Plummeting markets will make even the calmest investors feel nervous about their portfolios. Even more important than your current account balance, however, is whether you'll be able to protect yourself from the risks that face every retirement investor.
Last year, The Motley Fool's Rule Your Retirement newsletter service discussed the risks that you face in saving for your retirement. You can control one of them -- longevity risk -- through a combination of being conservative in setting aside enough for your golden years, as well as making the most of lifetime income streams like Social Security, pension income, and immediate annuities.
But some of the other risks -- such as inflation and "sequence of return" risk -- are harder to manage. As prices rise, you hope your investment returns will keep up, but the wrong mix of assets can leave you falling behind. Meanwhile, unlucky timing in retiring right at the top of the market can force you to endure a stomach-wrenching market drop just as you've stopped getting income from your job.
Quitting when you're ahead
You might think the best time to retire is when the markets are at all-time highs. After all, a long run-up in stocks makes it far easier to reach whatever financial goals you've set for yourself.
Yet while investing somewhat more conservatively in retirement makes sense, putting everything into ultra-safe investments creates new problems. For instance, Treasury bills will never lose you money, but their current yield of about 1.9% isn't going to give you enough to cover a standard 4% withdrawal rate in retirement -- let alone help you pay taxes and keep up with rising costs of living.
When the market swoons
Sometimes the stock market doesn't cooperate. Say, for instance, you retired at the end of 1999 with $1 million, keeping it all in an S&P 500 index fund and taking $40,000 annual withdrawals. After just eight years, you'd have less than $600,000 left -- despite the fact that adjusted for dividends, the S&P has had positive returns over that period.
Even if you were more conservative and put 25% into a long-term Treasury mutual fund, you'd still be below $800,000. With many people expecting to live 30 years or more into retirement, going through that much of your nest egg in the first decade isn't very comforting.
Even out returns
By itself, diversification won't necessarily get you smooth returns. Much of that is because market-cap-weighted indexes like the S&P 500 put more of your money into higher-priced sectors, causing you to lose more when they fall out of favor.
For instance, in 1999, the S&P 500 was heavily weighted toward technology, with nearly 30% of its value in tech stocks like Microsoft
The ideal solution for new retirees is to structure your portfolio so that diversification helps you even out the bumps in the road. That's increasingly challenging, as globalization has brought stock markets around the world into alignment, so that when one market drops, the others are more likely to follow. But a retirement portfolio with small positions in uncorrelated asset classes can help flatten out returns. Some examples include real estate investment trusts like Simon Property Group
With U.S. stocks already well off their highs, now may not be the best time to make major portfolio reallocations. But by identifying promising prospects now, you can begin moving gradually toward more diverse investments, which should help to safeguard your retirement portfolio from downturns.
For more about the issues retirees face, read about: