It used to be that as you approached retirement, you’d adjust the asset allocation of your investment portfolio by increasing bond holdings and cutting back on stocks. That was the golden rule. The reason: Historically, bonds carried less risk than stocks and were considered to be safer, more conservative investments.
But a newer strategy — risk allocation — may actually be a better way to safeguard your nest egg.
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To understand how to apply this new philosophy to your portfolio, you first need to be clear about what volatility is, where it can hide and how to control it.
Understanding Investment Volatility
Volatility indicates how much an asset's future returns are likely to deviate from its historic average return.
For example, a volatile investment could rise 25 percent one year and fall 30 percent the next. An investment with low volatility, however, might rise 4 percent one year and slip just 3 percent the next.
Investments that offer bigger potential returns tend to be the most unpredictable, with hefty upswings often complemented by big downswings.
In general, that’s how stocks behave. On the other hand, Treasury bonds typically have low risk and volatility, but they generally offer modest returns.
However, not all bonds fall into the low risk/low volatility camp these days. That’s why as you near retirement and transition to a low-risk portfolio, it’s important to understand the level of volatility of each of your investments.
The Big Mistake Investors Make
The problem with volatility is that it causes some investors to sell securities when they shouldn't.
People tend to rush to unload sinking investments and volatile securities are more likely to experience large drops than conservative stocks. Trouble is, the same investors often reinvest in the same type of securities after the market has recovered. In other words, they sell low and buy high, the opposite of what they should do. Consequently, volatile securities can result in severe portfolio losses.
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No one wants to ever lose money, of course, but the possibility is especially frightening as you near retirement. You have less time to recover from losses than when you were younger and you may need to sell investments to cover your living expenses. If you sell after taking a significant loss, it becomes much harder to bounce back.
Bonds No Longer a Safe Haven
It only makes sense, then, that you’ll want to lower the volatility in your portfolio as you get older to safeguard your retirement funds. But bonds don't necessarily reduce volatility the way they once did — for two reasons.
High-quality bonds crashed in 2008 along with stocks and since the financial crisis, Standard & Poor’s and Moody’s have come under fire for not adequately assessing the risk of the bonds issued by companies they rated. So today, a large number of corporate and municipal bonds simply aren’t top-rated or what’s known as “investment grade.”
In addition, foreign and emerging markets bonds can now be especially turbulent. Shaky economies worldwide mean that governments are finding it harder to meet their debt obligations, so their bonds have become riskier, behaving more like stocks. (For more about how bonds have grown more perilous, see Chris Farrell’s article, “Why Stocks Look Safer Than Bonds Right Now” on Next Avenue.)
2 Ways to Reduce Volatility
So what’s an investor nearing retirement to do to keep volatility in check while trying to make a portfolio grow as much as possible?
One strategy is to determine a target volatility for your portfolio based on your risk tolerance and investing goals. For example, if 5 percent a year is the maximum portfolio loss you can handle, look for investments that historically haven’t fallen more than that very often, if at all.
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You can do this before contributing to 401(k) accounts or investing in mutual funds by looking at the five-year historical returns in their prospectuses.
Pay particular attention to any years when the market experienced big losses, like 2008 and 2009. Did the 401(k) account or fund experience a big drop in value as well or were its losses minimal? If the investment consistently avoided large drops when the rest of the market tumbled, that could be a good pick for a low-volatility portfolio.
Alternatively, you could mix and match investments with different levels of volatility to arrive at the average portfolio risk you can tolerate, in this case 5 percent.
If you have a financial adviser or broker, be sure the pro understands that you want to approach your portfolio allocation from the viewpoint of volatility or risk, not potential returns. It's a solid strategy — and a safe bet.