A well-diversified investment portfolio is the gold standard for retirement. To construct one, investors need a solid understanding of a couple of key concepts, which we’ll cover today.
But first, we have to remember one crucial thing—constructing a diverse portfolio is only half the battle. Maintaining a diversified portfolio is the other half. With that in mind, we’ll discuss how to build a diverse investment portfolio, and we hope to bring you advice that is applicable both if you are a retiree or a younger investor.
Diversification is the name of the game here—this isn’t just a strategy but a crucial defense against the market’s unpredictable and volatile nature. If the proper safeguards aren’t put in place, this nature can quickly and easily erode years of hard work, savings, and investing.
By spreading your investments across a variety of asset classes, sectors, and even geographic regions, you can attain a good balance of growth and security. Once you’ve decided to call it a day regarding the workforce, you can enjoy yourself without constantly worrying.
Understanding Your Investment Goals
Before constructing a properly diversified portfolio, we must take a step back. Setting clear, well-defined, and realistic goals is essential to a financially secure retirement.
Once you have a clear rundown of what you hope to achieve and accomplish during your retirement years, you can start constructing a strategy that aligns with those objectives.
Defining Retirement Objectives
First, you have to have a clear end goal in sight. Retirement objectives or goals vary quite widely among individuals, but everyone needs a clear retirement plan for structure. While some would like nothing more than to retire to a quiet place and catch up on their reading, others eagerly await their retirement years to travel the world.
For some, the goal is to maintain a particular lifestyle or quality of life—while others want to kick their feet up and luxuriate at a far greater level than when they were working.
One major factor to consider is your family situation. Depending on whether or not you have children (and their ages), expenses like college or helping out for a downpayment can significantly affect how much money you’ll need.
Another consideration is debt. Data show that three key generations—Baby Boomers, Gen X, and Millenials have an average outstanding student loan debt of more than $30,000. While everything we’ll suggest in this guide still applies, paying off debt is always a priority when it comes to achieving and maintaining financial resilience.
Setting clear, measurable goals is the first step in tailoring your investment strategy to meet your needs. Consider factors such as your desired retirement age, expected lifestyle, and any and all financial obligations you might have, such as supporting family members or contributing to charitable causes.
As a rule of thumb, plenty of retirement experts recommend one of two approaches—either having ten times your salary saved up, or a portfolio allowing you to live on 80% of your pre-retirement income annually.
Assessing Your Risk Tolerance
Investing your money is an integral part of successfully navigating retirement—but risk will always be a factor.
Several factors come into play here. In general, younger investors have a higher risk tolerance, as they have more than enough time to recoup any losses (or wait for the markets to bounce back).
To assess your risk tolerance, consider your financial situation, investment time horizon, and emotional capacity to handle market fluctuations. Once that assessment is done (and you can enlist the help of professionals here as well), you’ll have a much clearer picture of the asset classes and investment strategies that are a good fit for you.
In general, those with low risk tolerance will favor fixed-income securities, investing in ETFs or low-risk stocks with a buy-and-hold approach. In contrast, those with higher risk tolerance can opt for growth stocks, options trading, and short-term trading in general.
If you’re already retired, you generally have a lower risk tolerance due to the limited timeframe for recovering from significant market downturns, so more conservative strategies are in order.
Asset Allocation Basics
Asset allocation determines how you spread your investments across various different asset classes. The goal is to find a distribution that provides the best returns for your desired level of risk.
Equities vs. Fixed Income
Equities (more commonly referred to as stocks) represent a unit of ownership in a public company. Stocks hold a lot of growth potential as an asset class, but they’re also quite risky and volatile. If you’re out for growth, then stocks will be a significant part of your portfolio—and the same holds true if you have a high risk tolerance.
Stocks have historically outperformed other asset classes in the long run, so if you’ve gotten an early start at retirement planning, they’re also likely a good fit for you.
Fixed-income investments, on the other hand, like bonds, treasury bills, and treasury notes are in essence loans you make to institutions (private or public) which then provide a steady stream of interest payments.
They tend to be less volatile than equities and provide a measure of safety for investment capital. However, the trade-off for this stability is lower potential returns. In many cases, fixed-income securities are ideal for retirees seeking to preserve capital and generate steady income.
The Role of Stocks in Retirement
Let’s get one thing out of the way—traditionally, retirement portfolios have leaned more heavily toward fixed-income securities because of their stability. However, the world’s recent misadventures with inflation have quickly demonstrated that age-old wisdom might no longer hold water.
To keep up with inflation and the rising cost of living, stocks have perhaps become more important than ever for the aspiring retiree. Let’s take a closer look at the how and the why.
Growth Opportunities
Stocks present investors with a huge growth opportunity through two channels: capital appreciation and dividends. Capital appreciation is an increase in stock price, allowing investors to profit when they sell the stock, while dividends are regular payments paid out to shareholders.
By utilizing the tenets of fundamental analysis and identifying companies that can consistently increase their earnings and revenues, investors can capture some of that growth for themselves. On the other hand, dividend payments can serve as a handy source of passive income.
It’s important to note that stocks are incredibly diverse, whether you look at them through the lens of market cap, geography, or industry.
Investing in stocks is a must in order to accrue savings that will outlive you—there simply isn’t an asset class that can match them in terms of returns. On top of that, being as diverse as they are, stocks are a great tool for diversifying, allowing you to invest in speculative, high-risk/high-reward companies and established businesses across a variety of industries and countries.
Assessing Stock Market Risks
As we’ve mentioned, there is no reward with risk, and while the growth potential inherent to stocks is enticing, it is accompanied by higher risks and greater volatility compared to fixed-income investments.
This poses a particular challenge for retirees—market fluctuations can bring down (and keep down) the value of an otherwise good stock for years on end, which isn’t ideal for someone who relies on their investments for income. In a few minutes, we’ll tackle strategies for ameliorating this issue, such as diversification and hedging.
With a good idea of your own risk tolerance, you can adjust how much of your portfolio will be dedicated to stocks. As a general rule, the closer you are to retirement age, the less you should invest in stocks, rerouting those funds to purchase bonds in their stead.
No matter how much you invest in stocks, regularly reviewing and adjusting your stock holdings and rebalancing your portfolio is a must for risk management. Another strategy to consider is dollar-cost averaging, which reduces risk and is easy to implement.
On top of this, consider investing in value stocks, defensive stocks, large-cap or blue chip stocks, or dividend-paying stocks—each category has at least one quality that makes them (in general) more recession-proof and stable.
Bonds and Fixed Income Investments
Fixed-income securities—bonds, treasury notes, and treasury bills, are a staple of stability in the world of finance. Unlike stocks, which are subject to the ebbs and flows of the market, fixed-income securities are generally a safe bet, making them more and more appealing as you close in on retirement age.
Whether you’re close to retirement age or a young investor thinking about the future, bonds will play a big role in your journey to financial independence—so let’s take a closer look at this type of investment.
Types of Bonds and Their Benefits
Bonds are loans made to an institution for which you receive a steady stream of interest rate payments as compensation. They come in several different forms, with the chief difference being who the issuer is.
Government bonds are issued by federal, state, and even municipal authorities. Owing to the government’s ability to print money and collect taxes, these bonds are considered some of the most secure investments in the world. However, they typically have lower yields than some alternatives.
Companies issue corporate bonds, which have higher yields. However, since these are businesses (private or public), the risk is higher. When considering corporate bonds as an option, make sure to examine the issuing company’s creditworthiness.
When it comes to retirement planning, municipal bonds are of great interest—as they’re often exempt from federal and sometimes even state and local taxes. The US treasury’s TIPS (Treasury Inflation-Protected Securities), which are indexed to inflation, are another interesting choice, as they can go a long way in protecting your money from being eroded away by inflation.
Each type of bond offers a different balance of risk and return, allowing retirees to choose investments that align with their income needs and risk tolerance.
Alternative Investments and Diversification
Beyond stocks and bonds, other types of investments can serve to diversify your holdings further, potentially leading to lower risks and higher returns. Let’s take a look at a few possible choices.
Real estate is a logical first choice. By owning a property (either directly, as a landlord) or indirectly (via a real estate investment trust or REIT), you can accrue passive (well, relatively passive in the former case) income while also benefiting from increasing property values. REITs are more “user friendly”, as they trade just like stocks, while also paying out huge dividends required by law.
Precious metals, such as silver, gold, and platinum, have generally been used as hedges against inflation. Buying physical gold is doable, but storage is typically an issue—investing in mining stocks is another possibility.
Since we’ve mentioned gold, we also have to mention commodities. Trading commodities, such as gold, oil, steel, soybeans, coffee, or other agricultural products, is another way to diversify—although the commodities market is quite specific and would usually require at least a year’s worth of paper trading experience to reduce risks.
Last but not least, those among us who meet the criteria to be considered accredited investors (avg. yearly income of $200,000 or $300,000 if filing jointly with a spouse OR $1 million in net worth excluding your primary residence OR a series 7, series 65, or series 82 FINRA license) also have access to investments such as private equity, hedge funds, and VC firms.
Managing Risk and Volatility
Risk and volatility are everpresent elements in financial markets, and successfully navigating these factors is a challenge that requires comprehensive, strategic planning. An investor’s goal is to strike a delicate balance between two goals that are often at odds—growth and security.
While there are plenty of ways to manage risk and volatility, broadly speaking, all of those methods fall into one of two categories—diversification and hedging.
Diversification Strategies
Diversification can be explained simply by quoting a common saying—don’t put all your eggs in one basket. If you spread your investments across a multitude of asset classes, industries, sectors, investment strategies, and even geographic locations, a single downturn won’t be nearly as damaging to your retirement plans as it would otherwise be.
This approach is based on the fact that different investments react differently to the exact same market conditions—to use the most basic examples, the macroeconomic factors that are good for bonds aren’t good for stocks.
There are many ways to diversify—some are simple and straightforward, while others require a bit more elbow grease. On the simple end of the spectrum, you can invest in broad-market ETFs to gain exposure to the entire US stock market or perhaps supplement that with an emerging markets ETF to gain exposure to developing economies.
If you prefer a more granular, hands-on approach, the 60/40 portfolio, consisting of 60% stocks and 40% bonds, is a perennial favorite for retirement planning. This portfolio is usually adjusted as the investor ages, shifting the balance toward more bonds and fewer stocks.
Hedging Techniques and Their Limitations
If you’ve ever heard of the expression “hedging your bets,” you probably already understand the gist of hedging as an investment strategy. In essence, it consists of placing an investment that is expected to perform inversely when compared to another investment, in an attempt to offset any potential losses.
If you’ve diversified your portfolio, you’re already doing one version of hedging, but there are plenty of additional ways to safeguard yourself from losses. However, they will most likely appeal more to the younger and less risk-averse investor audience.
First things first–avoid using Googling or any other manual research techniques. Many companies use link prospecting and SEO-related shenanigans to emerge as ideal hedge candidates. Trust the data, not publicity or PR tricks.
If you want to hedge your investments even further, trading options and futures, short selling, and diversifying further into non-correlated or defensive assets are some options at your disposal.
For options, buying puts allows you to protect yourself from declining stock prices, for example—while short selling even allows you to profit off of declining stock prices. In terms of defensive hedging, many investors like to allocate a portion of their portfolio to gold, as it is a proven hedge against inflation.
However, hedging isn’t for everyone, and it comes with its own difficulties. It can be quite costly, and the financial instruments you purchase to hedge may expire worthless. Remember that there is always a tradeoff with hedging—you receive protection from downside risk, but the upside potential is reduced as a result.
As we’ve said before, apart from diversification, most of these hedging strategies are for young investors or those with a high-risk tolerance. Young investors have an additional benefit: While options trading and short selling are more complex than traditional investing, young investors have plenty of time to learn the ropes.
In any case, hedging is complex and multifaceted—our most sincere advice is not to try it without consulting a financial advisor first.
Tax Considerations and Retirement Planning
Taxes are an unfortunate inevitability—but you’re not without recourse. With a couple of key pointers and a carefully constructed plan, you can minimize your tax bill in retirement, which ultimately leads to an increase in the longevity of your savings.
Let’s examine the two main points regarding taxes and retirement planning: tax-efficient withdrawal strategies and Roth conversions.
Tax-Efficient Withdrawal Strategies
Taxation can take a significant (and unnecessary) chunk out of your retirement funds if you don’t have a well-thought-out, tax-efficient withdrawal strategy. This consists of carefully determining what accounts you will withdraw from and when.
Once you get to retirement age, you should ideally maintain separate accounts for tax-deferred and tax-advantaged purposes, such as traditional IRAs, Roth IRAs, and 401k plans, in addition to regular taxable accounts.
One common approach is to begin by withdrawing from taxable accounts, taking advantage of the lower capital gains tax rates associated with them, and then moving on to tax-deferred accounts, which are taxed at the higher ordinary income tax rates.
Withdrawals from tax-free accounts come last, optimally in years when additional income could push investors into the next tax bracket. This allows retirees to manage their marginal tax rate more efficiently.
Furthermore, strategically timing withdrawals can reduce tax liabilities. For example, delaying Social Security benefits while drawing down retirement accounts can lead to lower taxes overall. Social Security benefits are subject to their own tax rules depending on your income bracket.
Understanding Roth Conversions
A Roth conversion is a technique that could potentially be beneficial for tax-efficient withdrawal. This approach consists of transferring funds in a tax-advantaged account like an IRA into a Roth IRA. The amount you “convert” will be taxed as ordinary income in the year you complete the conversion. However, on the flip side, all the growth in that account will be tax-free, and so will the withdrawals—just like other Roth IRA growth and withdrawals.
A key element of a beneficial Roth conversion is finding the right timing. If your income varies from year to year, converting in a year when you earn less than you usually do can go a long way in minimizing the immediate tax impact of this strategy.
Roth conversions also have benefits in terms of estate planning, as they don’t require minimum distributions for the original account holder. They also have the potential for longer tax-free growth and tax-free inheritance for beneficiaries.
Conclusion
While securing a safe, worry-free retirement is a universal goal, the strategies required are pretty specific. Thankfully, they’re relatively easy to apply with some planning and consistency.
By understanding foundational strategies such as diversification and the roles that different asset classes play in constructing a resilient portfolio, investors can be confident that their decisions result in a fair mix of profit and security.
Remember—investing should be an almost lifelong journey. While there’s always something new to learn, we hope that we’ve given you a good foundation for solving one of the most common problems faced by Americans today.
Featured Image Credit: Photo by Markus Winkler; Pexels
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