After a significant fall in portfolio value, investors are often “forced” to lock in losses and move to a lower risk portfolio to preserve the value of their remaining assets.
As markets subsequently rebound from these “fire sale” levels, investors don’t fully participate, leading to a permanent impairment of their capital. In practice, most retirees build their retirement savings gradually by contributing on at least an annual basis.
A heightened sensitivity to losses in later years has historically led investors to de-risk their portfolios as they approach retirement, usually by switching from equities to fixed income. Given the current level of government bond yields, however, that switch may significantly crimp future potential returns, and increase the risk that the fund loses value in real terms.
A similar dynamic is in play in the early years of retirement as the performance of the portfolio in those first years plays an important part in the long-term value of the retirement pool. The effect becomes increasingly important as the distribution rate approaches or exceeds the expected long term return of the portfolio.
What about balanced portfolios of stocks and bonds?
The ideal investment vehicle around the point of retirement should deliver stable, positive returns with adequate levels of income. Traditional portfolios simply cannot meet these objectives. Even balanced portfolios of stocks and bonds, which offered reasonable yields a few years ago, no longer provide sufficient income.
In previous periods of stress, returns from fixed income were boosted by a combination of interest accrual and a fall in yields. Going into the next equity correction, balanced portfolios will no longer have a cushion from the yield on bonds to offset the equity losses, but will need to rely almost entirely on capital gains.
Furthermore, a legitimate concern relates to the potential for a break in correlation between bonds and equities; rather than bonds providing stability to a balanced fund in the event of an equity correction, bonds may amplify losses.
An alternative to the balanced fund solution
In recent years, diversified absolute return funds have allowed some investors to accept a combination of income and capital to meet their spending requirements, rather than follow the riskier, pure income approaches. How fund managers achieve this objective varies by fund.
Some managers will purchase portfolio protection, whilst others will try to mitigate risk through diversification; most sit somewhere between. An obvious advantage of this tightly risk-controlled environment is that if one can maintain capital while others are suffering drawdowns, opportunities emerge to make investments at “fire sale” values.
These same absolute return strategies can also be implemented in ways that generate real, distributable income, while following an identical underlying investment strategy. While maximising income of a portfolio is a legitimate goal, it must be done with a close eye on associated risk.
