Strategies for Capital Preservation in Turbulent Times
In its historic nine-year climb, the stock market continues to hit new highs on a regular basis, leaving investors to wonder what the next big move will be. While we can’t predict the direction of the market, we know that any directional change in the market is likely to be accompanied by extreme volatility, the likes of which investors have frequently experienced since 2008.
Historically speaking, volatility is a good thing for long-term investors because it is what drives positive returns. However, for investors near or in retirement, it can be extremely detrimental to their retirement income payout, which needs to last 25 to 30 years or more. Avoiding stocks altogether would risk early depletion of assets or require a substantial reduction in life style later in life. Instead, retirees and pre-retirees need a strategy that takes into account market volatility while investing for current income and preserving capital for future income.
A well-conceived capital preservation strategy incorporates several components designed to meet current income needs while preserving capital, managing risks and attempting to ward off inflation.
Asset allocation is recognition of the fact that different asset types perform independently of one another and we can’t know how they will perform at any given time. For instance, stock and bond prices tend to move counter to one another. In very rare cases have they moved in tandem. That kind of non-correlation is the key to controlling the level of volatility and it is accomplished by pairing many different asset types in a portfolio. The exact mix of asset types depends on an investor’s specific investment objectives, time horizon and risk profile. A typical asset allocation for a capital preservation strategy might be 20% in stocks, 40% in bonds and 40% in cash.
With an asset allocations strategy in place, it must be reviewed regularly to ensure it continues to reflect the investor’s investment goals and risk profile. In a volatile market the allocation can change, which can introduce more risk into the portfolio. During a steep stock market increase, the stock allocation could increase to 30% and the bond allocation could decrease to 30%. While that may be all good if the market continues to rise, it can have a punishing impact on the portfolio should the market change direction. Through systematic rebalancing, buy and sell decisions are automatic and the investor’s target allocation remains intact.
The Cash Cushion
The greatest threat to a retirement income portfolio is a steep or sustained market decline, especially when it forces the sale of securities at an inopportune time. By building a cash cushion sufficient to cover near-term expenses, retirees can avoid accessing funds from their retirement portfolio when its value is declining. Considering the typical bear market lasts about 15 months, and the average market recovery takes about 24 months, retirees should have a cash cushion sufficient to cover three to four years of expenses. Cash refers to any safe and near-liquid vehicle, such as money market accounts, certificates of deposit (CDs) or Treasury bills. With a cash cushion, investors can ignore the inevitable fluctuations of the stock market.
Creating an Income Floor
Until about a decade ago, most retirees relied on an income floor created by their Social Security benefits and their pensions. With pensions going by the wayside and retirees living longer, that income floor must be created from investment income. Creating an income floor can provide the assurance that you’ll always have a predictable income while the rest of your assets are invested for growth and capital preservation.
The income floor method requires a careful evaluation of your income needs and the amount of assets needed to generate it assuming available yields. The yield portion of your portfolio might consist of investment-grade bonds, bond funds or a bond ladder consisting of bonds with maturities matching future years of retirement. Once the income floor is in place, the remaining assets can be invested according to your overall asset allocation strategy.
Combining any or all of these components in a capital preservation strategy requires a thorough understanding of your risk and return parameters as well as your specific need for lifetime income sufficiency. When properly designed and implemented, your capital preservation strategy removes the guess work involved in navigating turbulent times.
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