Most investors are not so great at managing risk. They seem to sell when they should buy, and buy when they should sell. As you get older, this behavior can be detrimental to your retirement.
To get better results, you need to learn how to manage risk successfully. There are four primary ways to manage investment risk. The best risk management approach in retirement employs all four.
You always have the option to avoid investment risk by choosing only safe, guaranteed retirement income investments. Choosing to avoid risk is one of the smartest decisions you can make until you have learned the skills you will need to manage risk appropriately.
You also want to avoid risk on money you may need at a moment's notice. For example, suppose you lost your job or have a medical issue. You want money set aside that is 100% available to you. Financial planners call this type of account "reserve assets" or an emergency fund. The price you pay to have this money readily available is that it earns a low rate of return. That is the price of safety. Smart investors always set aside reserve assets before they move money into riskier investments.
If you like to take investment risks, you also could accumulate an opportunity fund. You need to have cash available to take advantage of buying opportunities in real estate and stocks. Building up cash can be a smart move because it allows you to act quickly when opportunities show up.
When investing, you should diversify away all the risks you can. For example, if you own a single stock, you are subject to the risk of bad management of that company. To avoid this risk you can diversify across multiple stocks in that industry, though you'll still be subject to industry-specific risk, also referred to as business risk. For example, what if new laws have a negative impact on that entire industry?
To diversify against this risk you build a portfolio of stocks within multiple industries, or you buy index funds as the mutual fund itself will own hundreds of stocks. Even then, you are still subject to systematic risk if the system as a whole is flawed, or the economy as a whole goes through a prolonged downturn. Of course, the only way to eliminate this risk is to go back to option one, avoiding risk.
Managing investment risk through diversification, simply said, is “don’t put all your eggs in one basket.” The traditional approach to doing this is called asset allocation, and you’ll see it promoted by many financial advisors and popular personal finance magazines and books. Investment diversification is important, and it's important that you understand its limitations.
Diversification does help reduce investment risk, but you must remember that the long-term results of a diversified set of investments are far from certain. You can invest the exact same way and over booming economic periods your portfolio may grow like weeds, while doing the exact same thing over a recessionary period may lead to mediocre returns, or even to losses.
Only Take Calculated Risks
Warren Buffett is considered one of the greatest investors of our times. He has said, “You do things when the opportunities come along. I've had periods in my life when I've had a bundle of ideas come along, and I've had long dry spells. If I get an idea next week, I'll do something. If not, I won't do a damn thing.”
This is the concept behind taking calculated risks. To do this you have to know when not to act. And you need to have cash on hand, an opportunity fund so that when good ideas come along, you can act.
Employing a calculated risk-taking strategy takes knowledge, research, and common sense. It is not an autopilot approach. You have to understand how to view markets from a logical and rational approach, not an emotional one. You also need to understand certain ratios and indicators you can use to help you assess the market.
One ratio some financial professionals use in an attempt to determine if the stock market is overvalued or undervalued is the price to earnings ratio, or P/E ratio. Another indicator of recessions is the yield curve. The process of making investment decisions based on a calculated form of risk-taking is often referred to as tactical asset allocation.
Ensure the Outcome
The last strategy you can employ to manage investment risk is to insure against it. If you have car insurance, homeowner’s insurance, health insurance, or any other type of insurance, you are already familiar with this approach.
With traditional forms of insurance, there is a cost (the premium you pay) to ensure that specified losses are covered. Insurance on investment returns works in a similar manner and is often accomplished with the purchase of an annuity that pays life-long income. An annuity is particularly well suited to manage the retirement risk of outliving your money.
With certain variable annuities, you are charged an annual expense in exchange for a specific guarantee about the amount of money you can withdraw in the future. These guarantees often go by the name of a “lifetime withdrawal benefit” or “guaranteed withdrawal benefit” clauses.
Employing These Strategies In Retirement
When nearing retirement, it is best to use an allocation process that employs all these risk-reducing tactics. You set aside reserve assets, diversify the bulk of your portfolio, take calculated risks by assessing how much should be in stocks vs. bonds, and insure some of your income by using annuity products.