By Robert Wyrick
One of the most significant risks that new and soon-to-be retirees face to their savings is the possibility of a market correction in the early years of retirement.
Financial planners call this sequence risk. While the S&P 500 has averaged gains of around 10% per year over the last 70 years, most calendar-year returns are above or below this long-term average. When your investment goal is many years away, you can ride out the losses from bad years by staying invested in the market through thick and thin.
Sequence risk can be detrimental when significant losses occur right at or near your retirement goal. Absorbing a big hit to your nest egg just as retirement gets underway can leave you with a savings shortfall at an inopportune time—when you no longer have the luxury of time to recoup the losses.
Losses in your retirement savings can force you into difficult choices. You can either seek higher returns to make up the shortfall but at the cost of assuming greater risk. Or, you can withdraw smaller amounts from your savings, which may mean lowering your expectations for retirement and paring back your household budget.
Asset Allocation Isn’t Enough
In seeking to avoid steep losses, investors often turn to traditional strategies such as asset allocation. But for investors whose goals are more near term, traditional asset allocation models like 60/40 stock/bond portfolios may not be adequate.
Asset allocation is based on the idea that different investments exhibit different performance under similar market conditions. Or said another way, when some investments zig, others zag.
The problem is, this idea hasn’t worked in the real world where investors put their hard-earned dollars at risk. Looking at historical market performance, you can spot noticeable differences among various asset classes during up markets. But during down markets, these differences practically vanish—all asset classes follow the same downward path, leaving investors with no place to hide in their fully-invested portfolios.
One Bear Market can Ruin an Entire Decade
Let’s look at the 2008-2009 market downturn as an example. In the run-up to the market peak of October 2007 (see first chart below), some asset classes such as value stocks and emerging markets were clear outperformers. But the subsequent bear market erased these performance differences (see second chart below). Following the market top, all asset classes marched in lockstep to the bottom of March 2009.
What about the fixed income allocation? The purpose of combining stocks and bonds in a portfolio is to smooth out the variability of returns and shield investors from significant losses on either side of the market. But these balanced portfolios didn’t offer much protection from the stock market downturn in 2008. Investors who were confident in their moderate-risk portfolios found themselves exposed to risk beyond their comfort level or financial tolerance. This dislocation is even more exaggerated today, with record-low interest rates posing a risk to bond prices.
This is a long way of saying asset allocation works…until it doesn’t. The market’s orientation toward growth benefits investors over the long term. But when the time horizon is shorter—as it is in the few years just before and after retirement—investors need a more effective way to manage sequence risk.
Market timing offers an alternate risk management approach, but these techniques don’t seem to work either. No technical model can predict market behavior. For tactical strategies that move to cash to avoid losses, it’s not only hard to get it right on the way out, but more importantly, it’s even harder to get it right on the way back in – to capture the strong returns of a market rebound.
A Better Way to Manage Risk
A better strategy is to participate in equity market opportunities, but with a layer of protection against the risk of losses. A protective hedge in the form of put options on a market index like the S&P 500 will buffer the portfolio from significant losses in the event of a market downturn.
The protective hedge is always on, ready to kick in when needed during a market downturn. During up markets, the hedge cost may drag on performance, but the appeal of hedging comes in when avoiding significant portfolio losses. If losses can be minimized, it isn’t necessary to capture 100% of the upside to achieve market-equivalent returns. Participating in 70% of market gains but just 7% of market losses is a better proposition than participating in 100% of both. It also leads to fewer sleepless nights and less worry about the long-term viability of your retirement savings.
A portfolio manager can offset the cost of the protective hedge by seeking above-market returns in the underlying equity portfolio. For example, one way we seek alpha is by investing in asset classes showing significant momentum, e.g., technology stocks via the Nasdaq-100 tracking QQQ exchange-traded fund, or in stocks that are poised to benefit in the current economic environment. As an example, we’re looking at cloud computing and software-as-a-service firms, seeing the potential to build market share as remote working and education continues to expand during the COVID-19 pandemic.
Think Outside the Black Box
In a world where asset allocation has become the standard fare offered up by large fund houses and financial planners alike, investors are seeking a more thoughtful approach to managing the risk exposure and return potential of their portfolios. Money managers may use a “black box” asset allocation solution to easily systemize their advice to the masses, but history has shown these strategies do little to help investors when they need help the most. This year’s swift market drop, when most asset classes crashed in unison, is the most recent case in point.
The importance of avoiding losses in achieving long-term investment success is a critical lesson for investors to learn. A protective hedging strategy is an effective way to reduce downside exposure while allowing investors to participate in the market’s upside and invest in some of today’s most promising opportunities for growth. In my next article, I will discuss how to minimize the number of asset classes in your portfolio and focus only on owning the sectors of the economy most poised to offer growth.
About the author: Robert M. Wyrick, Jr.
Robert M. Wyrick, Jr. is Chief Investment Officer with Post Oak Private Wealth Advisors, a highly specialized, fiduciary fee-based firm focused exclusively on advanced risk managed investing, retirement distribution. As CIO Robert’s focus in on maximizing return for given levels of risk, and hedging fat tail market risk through the use of protective hedges to protect Post Oak’s clients from severe market declines.