Heightened Risks When You Reach Critical Mass

I have often times told clients before retirement that they have reached “critical mass” in their portfolio. What this means is they have enough money to retire on and live the comfortable lifestyle that fits their desires. The problem is that the investment markets don’t care. In fact when you have built up a significant portfolio and you are within a few years of retirement (or any goal, e.g. college tuition is due), your risks actually increase. That is due to Sequence Risk (for info on Sequence Risk send me an email or click on Sign Up Now at the bottom of the website include “Sequence Risk” in the First Name field) and Retirement Date Risk as recently written about by Michael Kitces. Retirement Date Risk acknowledges that you cannot afford a large loss due to the size of your portfolio and the lack of time that you have to rebound from a market downturn in the ten years before retirement. Basically, losses will be far more impactful in the ten or so years before retirement.

Michael Kitces recommends increasing the bond allocation of your portfolio coming into retirement and then slowly lowering it back to the normal pre-retirement level.  For example, if your target allocation to bonds was 40% ten years prior to retirement, slowly increase this allocation to 70% by retirement and then slowly lower it back to 40% fifteen years after retirement.  The increase in bonds is not for potential portfolio growth but for portfolio protection. Michael Kitces notes that this strategy does not take market valuation into consideration, just communicates the portfolio risks to a pre-retiree and a retiree.

 

 

While stocks are currently a riskier investment due to market over-valuation, bonds are also significantly overvalued (See this blog post for my explanation).  For this reason, mitigating Sequence Risk and Retirement Date Risk given current market conditions requires a different strategy than ramping up bond allocations. The investment method that we recommend to our clients is to increase/decrease allocations to stock, bond, and other asset classes (real estate, commodities, natural resources as well as allocations to foreign stocks and bonds where values are superior to domestic) in response to current market risks especially as one nears retirement.

Michael Kitces’ article was timely. Stock market values are extremely high and interest rate changes that will affect bond values are on the horizon.  (See our last quarterly blog post of market valuation) A lot of pre-retirees and retirees who have portfolios that subject them to significant Sequence Risk and Retirement Date Risk are going to be hurt and have diminished  retirement lifestyles if they do not take into consideration market overvaluation and the current market risks that I, Michael Kitces and a few others have written about. Please be proactive and review your portfolio. You don’t want to be reactive and diminish your risky investments when it is too late. The evidence is there to provide fair warning.

Please note that this does NOT mean to not participate in the market, just have a game plan. Money can be made and protected in all types of markets.

“If everyone is thinking alike, then no one is thinking.” – Benjamin Franklin