In the total-return approach, there are two ways to mitigate worry about periods when stock prices are falling. The first is to manage risk in the long-term portfolio. I’m continually amazed by the number of retired investors I meet who are worried about stock market risk, yet maintain stock market allocations in their portfolio of 60%, 70%, or more. If you’re in the spending phase and want to reduce the sense of psychological risk coming from spending down assets, a lower-volatility portfolio may be in order—consider something in the neighborhood of 35% to 50% of assets.
Second, consider keeping a cash buffer of one to two years of living expenses in a separate account, making transfers from your long-term portfolio to this account once or twice a year. This behavioral device, based on the principle of mental accounting, which segregates spending money from long-term assets, may provide some relief from worries about the volatility of the long-term portfolio.
I’m realistic that many investors will still stick with the traditional income approach. That means the search for higher yields entails moving, in today’s environment, to longer-term or lower-quality bonds, as well as stocks paying higher yields. But investors shouldn’t forget to weigh the risks—which include the increased level of interest rate and credit risk in such a portfolio, and the concentration risk associated with investing in specific stock market sectors.
Steve Utkus oversees the Vanguard Center for Retirement Research.
Notes: All investing is subject to risk, including the possible loss of the money you invest. Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments. High-yield bonds generally have medium- and lower-range credit quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit quality ratings. Diversification does not ensure a profit or protect against a loss. Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
