Traditional Investing may not work in retirement

All the way up until you retire, you’ve probably been taught some key principles of investing like diversification, dollar cost averaging and buy and hold.  As important as these traditional investing concepts are to investing for retirement, they may not apply the same way when you are investing in retirement.

Dollar Cost Averaging is a good buy strategy, not a good income strategy.

In your working years, you’ve hear people preach the merits of pay yourself first by investing systematically through payroll or through an automatic deduction from your bank account each and every month.  The added benefit of this forced savings is that you take advantage of dollar cost averaging where you benefit from systematically buying more units of an investment when prices are low and less units when prices are expensive.

When you retire, there is a natural shift to creating income from your investments.  For many retirees, this means a shift to systematic withdrawal plans (SWP) where you systematically sell investments to create regular, consistent income.  The problem with systematic withdrawal plans is the math that once worked for you with dollar cost averaging, now works against you.

For example, let’s say you have a $100,000 investment priced at $10 per share. If we want $500 per month of income, you will need to sell 50 units to create that income.  But what happens if you need the same income but prices fluctuate?

Unit value

Income

Units sold

$10.00

$500.00

50.000

$10.50

$500.00

47.619

$11.00

$500.00

45.455

$9.00

$500.00

55.556

$8.00

$500.00

62.500

$7.00

$500.00

71.429

 

If a market correction hits, and you see a 30% drop in the price you will need to sell 71.429 units to keep the same $500.00 of income. A 30% drop means you have to sell over 42% more units to keep the same income.  Anyone with SWPs in a prolonged recession or bear market will have a really tough time recovering from this math.

Related article:  Variable investments can work against you in retirement

Risk reduction is more important than diversification

As a result of this math, retirees looking to create income from their investments in retirement must take control of the risk in their portfolios and in most cases reduce price volatility.  This concept is not revolutionary.  In fact, it is pretty well known in the investment world that the older you get, the more conservative you should be.

The problem is with low interest rates, it’s tough for retirees to be overly conservative.  It is human nature to desire higher returns to prevent retirees from running out of money but with higher potential returns also comes higher risk.  This risk (otherwise known as volatility) can actually cause portfolios to deplete faster.

Related article:  Retirees may want to be more conservative with their portfolios

Buy and hold is not a good retirement income strategy

We’ve all heard the merits of buy and hold especially in down markets.  The worst time to sell is when the portfolio is down.  The goal should be to sell high, not sell low.

Many financial advisors and professionals will preach words of encouragement like “Hang in there.  Don’t panic.  Don’t sell.  If you sell now, you will realize the losses and sell low.  Right now, it’s just a paper loss and if you don’t sell, it will eventually come back up.”

Related article:  Buy and hold does not always work

This makes sense to me but if you believe this on the downside, you have to believe it on the upside too.  Think about it . . . When investments go up, it’s just a paper gain and eventually it will go down.  Wouldn’t you rather sell high than never sell at all?

As much as buy and hold has merits, it’s greatest flaw is it ignores one of the key components to making money . . . you have to buy low and sell high.

Buy and hold is a decent strategy for accumulation and investing for retirement but when you move from accumulation to income, then it’s important to change the way you think.

In retirement you may want to diversify money into buckets

Traditional investing looks at diversifying a portfolio by assets.  This is know as asset allocation.

Related article:  Understanding Asset Allocation

From a very basic perspective, asset allocation is really the science of mixing different asset classes based on your age, time horizon, risk tolerance and financial situation.

Although I am a firm believer in asset allocation, it may be important to take into account the amount of retirement income you need from your investments and really look at asset allocation from a bucket perspective.  In other words, break down the asset allocation in terms of how much income you need in the short term and invest some money into a safe bucket.  You can then allocate some of the equities into a risker bucket that does not need to generate short term income.

Related article:  Creating retirement income with buckets

My five cents

As you can see, retirees need to change the way they think about investing.  Any retiree that requires income from their retirement nest egg really needs to look at investing differently that typical conventional thinking.  The traditional rules of investing may not apply the same way especially in recessionary times.

Related article:  6 reasons why retirees need to look at their investment portfolios

If you think about demographics, the earliest baby boomers have already turned 65 and for the next 20 years, there is going to be a massive number of people retiring and drawing income in retirement.  It’s this demographic that especially needs to look at investing differently.

Written by Jim Yih

Jim Yih is a Fee Only Advisor, Best Selling Author, and Financial Speaker on wealth, retirement and personal finance. Currently, Jim specializes in putting Financial Education programs into the workplace. For more information you can follow him on Twitter @JimYih or visit his other websites JimYih.com and Clearpoint Benefit Solutions.

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