I’ve been thinking a lot about risk management lately. A retiree faces a lot of risks but not the ones that are usually talked about. The biggest two, in my opinion, are suffering a very large portfolio decline and retirement income not keeping up with inflation and taxes. This is mainly a thought post on these risks and what are the options an investor has to manage them.
To start, I want to separate the concept of risk and volatility. Standard finance theory defines risk as volatility, plain and simple. The more the price of an asset varies the riskier it is. First of all, volatility has two sides, upside volatility and downside volatility. I think all investors would consider higher upside volatility as less risky, not more. Also, with income producing assets, like dividend stocks, higher downside volatility can actually enhance returns . So much for standard finance theory.
Two main aspects differentiate a retiree portfolio from a non-retiree portfolio. Retirees are not adding new money every year to their portfolios and they must withdraw a portion of their portfolio every year to pay for living expenses. So, you can see why a large portfolio decline, particularly early in retirement, can be devastating for a retiree. On the other hand, over the long term, inflation and taxes are retirement killers and thus exposure to higher return assets, like stocks, is a must. The longer the retirement period the higher exposure to stocks is required to keep up with the ravages of inflation and taxes. Most retirement planning models completely ignore inflation and taxes. Its a lot easier to just talk about retirement planning for tax deferred accounts.
What are the options for managing such risks? The standard prescription is diversification. Allocate stock assets to various sectors and countries, allocate bond assets across durations and credit risks, keep some cash handy, and (as has become common nowadays) have some allocation to precious metals to protect you from the government destroying your currency. All these assets will perform differently over time, some up some down, and every once in a while you re-balance the portfolio by selling the expensive assets and buying the cheaper ones. The result of all this being you get better ‘risk-adjusted returns’, i.e. returns with lower volatility. The problem with this is two-fold. First, during very bad times like the 2008 financial crisis most risk assets tend to move down together or correlations completely reverse directions. Diversification protects an investor during mild market moves, normal recessions, etc… but it fails an investor at the most important time. Second, the lower allocation to stocks in order to reduce volatility may end up increasing risk for a retiree.
There are alternatives to standard diversification to manage risk. Some of the ones I have used, currently use, or am considering using are:
- Hold more cash. Cash is the ultimate volatility reducer. By holding more cash your portfolio volatility will go down but what it ultimately does is give you an opportunity to improve future returns when the market gives you a chance. In this way, cash is like a call option with an infinite maturity. It does have a cost, the cost being your potential loss in purchasing power by holding it, particularly in the presence of negative real interest rates like we have today. They key to this risk management approach is having a strategy of when to use it. It does your long term returns no good if you never use it.
- Time the market. There are many strategies the fall into this category. For me, the use of stop losses or trailing stops falls into this category. The problem with stops for me is the other side of the stop. Once your out, how and when are you going to get back in? Like the cash option above a strategy to get back in to risk assets is key. The one additional downside to using stops is the triggering of a taxable event when you sell. The other timing strategy that I have researched are momentum strategies. Despite what the efficient market people tell you, momentum strategies work. The ones I like in particular are 10 month moving average strategies to enter and exit risk assets. World Beta is a great site to learn about the background of this approach. The upside of this approach is the well defined exit and entry points.
- Use options to hedge the stock portion of the portfolio. Many professional portfolio managers use options to hedge their stock portfolios. There are many ways to achieve the hedge such as buying put options, using collars (calls and puts), or option spreads to achieve the hedge. The downside is usually the cost of the option hedge which does reduce returns. Using options to hedge a portfolio needs to be viewed like buying insurance. You can’t be upset because you ‘wasted’ the option premium. You put the hedge in place just in case.
- Use structured products to protect assets to the downside. As I discussed in my structured product post , I currently use these investments for my commodity and currency holdings. I would not use these structures for any income generating investment.
All of these risk management approaches I guess would be considered active risk management as opposed to the passive risk management of standard portfolio theory. I agree with that classification and think that in today’s environment it is more important than ever to stay vigilant and active in the sense of monitoring your portfolio for risk whatever your approach. I plan to do future posts on momentum strategies and using options to manage risk.
In summary, I believe active risk management is critical for all investor portfolios but in particular for retiree portfolios. In future posts I’ll cover the options strategies I mentioned plus the momentum strategies.