One of the big mistakes often made by people later in their careers and approaching retirement is a willingness to take on too much risk with their investments as they approach retirement.
It's a mistake we frequently see, as many employees are striving to hit their “number” (a desired net worth) or simply maximize their last few years or decade of accumulating assets. What’s more, this penchant for increasing risk late in one’s career is heightened during bull markets—like we’ve had since 2009—according to a recent article in the Wall Street Journal.
The study cited in the article and published by Morningstar found that:
"[O]lder workers are more likely than younger investors to experience what we call variable risk preference bias. That is, their willingness to take investment risk varies depending on recent stock-market performance.”
The study measured the risk tolerance of investors in separate age groups and across different market environments. It identified that:
“[D]uring the spring of 2007, older workers tend to appear relatively risk tolerant (they prefer a riskier portfolio). But when they took the same risk-tolerance test in the spring of 2009 after a steep fall in stock prices, older workers were much more risk-averse (they preferred a safer portfolio). Risk tolerance measured among younger workers wasn't nearly as affected by recent market performance.”
Other than the fact that this behavior runs contrary to the buy-low and sell-high behavior that is critical to investing success, there is another major risk for the near-retiree or the recently-retired to increasing portfolio risk around one’s retirement date. (For related reading, see: Top 3 Retirement Savings Tips for 55- to 64-Year-Olds.)
Sequence of Returns Risk
Known as the sequence of returns risk, losses to a portfolio in the early years of retirement are much more damaging than losses later in retirement (or early in your career). Late-career and early retirement are periods when one's portfolio value is likely to peak. Therefore, a significant loss during this period will have, in dollar terms, significantly more impact than during other periods.
It can be tempting to take on too much risk before you retire in order to hit a retirement “number” or goal portfolio value. However counterintuitive it may be, increasing risk to try to reach your number could actually give you worse odds of sustaining your desired spending over retirement.
How to Minimize Risk to Your Portfolio Before and During Retirement
Financial planner Michael Kitces calls the decade leading up to retirement and the first part of retirement itself the “retirement red zone” as your portfolio value is likely at its peak. So, if this period around one’s retirement date is indeed a bad time to increase the risk of your portfolio, what can be done to minimize the variable risk preference bias identified in older investors?
The Wall Street Journal article suggests two things. First, evaluate the risk you are taking with your portfolio and assess whether your financial plan can sustain a 20% drop in markets that tend to happen every five years on average. Or, simply outsource the management of your assets. The article suggests doing this through a target date fund (potentially best for those with a simple financial situation) or with a financial advisor who can help structure a portfolio with the proper level of risk for your individual wiring and your goals and objectives. In addition, an advisor can help you tackle other critical retirement-related questions like: When should I retire? How much can I spend in retirement? And, when should I start taking Social Security?
(For more from this author, see: Reduce Your Target Number and Retire Earlier.)