Market Risk

Understanding Market Risk

Retirement investors need to be aware of market risk: the possibility that their investments will lose value when the financial markets are down. Market risk exposure exists with direct investments, investment funds, variable annuities and retirement accounts, such as 401(k)s.

Investors assume this risk because, on the flip side, these investments offer more growth potential than conservative investments.

Overall, the advice from financial experts amounts to this: fasten your seat belt.

In other words, be prepared to ride out the ups and downs. Don’t pull out all of your variable investments, but take precautions. You may end up taking some short-term monetary hits along the way, but your finances will most likely end up in better shape than if you hadn’t invested at all.

Most people use the phrase market risk to refer to stock market volatility. However, all marketable investments, including U.S. Treasury securities, corporate bonds and real estate properties are subject to market volatility.

Thomas J. Brock, CFA®, CPAInvestment, Corporate Finance and Accounting Professional

Thomas Brock, CFA®, CPA, is a financial professional with over 20 years of experience in investments, corporate finance and accounting. He currently oversees the investment operation for a $4 billion super-regional insurance carrier.

Strategies for Mitigating Market Risk

Market fluctuations pose a very real risk to investors who are approaching retirement. If the market dives just as you’re getting ready to retire, you may have to delay retirement — or at least delay withdrawing or reallocating that money — because your investment needs time to recover.

If you withdraw from your original principal when the investment has limited returns, you shrink the principal and compromise your future returns. We know this as the sequence of return risk. 

Withdrawing the money on a downturn will cement your losses in place.

However, not all investment strategies carry the same amount of risk. There are steps you can take to mitigate the effects of market fluctuation.

One preliminary step is to evaluate your risk tolerance. Determine how much risk you’re willing to take with your finances to get the best reward for you. 

Then consider your investment horizon, or the amount of time you have before you plan to start tapping into your retirement investments. This determines how long you would have to recover from a significant market loss.

Diversifying Your Investments

Diversifying your investments is the most effective way to limit your risk exposure. Spreading your capital over multiple types of assets and sectors of the economy ensures that you aren’t too heavily invested in a poor-performing asset.

With stocks, diversification means including a mix of companies and stock types, such as energy, technology, healthcare, commodities and more in your portfolio. Diversifying outside of the US, into both developed and developing international markets can provide further diversification.

It’s also best practice to have your money distributed between different classes of investments, such as stocks, bonds, real estate and money market funds. This is known as asset allocation.

Your diversification should be done with thought and research. The Securities and Exchange Commission warns consumers not to engage in “naïve diversification,” which is when an investor chooses to invest equally in all investment options. This may increase your risk exposure.

“Diversifying your investments is an important strategy for mitigating market risk, but it’s important to remember that it does not provide a guaranteed limit on market loss potential,” Elle Switzer, director of annuity product management at TruStage, told Annuity.org. While holding a diversified portfolio is generally less risky than one that’s less diverse, this strategy cannot prevent losses entirely. 

Systemic risk, the possibility that all assets may lose value simultaneously during an abnormal shock in the local or global economy, cannot be diversified away. The only way to minimize systemic risk is to avoid participation. However, over an extended period, non-participation carries the risk of losing purchasing power on your savings due to inflation.

Mutual Funds for Retirement Planning

Mutual funds pool money from thousands of clients to invest in a selection of hundreds or thousands of stocks, bonds and other investments.

They do the diversifying for you and can be an effective retirement investment. Many 401(k)s offer a selection of mutual funds for investing your retirement savings.

It’s helpful to look for funds with low fees. This results in low expense ratios, the measure of administrative costs to the total value of the funds. The higher your expense ratio, the lower your return.

You might also investigate funds that are specifically designed for retirees, known as retirement income funds. These funds hold stocks, bonds and cash specifically chosen to balance the need to preserve your principal with the desire to have a decent monthly growth. 

Always discuss your allocation strategy with a trusted financial advisor when determining the best strategy for your needs.

Safe Investments for Retirees

If you have a low risk tolerance, you may feel more comfortable with investments that have a more conservative rate of return and lower risk. The downside of this is twofold: your money will not grow as much as it may have otherwise and you will be more exposed to the adverse, wealth-eroding impact of inflation. As a result, you will need to set more aside to have enough for retirement.

No matter what, some of your money should be invested outside the stock market so that your entire nest egg isn’t at risk. But if the idea of losing any of your money keeps you from investing for retirement, a high concentration of conservative investments may be for you.

“The safest strategy is one that provides guaranteed growth with no risk of loss, like a fixed annuity or bank CD,” Switzer said, “but this strategy will limit upside growth and could make it challenging for your returns to keep pace with inflation.”

It should be noted that annuities themselves are not actual investments but insurance products that you purchase, which is part of the reason they provide safety and security. You don’t have to be concerned with losing all of your initial “investment.”

When you buy an annuity, you pay premiums – either over time or in a lump sum – that are converted into a guaranteed stream of income during retirement.

These guaranteed, predictable payments can last the rest of your life.

Annuities can make sense as part of your investment strategy by providing a built-in layer of security. Knowing you will have those payments coming and that you will never run the risk of running out of money in retirement can help to insulate you from losses on your more aggressive investments.

When trying to balance when the right time is for risk versus conservatism, a good option might be to accept more risk when you’re younger and have more years to recover from any losses. As retirement approaches and your risk tolerance lowers, you can move your funds into safer vehicles, including things like annuities.

Rebalancing Your Portfolio

If you want a certain percentage of your investments as stocks and another percentage as bonds, you should revisit your portfolio each year to make sure the balance hasn’t changed. It could change depending on the performance of the investments.

For example, if the stocks do well, their worth could grow to the extent that they comprise a larger percentage of your overall investments. Ensure the balance of investments continues to meet your goals and risk comfort level.

The closer you get to retirement, the less risky your investments should be. A common rule of thumb proposes you can figure out how to split your assets by subtracting your age from 100, giving you the percentage of your portfolio that should be invested in stocks. The remainder should go to fixed income products like bonds.

This “100 minus your age” rule is a useful illustration of how your asset allocation should shift to carry less risk as you age. However, some consider it too conservative; Consider that a portfolio that’s 50% bonds and 50% stocks may not provide the returns a 50-year-old needs to retire on time. Therefore, generic rules of thumb won’t be appropriate for all investors.

If you’re investing through a 401(k), you will have a limited number of funds to pick from. Some will be more vulnerable to market volatility than others. Some will include bonds, which are less sensitive to market losses and pay interest regularly. Research your choices before committing.

Setting Up a Guaranteed Income Stream for Retirement

When you retire, you’ll still have basic expenses to cover. Many retirees find that continuing to receive regular income payments in retirement provides peace of mind because they know that they will continue to have enough money to live off of.

Buying an annuity, which provides a guaranteed stream of income regardless of market conditions, is an effective strategy for ensuring your ability to pay your bills. Annuities also protect you from longevity risk by protecting you against outliving your savings.

Besides retirement income streams, it’s prudent to have some money set aside for unexpected expenses or emergencies. 

If you’re near retirement, it’s a good idea to have ready access to enough cash to pay your expenses for one to three years. You can put most of that money into certificates of deposit, for example, with maturity set strategically for whenever you expect to need the funds.

Keep Investing During a Market Downturn

Investing during a market downturn might feel like you’re throwing your money into an abyss, but when stocks are down, you actually get more for your money. Think of investing during a downturn similar to buying during a sale.

Whatever you do, don’t panic and withdraw your money at the bottom of the market. If you do that, any losses will become permanent. The odds are good that the downturn will end, and the market will recover.

Timing aside, a downturn in market conditions can be an opportunity if you strategize wisely.

The U.S. Securities and Exchange Commission suggests some investment tips to help you make smart investing decisions. Among them:

• Perform a background check on your investment advisor.
• Don’t fall into detrimental investing behaviors.
• Consider the expense ratios of your investments.
• Pay attention to world events that may impact the market.

The commission also stresses the importance of confirming that the security you’re considering is registered with the SEC by consulting the EDGAR database or calling 1-800-732-0330.

Frequently Asked Questions About Market Risk