For many people, investing can seem like a daunting task given all the elements involved: economy, the Federal Reserve, corporate profits, investment selection, geopolitical risks, and volatility risk, to name a few. The introduction of a new element, COVID-19, has made investing that much more difficult because of the high degree of uncertainty around the path of the virus and its ultimate impact on the economy. All of this weighs on investor sentiment and increases market instability and variability.
For investors in or nearing retirement, heightened market swings can increase the risk of a major asset drawdown at the worst possible time, therefore reducing portfolio volatility is very important. One way to reduce the risk of a major capital drawdown is through portfolio diversification. Essentially, this means holding more than one asset class and preferably, several asset classes, such as stocks, bonds, commodities, and real estate, within the portfolio. Holding multiple asset classes helps to dampen volatility and reduce the impact on the portfolio of a major drawdown in one or more of those asset classes. For example, historically bond prices have tended to rise when stock prices decline. Holding both stocks and bonds in a portfolio helps to reduce the impact of a sharp decline in one asset class, thereby reducing portfolio volatility. A recent study by Morningstar showed that over 20 years, ending March 31, 2020, a diversified portfolio weighted 60 percent equities and 40 percent bonds actually outperformed an all-stock index, the S&P 500. This demonstrates how impactful diversification can be during a period of heightened market volatility.
Stable and growing portfolio income is increasingly important in retirement. In addition to supplementing other sources of retirement income, higher income in portfolios has shown to add stability to returns over long periods of time. The reason for this is prices of bonds and dividend-paying stocks tend to be more stable, which in turn helps reduce portfolio volatility. Studies have shown that dividend-paying stocks, particularly those that grow dividends, have generated higher absolute returns than market averages over long periods. Thus, holding quality stocks that pay stable and rising dividends provides the multiple benefits of rising income and enhanced portfolio stability and can lead to higher absolute returns.
Finally, having a good financial plan can help to reduce stress and anxiety for many retirees because it provides a better understanding and roadmap with respect to one’s finances and financial capacity. A good financial plan will take into account retirement assets, projected income and expenses, debt, investment returns, cash flow risks, longevity and health risks, estate planning, and other life goals. By providing the client with a path that provides the highest probability of success, a good financial plan can reduce financial stress and increase confidence in one’s financial outlook, thereby greatly enhancing quality of life in retirement.
Robert Toomey, CFA/CFP, is vice president of research for S. R. Schill Associates on Mercer Island.