It's never too soon or too late to start preparing for your retirement. With the world feeling more volatile than ever, the stock market is bound to encounter peaks and valleys in the coming years. Whether you're a new investor, you're preparing to retire, or you already have retired, it's essential to consider the effect of the stock market on your retirement savings.
Ultimately, the stock market is unpredictable, and both highs and lows are a guarantee. However, many investors often fail to consider the timing of a potential market downturn, and how an aggressive withdrawal plan early in retirement could potentially impact portfolio longevity. Moreover, some investors will put their portfolios at risk due to their emotional response to an unexpected downturn.
To protect against this, and downturns in general, you should focus on a disciplined investment approach, a conservative withdrawal plan, and other hedge options to ensure that your portfolio is able to survive market volatility.
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Sequence of Returns Risk
When you are still years away from retirement, a diversified portfolio is the focal point of a smart investment strategy. On the other hand, those preparing to retire and those already retired are exposed to the sequence of returns risk. Essentially, this occurs when a retiree withdraws too much money in early retirement during a market downturn, and the portfolio's ability to cover the intended life span is jeopardized.
Since the retiree is “selling low” when they withdraw, they are doing exactly the opposite of what will help them remain solvent through their retirement years. More importantly, this is purely a byproduct of the order of returns, rather than the specific returns themselves. In many ways, it's a game of luck played between bear and bull markets.
While this is something you cannot control, it is something that you can strategize against to protect your assets.
The Impact of Downturns on Defined Contribution Retirement Accounts
Current retirees aren't the only ones subject to market volatility. In fact, the movement away from the traditional pension plan means that many people are working with defined contribution retirement accounts instead. There are both pros and cons to this change. While you are in control of your ultimate retirement destiny, you are also likely to have less definitive retirement income to rely on.
If you have many years before retirement, then you have plenty of options to grow your 401(k) and protect it against volatility. One of the most important tactics is to continue to make steady contributions to your retirement accounts, regardless of the state of the market. Be careful not to fall prey to emotions and withdraw before age 59½; this will result in a 10% penalty in addition to normal income taxes. Moreover, it's important to become increasingly conservative as you approach retirement, as this will ensure there is a decreased loss with a market downturn. While there are no guarantees, an easy way to do this is with target-date funds, which will be rebalanced regularly based on the date. Once the market does take a hit, your retirement accounts will be better equipped for the fallout.
How to Hedge Against Market Downturns
Regardless of whether you are years away or currently in retirement, there are a number of ways to minimize losses to savings in the face of a market downturn.
To reiterate, the most important thing you can do throughout your life is to focus on building a diversified portfolio of stocks, bonds and cash. Likewise, rebalancing the asset allocation on a regular basis is important, based on positioning, income needs and risk tolerance. The rule of thumb is to subtract your age from 110 (it used to be 100, but with people living longer, the thinking on that has evolved) to give you the percentage of your portfolio that should be in stocks at any given time. For younger investors, it's OK to focus more on risky endeavors and stocks, while older investors and retirees should focus on less volatile instruments, such as bonds and cash.
For those close to retirement, or already in it, it's imperative to have a spending strategy as to where your money will go and how much you will spend. With an extended downturn, the traditional 4% rule has become the 3% rule. That means for a sustainable portfolio, retirees can withdraw 3% in the first year and then increase their withdrawals after that based upon inflation. Avoiding early withdrawals, being willing to pull back on spending, and having a strategy will offer protection against a bear market.
Finally, diversifying with backup options beyond the retirement portfolio is also a good hedge option. Having backup cash on hand will ensure that one is not entirely reliant on their ability to withdraw retirement funds, and help ride out a downturn. Other good options are a reverse mortgage line of credit or permanent life insurance with cash value.
Fundamentally, the market is going to experience downturns. However, you can still protect your retirement when you understand how your portfolio will respond to this scenario. If you take a disciplined investment approach throughout your life, diversify your portfolio, and have some hedge options in case of a downturn, you are practically guaranteed to be in a better position for retirement.
Securities and investment advisory services offered through Royal Alliance Associates, Inc. (RAA) member FINRA/SIPC. RAA is separately owned and other entities and/or marketing names, products or services referenced here are independent of RAA.