What Financial Risks Are You Willing to Take in Retirement?
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Once you retire, investing risk takes on a whole new meaning. At that point in your life, you have to start taking money out of your investment accounts to cover your costs. Despite that switch to withdrawal mode, you'll still need the remaining money to grow in order to cover your future costs for a retirement that might last decades.
That balancing act between current and future needs makes risk management much more important during retirement than it likely was before. What remains the same, though, is that your money is at risk no matter what you do with it. As a result, the question you need to ask yourself isn't "Should I take risks with my retirement money?", but rather, "What risks am I willing to take with my retirement money?"
What are your key risk areas?
Risk of volatility: Volatility is the classic "standard Wall Street" measure of risk. On a daily basis, asset prices move up and down, and there's no really good way of predicting which way they'll move on any given day. Volatility becomes a particular risk for retirees, who frequently must dip into their portfolio to cover their costs of living. Being forced to sell low to cover your costs is a risk of volatility, as it would leave you less to cover future expenses.
Countermeasure for volatility: The countermeasure for volatility is cash and high-quality, duration-matched bonds such as U.S. Treasuries. If you know you'll need money in the near future, have it in cash, which takes all the volatility risk out of the picture. If you know you'll need money in the next few years, have it in high-quality bonds that mature and convert to cash just before you need to spend it. That gives you the cash you need when you need it, at a higher rate of return than an all-cash portfolio.
Risk of inflation: Inflation is a particular risk for retirees because many pensions and annuities do not include inflation adjustments. Additionally, Social Security's inflation adjustment might not adequately compensate for the higher inflation rates experienced by seniors due to healthcare costs. Over time, inflation can bite seniors, hard. Over a 30-year retirement, a mere 3% inflation rate would mean things that cost you $1,000 at the start of your retirement would cost $2,427 near the end.
Countermeasure for inflation: The countermeasure for inflation is to own asset classes that can earn higher returns than inflation. Over the long run, stocks have done a tremendous job of beating inflation, and could very well continue as long as we have real long-run economic growth. The downside, of course, is that stocks are far more volatile than bonds and thus are much more exposed to that particular risk. That makes stocks a good option for the long run, but riskier for the short run.
Risks in individual securities: Above and beyond the general risks affecting different asset types as a whole, individual stocks and bonds face distinct risks. The value for each stock and each bond is based on the issuer's ability to meet its commitments and other financial expectations. Bonds take priority -- and in a bankruptcy, a company's stock is much more likely to be completely wiped out than its bonds. Still, even a bond's superior guarantee is only as good as its issuer's ability to pay.
Countermeasure for individual securities: The countermeasure for individual security risk is diversification. While one stock might go under, the odds are substantially smaller that the entire S&P 500 will simultaneously declare bankruptcy. That makes an index-tracking ETF such as the SPYDERs a decent option for the long-term stock segment of your portfolio.
Bonds behave a little different. Because bonds mature and bond funds usually don't, diversifying through a bond fund won't provide the same level of assured cash at maturity as owning a collection of individual bonds. If you invest via bond funds, you'll have to rebalance over time based on spending needs and bond maturity timelines. If you invest via individual bonds, you'll either want to stick with U.S. Treasuries or diversify among strong investment-grade bonds across each expected maturity date.
Find the balance point where you're comfortable
These are just some of the primary financial risks you'll face retirement. Most major risks have countermeasures, but those countermeasures themselves usually come with trade-offs. Your goal with your portfolio in retirement is to balance those risks and countermeasures given your financial assets and the expenses they have to cover.
You can't eliminate all financial risks, but you can usually find a balance that works for you. With that balance in place, you can better focus your time in retirement on the priorities that matter.
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The article What Financial Risks Are You Willing to Take in Retirement? originally appeared on Fool.com.
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