It’s Not Just About Return; Don’t Forget the Risk

Like many investors, you probably learned early on that diversification can help your portfolio with the risks of a volatile market. 

But could it be that all these years you were looking at risk and diversification the wrong way? 

Many people believe their portfolio is diversified if it’s balanced among low-risk, medium-risk and high-risk investments. Notice, though, that all those include the word “risk.” How diversified are you if every dollar is at risk and the only difference is a matter of degree?

Let me share what may be a different approach to helping guard against risk in retirement, whether that risk comes from a volatile market, taxes or poor planning.

• Start with building a fiscal house. Think of your portfolio as your fiscal house, with a foundation, walls and a roof. The foundation must be sturdy enough to withstand market volatility, and this is where you may consider investments that carry no risk, such as a CD, a fixed-indexed annuity or a multi-year guaranteed annuity.

Meanwhile, the walls are for low- to moderate-risk investments, including real estate or indexed universal life insurance. Finally, the roof is where aggressive investments such as stocks live. This should be money you don’t expect to use in five to 10 years. The roof may take a beating from financial hurricanes, so give these investments time to grow and time to recover.

• Tame those emotions. An oft-quoted phrase about market success is “buy low and sell high.” That phrase is easy to say, easy to remember and easy to understand. Sadly, it’s not so easy to do because no one can accurately time the market. 

But you can study how the market has performed historically. Doing so, you will see that reacting emotionally to market trends is no recipe for success. Unfortunately, we often hear clients say, “I’ve lost money. I want to get out.” Bad move.

If the market drops 30 percent, for example, and you pull out, not only have you lessened the odds of recapturing growth, you may end up with less than you started. Wait out those market storms.

• Long haul vs. short-term reality. There does come a time to  start easing some money out of aggressive investments. As you near retirement age, you can’t afford to suffer a big loss the way you could when you were younger.

Five years from retirement, start rethinking your risk. Your financial professional can give you a risk assessment to help you make those decisions, but you can also find do-it-yourself assessments online. Finally, I also use the rule of 100, which tells you how much of your portfolio should be in the market by subtracting your age from 100. 

Your risk assessment, your financial professional’s advice and the rule of 100 should all be weighed as in deciding what’s right for you. 

• Make the most of tax strategies and charitable giving. People often think taxes go down in retirement, but that’s not necessarily so. Essentially, three potential tax buckets exist: the tax-me-now bucket (income), the tax-me-later bucket (tax-deferred accounts, such as IRAs), and the tax-free bucket (such as Roth IRA accounts). One goal as retirement approaches is to get as much money as possible into that last bucket.

But most people have much of their retirement savings in the tax-deferred bucket. That means they will pay taxes on withdrawals, and when they reach age 72 they are required to take out a certain amount each year whether they want or need to do so. Those mandatory withdrawals, called required minimum distributions, can bump people into higher tax brackets.

One solution is a Roth conversion where you move money from your tax-deferred account into a Roth IRA. You pay taxes when you make the conversion, but the money then grows tax free and withdrawals are not taxed.  

Another method for lowering your taxes in retirement is strategic charitable giving. Let’s say you are approaching 72, RMDs are set to kick in, but you don’t need the money. You can donate your RMD to a charity and claim the deduction. One way to do this is to set up a donor-advised fund. Such a fund is maintained by a non-profit organization, but the donor advises how the money is distributed. The money grows tax free while the donor makes decisions on how to distribute it to charities.

Your retirement dream is achievable, but you need to make sure your risk is in line with your needs at each stage of your life. Otherwise, your fiscal house could come tumbling down.