How do I reduce the risk of investing?

How do I reduce the risk of investing?

Managing investment risk matters at every stage of life, but nowhere more so than in retirement. You want to enjoy the wealth you've spent decades building, yet the greatest risk of all is running out of money and having to rely on loved ones or the state. Getting the balance right between spending and security is one of the most consequential decisions you'll ever make.

In this video, Wade Pfau, Professor of Retirement Income at The American College, examines the rules of thumb advisers have long relied on, starting with the well-known 4% rule. Developed by a US financial planner in the 1990s using historical American data, the rule made an important point: markets are volatile, so you can't simply assume an average return and build a retirement plan around it. Looking at the worst-case historical scenario, he found a retiree could withdraw 4% of their portfolio, adjusting that amount for inflation each year, and their money would last exactly 30 years before running out. But Pfau cautions that today's low interest rates make retirement considerably more costly, and he worries about applying the 4% rule to anyone retiring in this environment.

You'll also learn about another common rule of thumb: "your age in bonds." A 50-year-old, on this basis, would hold 50% bonds and 50% stocks; a 75-year-old, 75% bonds and 25% stocks. Pfau suggests broadening the question beyond asset allocation to include product allocation, considering options like income annuities, since reliable income from outside your portfolio allows you to be more aggressive within it. He accepts that "age in bonds" can be reasonable as a starting point, but the research suggests something important: once you retire, don't keep steadily reducing your stock allocation as you age. Instead, keep it fixed at a level you're genuinely comfortable with. That level might be anywhere from 30% to 80% in stocks, and any of those ranges can form a sustainable strategy when built into a good overall plan.

The takeaway: reducing investment risk in retirement isn't about mechanically following rules of thumb. It's about choosing a sustainable strategy suited to your circumstances, and having a good adviser alongside you to help you make these important decisions. As Pfau's message underlines, there's no greater wealth than peace of mind.

Chapters / Key points

• Why managing risk matters most in retirement
• The biggest risk of all: running out of money
• What the 4% rule is and where it came from
• Why market volatility makes average returns a poor guide
• Why low interest rates make the 4% rule riskier today
• The "your age in bonds" rule of thumb explained
• Why product allocation matters as much as asset allocation
• Why you shouldn't keep cutting your stock allocation in retirement
• Why a fixed, comfortable allocation is more sustainable
• Why a good adviser is essential in retirement

Transcript

How do I reduce the risk of investing?

Robin Powell: Hello there. Managing investment risk is important at every stage, but especially so in retirement. Of course, you want to enjoy your wealth, but the biggest risk of all is running out of money and having to rely on loved ones or the state. In working out how much you can afford to spend, advisers have for many years used what's called the "4% rule." So what is the 4% rule? And is it still valid? Wade Pfau is Professor of Retirement Income at The American College.

Wade Pfau: The 4% rule was developed by a financial planner in the US using US historical data in the 1990s. He was pointing out that there is market volatility, that you can't just assume an average return and base a retirement plan off of that. So looking at US historical data, he found that the worst-case scenario was that someone could withdraw 4% of their portfolio in retirement to give them a spending amount that they'll adjust for inflation after that, and their money would last exactly 30 years before running out. Also, interest rates are so low today that it makes retirement more costly. I do worry about things like the 4% rule in the context of someone retiring in this low-interest world that we have.

Robin Powell: Another rule of thumb which advisers often use is the "your age in bonds" rule. A 50-year-old, say, should have 50% of their portfolio in bonds and 50% in stocks. At 75, the asset allocation should be 75:25, and so on. Of course, everyone's different, but in most cases Wade Pfau wouldn't recommend reducing exposure to stocks during retirement.

Wade Pfau: I think as a starting point the question should be broadened a little bit, so it's not just asset allocation but also product allocation. To think about things like income annuities, because I think your asset allocation can adjust if you have more income from outside the portfolio to rely on as well, you can be more aggressive. I think age in bonds can be reasonable, but the research also suggests: once you retire, don't keep decreasing your stock allocation as you get older and older. Try to keep it fixed at a level you are comfortable with. And whatever that level is could vary a lot. 30% stocks up to 80% stocks, just whatever someone is comfortable with. All those different ranges can provide sustainable strategies if it's incorporated into a good overall plan.

Robin Powell: Again, having a good adviser in retirement is essential. These are important decisions, and there's no greater wealth than your peace of mind.