Should you reduce portfolio risk?
Know when the time is right to begin de-risking your portfolio
How much will you spend in retirement?
Many of the recent investor meetings I’ve been involved in recently have directly or indirectly addressed the elephant in the room that everyone is thinking about: the right timing for reducing portfolio risk. The reasons many investors want to decrease risk are valid and shouldn’t be dismissed out of hand. Equity valuations imply low returns going forward, there’s more than enough headline risk to worry a normally even-keeled person, and basic demographics means many investors are ever-closer to retirement, which puts them at particular risk if there is a recession.
That last point is one I’d like to leverage for thinking about portfolio risk. Intuitively, we get nervous just before, at or just after retirement because we know that a big downturn can result in a significant loss of spending power (i.e. consumption) in retirement. If my portfolio declines by half, I can spend half as much in retirement.
That’s just the way it works. Sure, maybe it’ll recover and I can increase my spending when that happens, but if I want to ensure I won’t run out of money my future spending is inexorably tied to the volatility and performance of my portfolio.
Back to the main question: should you be de-risking your portfolio right now? If you’re getting close to retirement, it’s at least the right question to ask. But I don’t think you should answer it based on a market view trying to forecast the next recession. Answer this question based on where you are at in your life and what you need from your portfolio going forward.
To start, figure out if the type of drawdown associated with a recession would prevent you from retiring. If you can theoretically retire today, but a normal recession-based drawdown would force you to postpone retirement, then you are effectively taking more risk than you need to. You might want to reduce risk.
Now, the problem is that even if you want to reduce risk there’s no perfect way to de-risk a portfolio heading into retirement. Increasing cash allocations reduces day-to-day portfolio volatility, but we just experienced the largest loss of purchasing power for holders of cash in modern history. Cash lost almost 15 percent in real terms since 2009, which means that cash can now buy 15 percent less consumption in retirement. Alternatively, you could theoretically buy Treasury inflation-protected bonds that mature each year of retirement, but your personal inflation rate might not match the Consumer Price Index, and doing this assumes you know with certainty how much you want to spend each year. Diversifiers like gold or certain hedge fund strategies might provide protection, but they haven’t worked in every cycle. Explicit hedges like buying put options are expensive.
How to proceed? Our guidance is to start by doing two things: First, if retirement is in the cards for you in the next few years, start building out your Liquidity strategy. Doing so will do two things: (a) take some risk off of the table and (b) make sure you have assets to use for spending in the first few years of retirement. Second, make sure that your Longevity portfolio is properly constructed and well-diversified. From an implementation standpoint, reducing downside capture can go a long way, even if it means forgoing some of the upside.