Many people accumulate a portfolio of assets in order to fund their retirement. Once free of the workforce, those assets can be put to work generating returns to fund a retirement lifestyle that helps you enjoy your time and make the most of the opportunities available, while remaining financially secure.
While we are young, many of us are happy to take on riskier investments; after all, there is still time to make up for early losses. But as retirement approaches, the impact of losses can be more keenly felt – they reduce the pool of funds available to meet our needs as we age out of the workforce.
Investment preferences and allocations change according to life stages. When we are young we are in the accumulation phase, building our assets over time. Later we enter the consolidation phase, when we start to think about retirement and arranging our assets appropriately. Finally we settle into the distribution phase, where we can enjoy the fruits of our labours.
Retirement is less enjoyable, however, if you are constantly worrying about your portfolio. Returns are important, but so is limiting downside risk.
Here we take a look at 3 ways you can manage investment risk in retirement.
1. Asset allocation
Your asset allocation will change as you head towards retirement. Lower risk, defensive assets may take up a greater proportion of your portfolio than was previously the case. Defensive assets such as bonds tend to be lower risk, but offer commensurately lower returns. These can be contrasted with growth assets such as shares, which are higher risk but have historically provided a higher rate of return.
Your asset allocation will be dependent on your personal circumstances. Many retirees are seeking to generate an income from their portfolio. In our current low interest rate environment certain ASX 200 shares can be attractive for their dividend yields and may play an important role in a diversified portfolio.
2. Diversification
Simply put, diversification means not putting all your eggs in one basket. This means you should be invested in a range of assets classes as well as individual investments within those classes. Diversifying your investments across industries and sectors means you will not be caught short if a single industry suffers a downside event.
Diversification tends to lower the volatility of returns of the overall portfolio. As the returns on individual investments are not perfectly correlated overall returns are more stable. The majority of your assets may tend to be lower risk, but in a properly diversified portfolio there can also be room for some higher risk investments to increase returns.
3. Longevity risk
Longevity risk is the risk that you outlive your retirement savings. This could occur because you live longer than you planned on (hopefully in good health) or because of a loss of assets. Products such as annuities, which pay out certain amounts over a fixed period or for your lifetime, can give peace of mind.
Another option is to utilise Vanguard's dynamic spending rule, by setting maximum and minimum percentage withdrawal limits for annual spending. Retirees can spend a higher percentage of their portfolio's value when markets have performed well the previous year. When markets have performed poorly they must reduce their spending to the lower limit.
Foolish takeaway
Retirement should be spent enjoying your free time, not worrying about investment risk. By allocating your assets appropriately, diversifying, and managing your spending you can start managing investment risk in a way that works for you.
