Let’s face it, investing is difficult and the influence of human emotion on investing decisions makes it even more so. Even the shrewdest of investors can derail smart decisions by acting upon emotion. By nature, human psychology works against investing principles, as investors tend to overestimate the magnitude of risks and underestimate their ability to handle them.
Many retirees believe investing in a conservative portfolio is a prudent course of action during retirement. However, this philosophy comes with major pitfalls and could be detrimental to the longevity of their portfolio and quality of life if they run out of money. Most retirees will need to tolerate a certain level of portfolio risk – over the long term – to earn the requisite return that would sustain their lifestyle through retirement, while simultaneously remaining prepared for unforeseen circumstances.
Unlike planning for a time-certain event, such as paying for a college education, the length of retirement is not certain. In most cases, an undergraduate experience begins and ends in a predictable timeframe and the resources needed to fund a degree can be determined with good planning. Whereas a college savings account should reflect a more conservative allocation as the beneficiary’s timeline for attending school and using the funds becomes more certain, the same cannot be said for retirement planning.
Retirement can represent more than a third of one’s lifetime, and portfolio withdrawals could be required over that entire period. If you knew exactly when you were going to die, you and your financial advisor could create a very efficient financial plan. Wouldn’t it be nice if it were that simple? The reality is, it’s not, and knowing how long you will live and need to take portfolio withdrawals is indeterminable. Luckily, what is certain for most people is that retirement will span the course of decades, and so having a diversified portfolio and subsequently greater risk isn’t so concerning, given the time frame from which to recover from losses.
The key is keeping your emotions at bay while remembering an important piece of market history – all market declines have become recoveries. Experiencing a market decline never feels good, but ultimately, it’s understanding that the probability of a recovery is extremely high.
Four reasons you should have a diversified portfolio through retirement:
- Single asset class risk – Having too much of your portfolio invested in one asset class (groups of securities with the same characteristics) can pose a threat to the long-term performance of your portfolio, especially cash equivalents. At any time, individual asset classes can suffer prolonged periods of underperformance. Therefore, it’s important to remain diversified across all asset classes and styles (Equities/Hard Assets/Bonds/Cash), as each asset class will fall out of favor from time to time. Diversification can help offset the returns of asset classes that are underperforming.
- Sequence risk – Sequence risk, also called sequence-of-returns risk, is the risk of earning lower or negative returns early on in retirement while simultaneously taking withdrawals from your portfolio. Two retirees with identical wealth can have entirely different financial outcomes depending on when they started taking portfolio withdrawals even if their average portfolio returns are the same. Sequence-of-returns risk is a function of volatility and can be mitigated by maintaining a properly diversified portfolio while also effectively managing your portfolio withdrawals.
- Sustainability of portfolio withdrawals – Recent studies show life expectancies are on the rise, and outliving your portfolio is a risk one needs to consider when determining asset allocation. Our firm has a turn-key system for generating supplemental income from a portfolio during retirement called DIESEL®. The sustainability of withdrawals may be enhanced with a diversified portfolio that produces reasonable, reliable, and repeatable returns. Read more about DIESEL® here.
- Medical costs – One of the most significant threats to retirement affordability and portfolio longevity is rising medical costs. The cost of medical care has outpaced inflation for the past 20 years, and these increases are expected to continue. Additionally, health spending, as a share of after-tax income, will rise dramatically. In 2000, medical care spending for older married couples was 16 percent of their total income and by 2010 it had increased to 24 percent. According to the Center for Retirement Research, that number is expected to increase to 29 percent in 2020, and 35 percent in 2030. Earning a reasonable return to help hedge against rising medical costs will be required for most retirees. Large and unexpected out-of-pocket medical expenses, such as battling a long-term illness or going to an assisted living facility or nursing home, could severely impact your expenses, putting additional constraints on your portfolio.
While investing conservatively in retirement could stabilize your emotions, it could also potentially result in earning a lower average return, thus negatively impacting your portfolio value and the sustainability of withdrawals. I’m not advocating retirees swing for the fences, but rather suggesting a slightly less comfortable emotional state by diversifying your portfolio across all asset classes and styles. The payoff could positively affect your retirement outcome and overall quality of life.
Disclosure: There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Investing involves risk including the potential loss of principal.