How to think about risky stocks when you're approaching retirement

If retirement is on the horizon, think about taking some risk off the table.

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This article was originally published on All figures quoted in US dollars unless otherwise stated.

Retiring into a potential recession isn't what anyone would want, but there are ways to maintain some control over your portfolio in times of economic decline. Making some big-picture adjustments to your investments in the years leading up to retirement can pay big dividends down the line, all while creating additional security for your spending plan. 

Let's think further about how you can protect yourself if you're feeling some anxiety leading into your senior years.

The threat of sequence risk

The goal for most people during their working careers is to accumulate wealth. In the years leading up to retirement, the goal tends to center around preserving wealth.

Since we can reasonably estimate that the economy could be headed for some difficult years, modifying your strategy going into retirement is even more necessary. Further, given the vast number of variables that go into retirement planning (i.e., how long you think you'll live, how much you expect to spend, etc.), it's important to create certainty around money to the extent possible. 

One of the less commonly discussed topics in retirement planning is sequence risk (sometimes called "sequence-of-returns risk"). Put simply, sequence risk is the potential for running into a poor string of returns in the years after you stop working, which can then lead to portfolio failure in the long run.

In other words, if you experience steep portfolio declines in the early years of retirement -- when you've already started drawing on the money to cover living expenses -- you run a higher risk of running out of money than if you were to retire into a bull market

Addressing sequence risk

For example, say you maintained an 80% stock/20% bond asset allocation throughout your working career. Given the raging bull market of the 2010s, this allocation performed particularly well.

However, if retirement is on the horizon, you might think about briefly moving to a 20% stock/80% bond asset allocation. Rethinking your asset allocation can help shield against the threat of poor returns in the early years of retirement, which present a substantial threat to retirement success. 

The easiest way to go about handling sequence risk is by increasing your share of lower-risk investments (like bonds and cash), relative to stocks. As 2022 has shown us thus far, bonds are not entirely risk free, but they do generally come with a lower risk of extreme drawdown -- especially relative to stock investments. Even though you might not get big returns out of bonds, they do exist as a valuable risk-control measure that offer at least some diversification benefit. 

A numerical example

Say you started your retirement in 2022 with a $500,000 portfolio and an 80% stock/20% bond asset allocation. After the stock market lost 20% and the bond market lost 10%, you'd be left with $410,000. From there, you'd have to withdraw money for expenses, which could have a deleterious effect on the long-run viability of your portfolio. 

In an alternative world, imagine you started with the same $500,000 portfolio but a more conservative 20% stock/80% bond asset allocation. In this example, after the stock market again lost 20% and the bond market lost 10%, you'd be left with $440,000. This is still a loss, but an improvement from the riskier portfolio used in the first scenario. 

While this is by no means a way to shield your portfolio completely, it does provide some cushion in the event stocks continue their slide for the next few years.

Retiring isn't easy but possible

The reality remains that retirement is a financially challenging milestone for the grand majority of workers. But between Social Security, personal savings, and (increasingly) active income, retirement is absolutely achievable.

As you get closer to retirement, consider the risks at hand and the magnitude of stock market loss you'd be willing to tolerate. From there, adjust your overall asset allocation as necessary, but also be sure to keep a healthy cash reserve on hand. 

This article was originally published on All figures quoted in US dollars unless otherwise stated.

The Motley Fool Australia's parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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