How a Hedging Strategy May Help Your Retirement Plan Survive

This is part 2 of a 2 part series.

Many retirees continue to invest as though they’re still in the accumulation phase as I stated in my 1st article, How Bear Market Risks are Bad for Your RetirementDuring a retirement planning class which I teach at our local community college, I have asked potential retirees what is it about your account that you are using to manage the risk in your portfolio.  Many class attendees’ explain to me that they’re using diversification and asset allocation to control risk in their portfolio. However diversification and asset allocation do not control risk or prevent against loss. So let’s take a look at what diversification and asset allocation do accomplish because they are very important.

Diversification protects us against what’s called non-systematic risk, the risk that we have all our money in one security and that security goes out of business or has a massive loss even though the overall market may be doing fine, think Enron, WorldCom or Lucent. So it protects us from having all our eggs in one basket.  But what happens if the entire basket drops. Does diversification help us then? Ask yourself how much did diversification help for the equity portion of your portfolio during 2008? Probably not much because diversification doesn’t provide protection against overall market risk known as systematic risk.

How about asset allocation? What will that accomplish in our portfolio? Asset allocation is very important also.  It directs us to put our money into different asset classes think, stocks, bonds, cash, real estate and commodities.  Declines during the distribution phase (retirement) during a bear market can deal a fatal blow to a well-diversified, asset allocation where a retiree has assets properly deployed into different asset classes. Asset allocation can help bring down volatility. But the question during retirement is even if we have a low volatility portfolio (as measured by standard deviation), how much will we lose in a bear market? Don’t think that just because you have a low volatility portfolio or a low standard deviation portfolio that your account can’t lose a lot of money.

Consider that bond portfolios are typically very low standard deviation portfolios they don’t usually have a lot of volatility. However what happens if we get into a scenario where interest rates rise gradually over number of years? Bond portfolio could lose a lot of money slowly over time without all that much volatility. Retirees understanding that they need to have a lower risk portfolio during retirement have loaded up their portfolios with bonds.

While US government bonds will help bring down the standard deviation on your portfolio; meaning that your portfolio will have less volatility, the real question is are they reducing risk? The question you have to ask yourself is what is the duration of my bond portfolio and is adding bonds helping or am I just creating a portfolio that in a bear market may lose money more slowly than a high volatility portfolio, but it could still lose a lot of money over time? We all got to see firsthand how well diversified and nicely allocated portfolios lost a lot more during the 2008 downturn than many people expected. As we learned in the first article of this series, one of the most important aspects in retirement investing is the sequence of returns and how losses early in the distribution phase (retirement) can have devastating effects on your retirement plan. And although the next bear market may not kill your portfolio, the question is will it wound your portfolio enough so that your portfolio can never recover?

Retirees need to realize that diversification and asset allocation alone simply won’t cut it. Investors need to add to diversification and asset allocation, some type of hedging strategy for bear markets to protect their portfolios against large draw downs. A hedging strategy seems very technical but one example can actually be as simple as allocating a larger percentage of your portfolio to cash when the markets move into a negative trend. Working with a financial advisor who understands the risks that retirees face, an advisor who tracks the supply and demand, trends and relative strength of the markets and who uses that information to manage clients’ portfolios can be an invaluable resource during retirement.

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

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