By investing for retirement, you are helping to manage a critically important financial risk: the chance that you will outlive your money. But choosing to invest is just one step in your financial risk management strategy. You also need to manage risk within your portfolio to help it stay on track. Following are steps to consider.
FAMILIARIZE YOURSELF WITH THE DIFFERENT TYPES OF RISK
All investments, even the most conservative, come with different types of risk. Understanding these risks will help you make educated choices in your retirement savings plan mix. Here are just a few.
- Market risk: The risk that your investment could lose value due to falling prices caused by outside forces, such as economic factors or political and national events (e.g., elections or natural disasters). Stocks are typically most susceptible to market risk, although bonds and other investments can be affected as well.
- Interest rate risk: The risk that an investment’s value will fall due to rising interest rates. This type of risk is most associated with bonds, as bond prices typically fall when interest rates rise, and vice versa. But often stocks also react to changing interest rates.
- Inflation risk: The chance that your investments will not keep pace with inflation, or the rising cost of living. Investing too conservatively may put your investment dollars at risk of losing their purchasing power.
- Liquidity risk: This is the risk of not being able to quickly sell or cash-in your investment if you need access to the money.
- Risks associated with international investing: Currency fluctuations, political upheavals, unstable economies, additional taxes — these are just some of the special risks associated with investing outside the United States.
KNOW YOUR PERSONAL RISK TOLERANCE
How much risk are you willing to take to pursue your savings goal? Gauging your personal risk tolerance — or your ability to endure losses in your account due to swings in the market — is an important step in your risk management strategy. Because all investments involve some level of risk, it’s important to be aware of how much volatility you can comfortably withstand before you select investments.
One way to do this is to reflect on a series of questions, which may include the following:
- How much do you need to accumulate to potentially provide for a comfortable retirement? The more you need to save, the more risk you may need to take in pursuit of that goal.
- How well would you sleep at night knowing your investments dropped 5%? 10%? 20%? Would you flee to “safer” options? Ride out the dip to strive for longer-term returns? Or maybe even view the downturn as a good opportunity to buy more shares at a value price?
- How much time do you have until you will need the money? Typically, the longer your time horizon, the more you may be able to hold steady during short- term downturns in pursuit of longer-term goals — and the more risk you may be able to assume.
- Do you have an easily accessible emergency savings account with at least six months worth of living expenses? Having a safety net set aside may allow you to feel more confident about taking on risk in your retirement portfolio.
DEVELOP A TARGET ASSET ALLOCATION
Once you understand your risk tolerance, the next step is to develop an asset allocation mix that is suitable for your investment goal while taking your risk tolerance into consideration.
Asset allocation is the process of dividing your investment dollars among various asset categories, typically stocks, bonds, and stable value investments. Generally, the more tolerant you are of investment risk, the more you may be able to invest in stocks. On the other hand, if you are more risk averse, you may want to invest a larger portion of your portfolio in conservative investments. However, consider that within bond asset classes, there are many different varieties to choose from that are suitable for different risk profiles.
BE SURE TO DIVERSIFY
All investors — whether aggressive, conservative, or somewhere in the middle — can potentially benefit from diversification, which means not putting all your eggs in one basket. Holding a mix of different investments may help your portfolio balance out gains and losses. The principle is that when one investment loses value, another may be holding steady or gaining (although there are no guarantees).
What about more conservative investors, such as those nearing or in retirement? Even for these individuals it is generally advisable to include at least some stock investments in their portfolios to help assets keep pace with the rising cost of living. When a portfolio is invested too conservatively, inflation can slowly erode its purchasing power.
PERFORM REGULAR MAINTENANCE
During regular portfolio reviews, you’ll want to determine if your risk tolerance has changed and check your asset allocation to determine whether it’s still on track. You may want to rebalance — or shift some money from one type of investment to another — to bring your allocation back in line with your original target, presuming it still suits your situation. Or you may want to make other changes in your portfolio to keep it in line with your changing circumstances. Such regular maintenance is critical to help manage risk in your portfolio.
When developing a plan to manage risk, a BWFA professional can help take emotion out of the equation so that you may make clear, rational and informed decisions.
Chris Kelly | CPA, CFP®, M. Accy | Financial Advisor, Portfolio Manager & Executive Manager | ckelly@bwfa.com