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Retirement Investing Strategies: Balancing Growth & Volatility

In my last entry, I discussed the issue that most retirees need a portfolio designed with some element of growth while at the same time having mitigated volatility. How do you do this because these two factors work against each other? To get an appropriate balance, this is what you need:

Stock Diversification via Asset Allocation: Diversification in your portfolio if done properly is the glue that provides for growth while mitigating downside volatility. Many people fail at diversification. If you were truly diversified, you wouldn’t have lost nearly half (or more) of your portfolio’s value in the last bear market and you would have recovered several years ago, not just recently. Many people have a problem with asset allocation because they have to accept the fact that at any point in time in their portfolio, there is always going to be something that is doing well and another holding that is doing poorly. That’s what led people to fall into the trap of placing all their money in large growth stocks in the late 90’s and shunning under-performing small and mid-cap value or international stocks; with dire consequences that followed. Small cap value stocks historically have provided the highest returns (with the greatest risk), but you couldn’t tell that to someone in 1999. The focus should be on the forest, not the trees; what matters is overall portfolio performance, not what each individual investment is doing.

Playing Good Defense: Just like in sports, playing a good defense can actually score some points. For example, a good strategy is keeping enough cash reserves on hand. When the stock market tanks, this emergency fund can cover your cash flow needs until the market recovers so you don’t have to sell investments at a cyclical bottom. Bonds also are useful because they are they tend to do well in a deflationary environment when stocks don’t fare nearly as well. Often people view cash and bonds as an “either or” situation, usually chasing the highest yield; but bonds actually appreciate when rates go down where cash equivalents don’t; that’s a big difference. But bonds also aren’t immune to all risk. Another asset class to consider is commodities. Commodities are a terrible asset class if looked at in a vacuum because they lag the stock market for long stretches of time and are extremely volatile. But when added in small doses to a diversified portfolio of stocks and bonds they can actually enhance returns and lower volatility; the best of both worlds. Real estate also adds another layer of sophistication as well. Also, my clients are very familiar with what I call alternative asset classes. These are funds with distinct investment styles that don’t correlate highly with stocks or bonds. Many of these funds that use stock are classified in the long-short category by Morningstar. There are hybrid bond funds as well that fit into the alternative category. In combination, the use of alternatives is designed to create positive returns in all market environments; when added to a portfolio of stocks and bonds, this gives up little in upside potential while substantially mitigating downside risk and should be a consideration for an added layer of protection.

So ask yourself, are you doing the following:

With your stock portfolio, do you have allocations towards domestic, foreign and emerging market stocks (the latter two un-hedged against the dollar)? Is this portfolio broken down between large, mid and small cap stocks? Do you have a good balance between growth and value stocks?

With your bond portfolio, is it aligned with your stock position to match your risk profile? Do you diversify between domestic, foreign and emerging market bonds (the latter two un-hedged against the dollar)? Do you diversify between bonds with short and intermediate term duration? Do you have bonds with varying credit quality? Do you use any hybrid bonds such as TIP’s or floating rate bonds that protect against inflation or higher interest rates?

Have you determined your cash flow need over the next two years beyond what is covered by pensions, Social Security and other non-investment sources? Do you have enough cash on hand to cover the next 1-2 years of cash flow needs? If not, do you have bond or other defensive asset exposure that would cover this need?

Do you use or have considered other asset classes such as real estate, commodities or other alternative strategies to help mitigate risk? Do you look for different asset classes to diversify into?

If you haven’t, then I hope that I gave you something to think about. And this isn’t the cookie cutter breakdown that you will see in those money makeover columns by the financial media. Many of these items are cross related. For example, you can have a part of your stock allocation that could be considered foreign, small cap and value all at the same time. So don’t think of this as a pie chart, think of this diversification as a Rubik’s cube. Want a great example of how asset allocation and diversification works? Check out the article The Math of Recovery by Craig L. Israelsen in the February edition of Financial Planning magazine.

In my last entry, I will be back to discuss the final piece of the puzzle, the actual distribution strategy.

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