend stocks, higher downside volatility can actually enhance returns. So much for standard finance theory.

Two main aspects differentiate a retiree portfolio from a non-retiree portfolio. Retirees are not adding new money every year to their portfolios and they must withdraw a portion of their portfolio every year to pay for living expenses. So, you can see why a large portfolio decline, particularly early in retirement, can be devastating for a retiree. On the other hand, over the long term, inflation and taxes are retirement killers and thus exposure to higher return assets, like stocks, is a must. The longer the retirement period the higher exposure to stocks is required to keep up with the ravages of inflation and taxes. Most retirement planning models completely ignore inflation and taxes. Its a lot easier to just talk about retirement planning for tax deferred accounts.

What are the options for managing such risks? The standard prescription is diversification. Allocate stock assets to various sectors and countries, allocate bond assets across durations and credit risks, keep some cash handy, and (as has become common nowadays) have some allocation to precious metals to protect you from the government destroying your currency. All these assets will perform differently over time, some up some down, and every once in a while you re-balance the portfolio by selling the expensive assets and buying the cheaper ones. The result of all this being you get better ‘risk-adjusted returns’, i.e. returns with lower volatility. The problem with this is two-fold. First, during very bad times like the 2008 financial crisis most risk assets tend to move down together or correlations completely reverse directions. Diversification protects an investor during mild market moves, normal recessions, etc… but it fails an investor at the most important time. Second, the lower allocation to stocks in order to reduce volatility may end up increasing risk for a retiree.

There are alternatives to standard diversification to manage risk. Some of the ones I have used, currently use, or am considering using are:

  1. Hold more cash. Cash is the ultimate volatility reducer. By holding more cash your portfolio volatility will go down but what it ultimately does is give you an opportunity to improve future returns when the market gives you a chance. In this way, cash is like a call option with an infinite maturity. It does have a cost, the cost being your potential loss in purchasing power by holding it, particularly in the presence of negative real interest rates like we have today. They key to this risk management approach is having a strategy of when to use it. It does your long term returns no good if you never use it.
  2. Time the market. There are many strategies the fall into this category. For me, the use of stop losses or trailing stops falls into this category. The problem with stops for me is the other side of the stop. Once your out, how and when are you going to get back in? Like the cash option above a strategy to get back in to risk assets is key. The one additional downside to using stops is the triggering of a taxable event when you sell. The other timing strategy that I have researched are momentum strategies. Despite what the efficient market people tell you, momentum strategies work. The ones I like in particular are 10 month moving average strategies to enter and exit risk assets. World Beta is a great site to learn about the background of this approach. The upside of this approach is the well defined exit and entry points.
  3. Use options to hedge the stock portion of the portfolio. Many professional portfolio managers use options to hedge their stock portfolios. There are many ways to achieve the hedge such as buying put options, using collars (calls and puts), or option spreads to achieve the hedge. The downside is usually the cost of the option hedge which does reduce returns. Using options to hedge a portfolio needs to be viewed like buying insurance. You can’t be upset because you ‘wasted’ the option premium. You put the hedge in place just in case.
  4. Use structured products to protect assets to the downside. As I discussed in my structured product post, I currently use these investments for my commodity and currency holdings. I would not use these structures for any income generating investment.

All of these risk management approaches I guess would be considered active risk management as opposed to the passive risk management of standard portfolio theory. I agree with that classification and think that in today’s environment it is more important than ever to stay vigilant and active in the sense of monitoring your portfolio for risk whatever your approach. I plan to do future posts on momentum strategies and using options to manage risk.

In summary, I believe active risk management is critical for all investor portfolios but in particular for retiree portfolios. In future posts I’ll cover the options strategies I mentioned plus the momentum strategies.

Full Disclaimer - Nothing on this site should ever be considered advice, research or the invitation to buy or sell securities. These are my personal opinions only.

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9 Responses to Risk management for retirement portfolios

  1. Lynne says:

    Just wanted you to know I read this blog a lot and really like hearing what you have to say about investing. And wanted to thank you for taking the time to write about what you love talking about. Thank you again!

  2. Rick says:

    You are where we want to be and to be honest with you I am jealous. What is stopping Cathy and I from jumping out of our jobs is that we don’t see our money working hard enough for us to jump out although between the two of us we have about 1.5 mill saved. We are both 55 y/o, rather thrifty, but we are scared of loosing our healthcare insurance benefits at work, the costs of maintaining the house, although it is paid off and the loss of saving 50k a year in retirement plan contributions. Your coments or advice as to how overcome the fears of retirement before 65 will be appreciated.

    • libertatemamo says:

      Hi Rick, thanks for the great comment. I can certainly understand your concerns about calling it quits. This is my third time trying – so far successful. The previous two times I got scared back to working due in large part to financial concerns. One thing I’ve learned is that early retirement is as much psychological as it is economic. Obviously, I don’t know any details of your situation, but just based on what you wrote I would say that economically you and your wife are absolutely capable of retiring early. I wrote a post a few weeks ago called ‘Recipe for a happy retirement’ where I talked about some of the psychological issues I went through in retiring. In that post I really didn’t talk about how I got over my economic fears enough to make the jump but that was a big part of the process. A key for me was making a very conservative retirement plan as far as investment returns go, my wife and I chose to live a frugal lifestyle – just one of the many reasons we chose to go RV’ing full time, and lastly a commitment to stay flexible. Even now that I’m retired I can choose to work part time if needed, I can reduce my living expenses, etc… in other words there are many choices in between working full time and not working at all to fill in gaps. And finally, as my wife always says, ‘what’s the worse that can happen, we go back to work?’ So, worst case for me, from now until maybe that worse case event of going back to work in the future, I’m living my dream. Not a bad tradeoff.

      Anyway, sorry for the long reply. I’d be happy to discuss your situation in some more detail of you want. Drop me an email and we can discuss further. I’d love to help more people make the jump to early retirement.

      • Rick says:

        Thank you for the reply.

        Did you ever consult with a retirement counselor? It seems like this is the latest financial advising craze. Is this a good way to go? Did you and your wife have consolidated investment accounts or did each of you steer your own investments?


  3. libertatemamo says:

    Rick, we did not consult with a retirement counselor. I’ve been an investment buff since I was in my teens and have always managed our portfolio. It may or may not be useful for you to consult with one depending on what you’re looking for. A fee based financial planner would be the way to go if you’re interested in this route. On the other hand, I don’t think its necessary, you can learn all you need to know online. I can tell you that their advice will be pretty standard; diversify across asset classes, follow the 4% rule, etc… A good resource is a newsletter from the Motley Foll called ‘Rule Your Retirement’. Its a great place to get started on these retirement topics. They have a good message board as well. I think its $150/yr or so, much less than a retirement counselor will cost you. I’m on those boards every once in a while as well. I think its well worth the cost whatever path you choose. The more you know the better off you’ll be.

    As to your last question, we’ve always had consolidated investment accounts, we met when we were both $10K in debt, and I have always managed those accounts.


  4. Rick says:

    Paul, thank you for your feed back.


  5. David Fleischer says:

    Useful. I look forward to the next post on the 10 month average…

  6. Pingback: Reducing risk and enhancing returns through market timing « Investing For A Living

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