Anyone who lived through the great recession of 2008 and 2009 knows the impact of being too risky. After all the huge sell off in the stock market effectively wiped out $6.9 trillion in shareholder wealth and decimated other savings vehicles such as 529 college savings plans. Since then the stock market has recouped its losses and then some, but it still continues to be a wild ride for investors.
Riding out the gyrations in the stock market is often the best strategy, but the closer to retirement you are, the more you may need to adjust your risk tolerance. You don’t want to end up with zero retirement savings when you are ready to walk off into the sunset all because you kept a too risky investment profile. At the same time you want to grow what you already saved since retirement can last more than 20 years. In order to do that, risk has to be adjusted to make sure there’s a balance between growth and preservation. (For more, see: What is Your Risk Tolerance?)
Stock and Bond Exposure Changes Over Time
For many retirement savers, their asset allocation is divided between stocks and bonds, with the exposure to each class dependent on their age. The younger you are, the more stock exposure. The older, the less. To determine what asset allocation you should have the old way was to subtract 100 from your age. Now with people living longer that’s changed to 120, so a 25-year-old is going to have an asset allocation of 95% stocks and 5% bonds, while a 35-year-old’s asset allocation would look more like 85% stocks and 15% bonds.
Furthermore, a 55-year-old will have 65% exposure to stocks and 35% exposure to bonds, while a 65-year-old will see that decline to 55% stock exposure. In order to protect your savings and achieve modest growth, investors are going to have to adjust their asset allocation to keep risk in line with their time horizon. That means getting more bond exposure if necessary or even adding more stocks if you are being too conservative.
Diversification Within Stocks and Bonds Matters
While shifting more money toward bonds is an easy way to adjust your risk tolerance, that’s only the first step. Within stocks and bonds, you also want to make sure your holdings aren’t too risky. One of the tenants of a sound financial plan is diversification. Having all your eggs in one basket sets you up for a real hit if the investment nosedives. (For related reading, see: Diversification Beyond Stocks.)
Investors may think they are covered if they have both stocks and bonds in their portfolio but diversification goes beyond that. The holdings within each asset class also have to be adjusted for a new risk tolerance. Take stock for starters. People getting more conservative still need exposure to stocks but the type of investments may need to change. Sure it’s okay to hold growth stocks or growth mutual funds but it’s not okay to have all your stock exposure there. Investors have to spread out the risk which means having a portfolio that includes stable blue chip stocks, value stocks, growth stocks and even international exposure.
Investors shouldn’t invest in those high fliers that could or could not make them a fortune. The idea when adjusting your risk tolerance to save more is to seek modest growth with the least amount of risk. An easy way to get diversification is through mutual funds. But even with stock funds, investors have to be mindful that there isn’t too much overlap with their different stock funds.
On the bond side of things, investors have to make sure they are diversifying among different fixed-income vehicles with varying durations. At the same time, investors need to ensure they aren’t being exposed to the risky sides of fixed income. For instance, high yield bonds are going to give you better returns than a government bond or investment-grade corporate bond but they aren’t risk free. (For more, see: Are High-Yield Bonds Too Risky?)
When adjusting for risk, investors still want high-yield bonds in their portfolio but it can’t be all. They should have safer government bonds and high quality corporate bonds as well. Investors who don’t have the time or desire to pick and choose their bonds can purchase a diversified bond fund that will give them exposure to different quality bonds. (For more, see: Six Biggest Bond Risks.)
The Bottom Line
Investing with an eye toward retirement is going to require you to be flexible when it comes to risk tolerance. The older you get the less risky your investments need to be. At the same time, you don’t want to get too conservative and hurt your buying power in the years to come. In order to balance the need to preserve your savings and grow it, investors are going to have to adjust their risk tolerance as they get closer to retirement. By making sure the asset allocation has the proper exposure and is diversified with stocks and bonds, you can protect and grow your retirement savings.