One of the fundamentals of financial planning is determining the right mix of stocks and bonds in your retirement portfolio. Your ideal mix is based on several factors including your age, risk tolerance, life expectancy and retirement income needs. A basic rule of thumb is to subtract your age from the number 110. That number is the percentage allocation that your portfolio should be invested in stocks. For example, if you are 50 years of age, then the ratio of stocks to bonds in your portfolio should be 60/40.
This guideline isn’t perfect for everyone, but it’s a starting point. What is true for everyone is that as you age, you should have less of your money in stocks and more in bonds, money market accounts and other lower risk assets. If you find that your stock market gains have skewed your portfolio toward stocks because of the latest bull market, you may need to adjust your allocation to lower your stock market risk.
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Here are eight ways to reduce stock market risk in your retirement portfolio:
1. Sell individual stocks and equity funds. The most obvious and easiest way to decrease your stock market risk is to sell stocks. But selling stocks outside of your retirement accounts can lead to tax consequences. Selling stocks with gains will trigger a capital gains tax. To minimize capital gains tax consequences, sell stocks or equity mutual funds and exchange-traded funds in your tax-advantaged retirement accounts first and reallocate to non-equity funds. Another good strategy is to sell losing stocks in your taxable portfolio, which will help balance any gains for the year and benefit you at tax time.
2. Buy bond funds or ETFs. Another easy way to lower stock market risk is to reallocate a greater portion of your portfolio into bond funds or ETFs. Mutual fund companies allow you to simultaneously sell a fund and buy another, making the switch from stock funds to bond funds very simple. You can also use the cash proceeds from a sold equity fund or individual stock to purchase bond ETFs in your accounts. Aim to own funds and ETFs with low expense ratios to keep as much of your earnings as possible.
3. Purchase real estate. Once you’ve sold some equity holdings, you can use the after-tax proceeds to purchase real estate. Investment properties help protect against inflation and can be used to generate income. The more cash you invest as a down payment, the less risky the purchase. Consider your risk tolerance before borrowing to invest. Also, decide if you want to be a landlord. For a reasonable fee, real estate management companies can deal with tenants and repairs while you receive the monthly rent.
Another option is real estate crowdfunding sites. In recent years, these investment platforms have emerged to enable investors to own small portions of commercial and residential real estate properties. The platforms use technology and recent changes to securities laws to create investment opportunities for those looking for more real estate exposure.
[See: 9 Ways to Avoid 401(k) Fees and Penalties.]
4. Open a self-directed IRA. If you’ve sold stock investments in a retirement account such as a 401(k) or IRA, you can transfer those funds to a self-directed IRA and then purchase alternative investments. Self-directed IRAs can be used to invest in real estate, a small business, commodities, private notes and loans and other types of non-traditional investments. Self-directed IRAs are particularly useful for people with expertise in a certain investment discipline other than stock and bond investing. A self-directed IRA gives you access to a wider range of investments while keeping the tax advantages.
5. Build a municipal bond portfolio. Municipal bonds are debt securities issued by government entities such as counties, cities or states. They have two main benefits that are attractive to retirees. First, they provide a reliable income stream that isn’t subject to market fluctuations. Second, municipal bonds are exempt from federal taxes and often state and local taxes. Building a portfolio of geographically diversified municipal bonds at varying maturity dates can lower your overall portfolio risk and help you diversify away from stocks.
6. Buy a protective put option. Options are intimidating for people who don’t understand them. They can be risky if you don’t know what you’re doing. But by design, they are financial tools to help increase or lower the risk/return profile of a security you own. One common method to hedge against downside equity risk is to buy a protective put option on a broad market index already in your portfolio. This strategy is ideal for those who are worried about near-term market declines, but expect the markets to grow over the long term.
For example, if you own a S&P 500 index ETF, you can buy a put option against it to protect against downside risk. Buying a put option gives you the right to sell a security at a certain price within a given time period. The cost of the option will lower your upside gains. If you’re not familiar with options, consult a financial advisor before initiating a protective option strategy.
7. Lower risk with inverse ETFs. Inverse ETFs are securities designed to perform the exact opposite of a given index. For example, if the S&P 500 index rises 1 percent in a day, an inverse ETF for the S&P 500 would lose 1 percent over the same period of time. Inverse ETF managers use derivatives and investing techniques to achieve this performance. But since these are ETFs, any investor can easily purchase them on the open market.
Since stocks are likely to rise over long periods of time, inverse ETFs should only be used for short-term to medium-term time frames to protect assets. They are particularly useful if stocks rise quickly in a short amount of time and may be overvalued. Keep in mind, since inverse ETFs are meant to lower your stock market risk, they will also lower the upside returns of your portfolio if the broader markets rise.
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8. Hire a financial planner. When in doubt about your personal risk tolerance and how it relates to your investments, hire a fiduciary financial planner to evaluate your situation. An independent second opinion can help flush out any biases or uncertainty by applying risk assessment techniques to your portfolio. If you don’t want to relinquish control of your money, a fee-only advisor can help formulate a strategy for a fixed hourly cost. Considering the importance of your retirement nest egg, investing in advice may deliver the best return of all.
Craig Stephens is a blogger at Retire Before Dad.
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8 Ways to Lower Your Stock Market Risk in Retirement originally appeared on usnews.com
