If you are nearing retirement, managing market volatility becomes critically important. Investors with long horizons can tolerate the risk of having negative returns in some years and positive returns in others as they pursue greater long-term returns. As one’s time horizon shrinks though, the sequence of returns becomes much more important. When you are making retirement withdrawals in a market downturn, you are potentially “locking in losses.”
To help manage the potential impact of sequence of returns risk in or nearing retirement, you can employ some of the following strategies:
- Stress Test Your Portfolio - Historical returns are simply not sufficient information to evaluate investments when nearing or in retirement. You should also consider three key measures of risk: maximum drawdown, returns per unit of risk (Sharpe ratio), and the correlations between different types of assets.
- Tune-Up Your Portfolio - After stress testing your portfolio, you may want to adjust your portfolio to increase the focus on investments designed to have less volatility during down markets.
- Precautionary Measures to Minimize Sequence of Returns Risk – To help meet retirement income needs, you may want to consider establishing a short-term investment pool a few years prior to retirement that can be drawn upon to generate income in the event of adverse market conditions.
- Put Your Action Plan in Gear - Investors nearing their retirement drawdown period will want to work with their financial advisor to create an action plan.
Sharpe Ratio is a risk-adjusted measure of reward per unit or risk. The higher the Sharpe ratio, the better. The numerator is the difference between the portfolio's annualized return and the annualized return of a risk-free instrument; the denominator is the portfolio's annualized standard deviation (population).
Correlation expresses the strength of relationship between distribution of returns between two data series. Correlation is always between +1 and –1, with a correlation of +1 expressing a perfect correlation, meaning that the two series being compared behave exactly the same, a correlation of –1 meaning the two series behave exactly opposite and a correlation of zero meaning movements between the two series are random.
Standard deviation is a widely used measure of performance volatility.
There are no guarantees that the historical performance of an investment, portfolio, or asset class will have a direct correlation with its future performance.