With interest rates coming off a 36-year low and expected to rise, most investors expect to see bond prices fall and consequently deliver a negative return in what is considered a low-risk asset. We have seen a rebound in equities, and with the S&P 500 and Dow at all-time highs, some say the stock market is richly valued. As a retiree seeking income from your investments and looking to preserve your principal, where can you turn? What are ways retirees can invest for income and still minimize risk?
You have always heard you need a diversified portfolio and that has not changed, but what has changed is how you diversify it. Retirees need to determine the proper asset allocation of stocks, bonds, cash and alternatives based on income needs, time frame, and tolerance for risk. (For related reading, see: 6 Asset Allocation Strategies That Work.)
How to Diversify Investments in Retirement
Let’s look at bonds first. If you invest in a traditional bond portfolio you are exposing yourself to interest-rate risk as rates rise and bond prices fall. You need to understand the average duration of the bond investments you hold. For example, a typical intermediate-term bond fund will have a duration of 5-10 years. If the average duration is eight years, then a 1% increase in rates will result in an 8% decrease in the net asset value (NAV). This would wipe out all the interest gains and then some. The shorter the duration, the less the potential loss.
So it is important to look for other assets that have low-risk characteristics or standard deviation similar to bonds but produce absolute returns, that is, a positive return regardless of which way rates are moving. Floating rate income, TIPs and some market neutral funds can be a good way to diversify your fixed-income portfolio. You may also want to look at structured notes as a way to produce yield and protect your downside.
Dividends as Equity
For the equity portion of your retirement portfolio, consider blue chip dividend-paying stocks or dividend growth strategies. Many large-cap funds pay dividends in excess of 2.5%, plus you have the upside appreciation potential over time to keep pace with inflation during your retirement years. Remember to keep focused on the longer term and not be too concerned with short-term volatility. Dividend-paying stocks have outperformed most other asset classes over time. Small-cap stocks have been one of the best-performing asset classes, so it would make sense to find dividend-paying small- and mid-cap equities as well.
When searching the universe of mutual funds and ETFs, there are not many of these, but a couple that have attracted our attention are WisdomTree Midcap Dividend Fund and WisdomTree Small Cap Dividend Fund with yields of 2.63% and 3.03% respectively as of December 30, 2016. Of close to 2,000 ETFs available in the U.S., a search revealed only four that are exclusively dividend-driven and which also hold just domestic small- or mid-cap stocks. Two of the portfolios feature issues that have exhibited dividend growth while the other two ETFs (the WisdomTree funds) include all dividend payers in their capitalization range. (For related reading, see: Dividend Facts You May Not Know.)
Include Alternative Assets for Diversification
Also important in developing a portfolio for retirement is a focus on absolute return strategies, and many of these fall into the alternative asset class. Alternatives are anything that is not a stock, bond or cash. Alternatives have no correlation or negative correlation to other asset classes so they are great diversifiers. Our retired clients typically have one-third of their portfolio in alternatives. Examples include managed futures and long/short strategies as well as volatility strategies using options. An example is LJM Preservation and Growth which has shown a positive return every year since its inception 10 years ago with the exception of one year, 2013, when the stock market went straight up and there really was no volatility. The fund was up in 2008 when stocks and bonds were not, and therein lies the importance of a diversified portfolio to manage risk.
By rebalancing your investments quarterly or semi-annually back to the original investment allocations you can create the cash needed to sustain your monthly withdrawals in retirement until the next rebalance. We do not recommend a withdrawal rate in excess of 4% in light of current market and economic conditions. (For related reading, see: Alternative Assets for Average Investors.)