Most investors' top priority is saving enough to fund a nice retirement. And to this end, many investors understand the importance of maximizing their savings and minimizing their taxes. For instance, while a work-sponsored 401(k) plan is a great retirement savings vehicle, plenty of people also make regular contributions to a traditional or Roth IRA. These folks also aim to make smart investment decisions with their money.
However, there's one mistake that's easy to make, and it could easily derail your dreams of retiring when you expect, or maybe even retiring early. That mistake is failing to adjust your portfolio's exposure to risk two, three, or even five years before your intended retirement date. The market can take quite a hit in a short period of time. You don't want your investments to be valued far below their peak right at the time you want to call it quits.
Problems surface much faster than they fade away
If you're reading this, then odds are good you're aware of the merits of a well-balanced portfolio. It's more than a matter of sector diversification, however. Even younger investors with plenty of time to ride out more than one cyclical headwind should hold more mundane equities like bonds as well as counter-cyclical instruments such as commodities or real estate.
Of course, most investors -- at least most U.S. investors -- don't do a particularly great job of getting diversified and then staying diversified. Lots of people end up owning too many aggressive growth stocks. And a sizable swath of investors is actually underexposed to equities.
Both are problems, to be sure. The former problem is the potential pitfall for anyone nearing the beginning of their golden years. When the market tanks, it can do so in a hurry and without any warning, dragging all stocks lower with it.
Take the setback associated with the arrival of COVID-19 in the United States as an example. The S&P 500 was still edging higher as of Feb. 2020 even as the coronavirus was already circulating in China. A month later it had lost one-third of its value. A million-dollar portfolio fully invested in the popular Vanguard S&P 500 ETF would have shrunk down to about $665,000 in a matter of weeks.
Fortunately, for any prospective retirees at the time, the market bounced back pretty quickly; by Aug. 2020, the index was back to February's levels, en route to record highs. It would have been difficult to remain confident enough in an all-stock portfolio in the midst of that mania, however, and the speed of that recovery was an exception, not the norm.
Case in point: The S&P 500 didn't revisit the highs hit right before 2000's dot-com meltdown until 2007, right before the subprime mortgage meltdown upended the market again. The S&P 500 didn't get back to 2000's peak until 2013.
That was an unusual scenario, but it happened nonetheless. It's a problem simply because no pre-retiree has 13 years to wait for such a market recovery. Very few people saw those setbacks coming until they were well underway.
How to handle it
So what's the right way to start dialing back your retirement fund's risk exposure?
First, understand that simply diversifying a portfolio with seemingly lower-risk holdings or different kinds of assets doesn't guarantee you'll be completely shielded from a setback. Sometimes, all categories of investments rise and fall together. Spreading your retirement funds out to positions in non-growth stocks should mute a good deal of cyclical setback, but it won't sidestep all of it.
Nevertheless, you should still do what you can to keep volatility from forcing you to postpone your retirement.
To this end, know that this shift is a process that can -- and arguably should -- start as much as five years before your planned retirement date. This doesn't inherently mean you must start shedding any and all equities at this time; you may end up not shedding any just yet.
Three to five years out is when you'll want to begin taking a close, critical look at all of your individual holdings with the goal of making realistic decisions regarding the stock and company in question. Is the stock so overvalued it may stagnate for five years? Is there any actual assurance the company in question will be able to reach wildly lofty goals? If it's a speculative pick like GoPro was back in 2014 or cannabis company Canopy Growth back in 2018, there's a very good chance it could struggle for five or more years ... if it's going to recover at all. It may be time to make an exit at the best available price even if that means taking a loss on the trade.
This is something you'll want to keep doing, too, if you're in the habit of hopping into story stocks when they're hot.
You'll also want to start shifting away from riskier, more volatile growth stocks (even the proven ones) toward more reliable stock picks. It wouldn't hurt to start scooping up undervalued dividend payers, for example, as they go on sale.
Beginning about two years in advance of your retirement, you'll want to start building a bond ladder for the fixed income portion of your portfolio too. That's just the term used to describe the process of staggering the maturity dates of any fixed income you own -- or buy in the meantime -- so they're not all essentially the same bond. You'll want to own maturities ranging from a few months to a few years out, rebuilding the bond ladder as each of these instruments matures. This approach provides you with interest income that's more or less in line with the marketwide average at any point in time. It also mutes any price volatility linked to changing interest rates.
You don't have to commit all of your idle cash from this point forward to a bond ladder. You'll just want to start building one.
As complicated as the process may sound, this might help keep things in perspective: If you're not fully prepared for a bear market at the point when you retire, you'll likely be forced to make short-term investing decisions that make things even tougher in the long run. Three to five years should be a long enough time frame to navigate any bear market that materializes.
Tailor any solution to your personal situation
If you're looking for an age-based target allocation, you won't find one here. That's because every investor is unique. A $5 million retirement portfolio is very different from a $500,000 portfolio. The multimillionaire can likely afford to retire on dividends alone. The half-millionaire can't. You have to find an allocation that works for you and your situation.
Regardless of your personal scenario though, you must be willing to start your retirement fund's growth wind-down years ahead of time even if you don't have to finish the process until months before you stop working.
It's time well spent. There's nothing more financially devastating and heartbreaking than starting your retirement with significantly less than what you had just a few months earlier.
