Is it too late to de-risk? Christine Benz, Morningstar’s director of personal finance, tackles this question in a new column. It’s a subject on many client minds as stock market volatility grows and many portfolios drop in value. She reviews five questions investors should ask — or review with advisors — as there are many ways to come to that decision.
In the piece, Is it Too Late to Derisk?, Benz says — especially for those who are skewed heavily toward equities — the decision becomes “if they should leave their investments in place to recover or take steps to reduce risk in their portfolios.”
“There aren’t any one-size-fits-all answers,” she says, and it depends on many factors including time horizon to retirement. Here are five questions she explores.
1. How soon until your client begins spending?
This is the big question, and clients who are 10 years or so away from retirement don’t necessarily need to make any changes to be more conservative. “After all, the return potential of bonds and cash is very low, given today’s low starting yields, so the less return you need to surrender to obtain peace of mind, the better,” she writes.
However, those within two to five years from retirement might be more at risk, especially if they are heavily skewed to stocks, and that might call for “taking steps to cut back on risky investment soon, even if it feels late in the game.” History does show stocks are likely to recover, she says, but it could take awhile. Since the 1920s, bear markets have lasted six months to three years. Further, stocks could drop further.
2. How flexible is a client’s retirement date and spending plan?
Do your clients have to retire in two years, or could it be more? Their flexibility is a big factor, and less “wiggle room” may make de-risking more urgent. But if a client can delay retirement, it gives the market (and their portfolio) more time to recover.
Also, clients should consider planned spending in retirement and if it can be reduced in early years of retirement. If so, it may mean they can retire as planned, she notes.
3. How extreme is a client’s asset allocation?
Once a retirement date has been determined, it’s time to review a portfolio’s asset allocation. First review how much is in cash and high-quality bonds. Typically, Benz says, these assets have “done the best job of holding their grounding during equity swoons.”
Those clients who want to retire soon should have a few years’ worth of portfolio withdrawals available, she says, and “preferably even more set aside in safer assets.” Various tools (on Morningstar’s website and others) can help determine “right size” allocations, but as Benz notes “you can’t tell your balanced fund to take your withdrawals from bonds alone during a bear market, leaving equity assets intact.” This only can be done with “discrete, stand-alone exposure to bonds and cash.”
4. How viable is your client’s plan?
Advisors need to review how sustainable a client’s plan is given their planned retirement start date and spending plan. If it’s on track, then they can make more changes to the portfolio for peace of mind, Benz says. Of course, if recent volatility is keeping a client up at night, it might be time to take some risk off the table.
For those who have a tighter plan, i.e. a better chance of running out of money unless balances grow, Benz suggests staying in the market, giving the money a chance to bounce back, unless they can wait longer for retirement or change spending plans.
5. Can your client mentally tolerate further drawdowns?
Clients need to take stock of their risk capacity, that is, how much do they need for their plan to work, Benz says. That risk capacity “should be the biggest driver of how much room to make for more volatile investments with higher return potential,” she explains.
However, the ability to handle losses, or risk tolerance, needs to be explored. Those who may want to move to cash may need to look at modest de-risking that includes “scaling back slightly on equities or maintaining the same equity exposure but scaling back on the riskiest of stock funds and favoring lower-risk funds instead,” Benz says.
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