If you’ve been following the economic news the past few weeks, you’re probably as sick as I am of hearing the term “fiscal cliff.” Last week Congress says they’re making progress and the stock market rallies. Today they say they’re not happy because of the lack of progress and the stock market immediately tips over. It’s a day trader’s dream come true and an investor’s biggest headache.
I think this raises a more interesting topic though regarding control. If you’re the type of person that prefers to retain control (I know I am) and would rather not have your investment returns subject to external events that are outside of your control (the decisions made by Congress), it might be time to rethink your investment strategy. More importantly, if you’re approaching a goal such as retirement, you probably don’t want the success of reaching that goal in the hands of markets which you cannot control. Just ask anyone that had plans to retire around 2008/2009 but left too much of their portfolio invested in stocks/real estate. Guess who’s still working today trying to make that money back?
Let’s think about investing in the traditional sense that most people do: the choice between stocks and bonds. Historically, stocks have offered better growth potential and higher rates of return, while bonds have been a stable source of income. The general rule of thumb is to shift your portfolio allocation to a higher percentage of bonds as you get older (i.e. approach retirement). But, with the rates of CD’s and government bonds as low as they are, how does an investor that still needs decent growth do so without losing control of returns and subjecting the success of reaching their goals to things like a falling stock market?
I believe you have two choices. You either:
- Don’t target a specific date to retire on. Or, more likely,
- Plan ahead and utilize alternative approaches to investing.
Before moving on, I think it’s important to note that I’m not saying stocks are a bad investment, nor do I think that they are a bad investment right now. I think stocks are a fantastic long-term investment. What could be easier than sitting back and sharing in the annual profits of a company? I also believe that stocks have a place in nearly every portfolio – even people approaching or in retirement. It’s simply a question of how much of their portfolio is allocated to stocks and how long can they go before they need to access that money.
So the question becomes, how can an investor build a plan that allows for growth potential without the risk of his/her portfolio getting cut by 15% to 20% or more right before retirement (thus ensuring control and success of reaching your goal)?
The first step is to take action years ahead of time to ensure your success – often 4 or 5 years beforehand. The earlier you begin to implement a plan, the easier things will be allowing you to follow the more conventional approaches to investing. In terms of retirement, this means setting up enough annual income streams to allow the stock allocation of your portfolio plenty of time to endure the ups and downs of the market.
For those hoping to retire in the very near future and still needing some growth, or just sick of stock market volatility, let’s get creative. My favorite approach is to use option spreads on the stock market. Options give you exposure to stocks without actually investing in them. Essentially, it allows you to retain some of the upside growth potential of stocks while significantly limiting your downside risk. I call this approach a Managed Volatility Portfolio since you’re pulling your target returns into a tight range each year (let’s say -5% to +15%). This is the same investment strategy that insurance companies use behind their equity indexed annuities and life insurance policies. So why can’t an investor utilize the same approach in their retirement portfolio? Not only can they, but I believe they should if they wish to increase the likelihood of success of reaching major lifetime goals like retirement.
Now it’s important for me to note that options can be very complex and if you don’t know what you’re doing, you should not invest in them on your own. Please consult with an experienced investment professional (with options experience). Additionally, in my opinion, anyone that tells you options are “risky” and should be avoided at all costs does not understand how they work and how to properly use them. When used properly, they are perhaps the best way to manage stock market volatility. The approach mentioned above is just one way that I use them to help my clients reach their goals. The are many more great uses but I’ll save those for later posts.
As always, thanks for checking out my blog!
-Nick