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“If you take no risks, you will suffer no defeats. But if you take no risks, you win no victories.” –Richard M Nixon
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Investors are rewarded for taking risks. This is a core fact of investing. An investor would expect a greater return for an investment in the stock market than an investment in the bond market because investing in stocks involves greater risk. Investors expect a greater return per unit of risk in the stock market versus the bond market.
Early in my working career, risk was my friend!
Assuming a little higher risk in my portfolio increased my chances of a higher-than-normal return. Having a 50-year investing window meant that I could tolerate more risk while investing in both up and down market cycles.
Risk was a helpful partner that allowed me to maximize my investing potential.
But, like many partnerships, things change over time. As I moved closer to the end of my working career and closer to Retirement, risk became an ever-increasing problem as my investing horizon and my ability to overcome bad sequences of return decreased.
Instead of a catalyst used to speed up the process of attaining financial independence, risk became an accelerant with the potential to overheat or destroy my retirement portfolio.
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So, what happens when your partnership with risk no longer works? How do you dissolve the partnership? This process is termed portfolio de-risking.
There are several terms similar to portfolio de-risking associated with the approach of retirement. Some of these terms include net worth, financial independence, having “enough”, sequence of returns risk, and portfolio de-risking.
This can be a problem for workers approaching Retirement as each refers to something of importance. De-risking, although not a familiar term for most workers, is one of those important terms.
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The Oxford Language Dictionary defines De-Risking as taking steps (especially in a business context) to make (something) less risky or less likely to involve a financial loss.
Portfolio De-Risking refers to the process of strategically shifting investments from higher-risk assets to lower-risk assets to protect wealth and mitigate potential losses. This is particularly relevant for investors approaching retirement or those with a shorter time horizon for their investments.
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Why De-Risk?
- Protecting wealth: Safeguarding existing capital becomes more crucial than pursuing aggressive growth as retirement approaches. As I stated, the Risk that was once a partner and friend becomes more of a problem.
- Reducing volatility: Derisking helps to smooth out the ups and downs of market fluctuations, providing greater predictability in your portfolio’s performance.
- Mitigating sequence risk: This is the risk of experiencing large portfolio losses early in retirement, which can significantly impact the longevity of your savings. For more information on sequence of returns risk see: TAMING THE SILENT RETIREMENT KILLER: UNDERSTANDING SEQUENCE OF RETURNS.
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Common De-Risking Strategies
- Shifting away from stocks: Bonds offer lower volatility and more reliable returns when comparing stocks to bonds. This lessened volatility makes them a cornerstone of derisking strategies.
- Reducing exposure to high-yield debt: High-yield bonds, while offering potentially higher returns, often behave more like stocks and may not provide the desired risk reduction.
- Increasing allocation to cash or short-term bonds: These assets provide immediate liquidity and a buffer against market downturns, allowing you to avoid selling riskier assets when at a loss.
- Diversifying across asset classes and regions: Spreading your investments across different asset classes (stocks, bonds, real estate, cash) and countries can help mitigate the impact of localized economic issues and market downturns.
- Investing in high-quality companies and lower-volatility equities: Within your equity allocation, consider focusing on companies with strong fundamentals and a history of stable performance. Low-volatility equity strategies can also offer comparable returns with reduced risk.
- Purchase an Annuity: Purchasing an annuity is an excellent way to decrease risk, as most annuities are not subject to market fluctuations, and market returns. Retirees seeking maximum safety should seek out annuities without direct or indirect ties to stock market returns. Much has been written about purchasing an annuity versus receiving a lump sum payment from a pension plan. An annuity purchased in a de-risking transaction normally retains the spousal protections from the plan and the protections from creditors. Instead of being insured by the Pension Benefit Guaranty Corporation (PBGC), participants receive coverage under the state insurance system. Josh Gotbaum, former PBGC director, which insures private-sector defined benefit pension plans, has said that the state insurance system, with states’ insurance guaranty association coverages, is at least as good as PBGC coverage, and that policy-makers should not be concerned about de-risking when it involves a private insurance company. He made those comments in testimony before the U.S. Department of Labor’s ERISA Advisory Council on August 29, 2013. Annuities, whether paid from the plan or a private insurer, should be encouraged because they provide more protection to the participants than lump sum payments. -American council of life insurers
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Key Considerations
- Time horizon: The closer you are to retirement or your financial goal, the more aggressive your derisking strategy should be.
- Risk tolerance: Understand your comfort level with potential losses and tailor your derisking approach accordingly.
- Retirement goals and spending needs: Factor in your expected retirement spending and other income sources when determining the appropriate level of risk for your portfolio.
- Tax implications: Be aware of the potential tax consequences when selling assets, especially in taxable accounts.
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Implementing a De-Risking Plan
- Consult with a financial advisor: A professional can help you assess your circumstances, define your risk tolerance, and develop a customized derisking strategy.
- Review your asset allocation regularly: Monitor your portfolio’s performance and make portfolio adjustments as needed to stay on track with your financial goals.
- Consider using target-date funds: These funds automatically adjust their asset allocation by gradually shifting towards more conservative investments as you approach your target retirement date.
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Final Thoughts
Preparing for retirement is much harder than most people think. There are multiple decisions and inflection points that must be considered. Each of these inflection points and decisions has the potential to significantly affect the rest of your life.
The decision to de-risk a portfolio prior to retirement is one of those decisions. It’s important to note before the end of this blog that I am not saying the proper strategy is to remove all risk. A 100% cash or bond portfolio is not 100% risk-free. All cash or all bond portfolios are subject to inflation risk where periods of high inflation can significantly decrease the effectiveness of these stock-free portfolios.
A more reasonable approach is to reduce, but not eliminate, the amount of stock exposure in a portfolio when approaching Retirement. Portfolios with an 80% or 90% stock exposure can be reduced to a 50% or 60% level of stock exposure. This reduction in stock exposure significantly reduces risk while maintaining some inflation protection provided by stock exposure.
De-Risking is an essential part of sound financial planning, particularly as you approach key life stages or milestones. By proactively managing risk, you can increase the likelihood of achieving your long-term financial objectives with greater peace of mind.
Once you’ve won the game, quit trying to win the game!
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