By Ben Power
This article originally appeared in the Sydney Morning Herald.
Retirees face a volatile investment market outlook with Brexit uncertainty, the US/China trade war and the rise of populism in Europe. That risk is being heightened because all major asset classes, including shares and bonds, appear to be expensive.
"Retirees need to be thinking about how they manage that risk," says Ben McCaw, Portfolio Manager at MLC Investment Management.
While retirees may be tempted to sell and move to cash, McCaw says they should consider more sophisticated risk management strategies that protect them against steep market falls but enable them to stay in the market.
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Retirees vulnerable to market sell-offs
McCaw says retirees are particularly vulnerable to market sell-offs. After a 50 per cent price fall, an investor requires a 100 per cent price rise to catch up and get their capital back.
"Retirees, however, don't have time to catch up," he says. "So it's vital they don't experience big falls."
McCaw says the most common risk management strategy is to shrink market exposure and go to cash. That’s particularly tempting now because government bonds are yielding such low rates.
The costs of investing in cash
"Cash seems cheap; it doesn't seem to have a cost because you don’t pay anything right now," he says. "But you pay later if it turns out you were wrong."
McCaw says retirees sitting in cash can get caught out two ways. The first is if inflation picks up and erodes the real (after inflation) value of a retirement portfolio, potentially forcing retirees to cut back on their lifestyle.
Retirees stuck in cash could also miss out on returns if markets continue to rise. "That's a real risk for retirees, particularly unfunded retirees who need to maintain as much risk as they can tolerate," McCaw says.
Other tools and strategies for retirees to consider
McCaw says rather than cash, there are other tools and strategies that retirees should consider when looking to manage market risk.
Commodities is one asset class that can help manage risk, particularly inflation risk, when sitting alongside other assets such as inflation-linked bonds and gold.
Retirees should also look at alternative assets, including insurance related investments (IRIs), infrastructure and private equity. Alternative assets are less correlated to major asset classes like equities and bonds, helping to smooth portfolio performance.
McCaw says alternative assets might sound risky but this is mitigated when they are bundled into funds.
One of the most important risk management strategies for retirees
McCaw says one of the most important, but often ignored, risk management strategies for retirees is to invest in options, or funds that use options to hedge risk. "The benefit of options is they cap the downside, but unlike cash, you remain exposed to the upside," he says.
McCaw says options particularly make sense for retirees when risk is high and the outlook is hard to predict.
Like any insurance product, investors must pay a premium to use options. But that premium may be cheaper than the cost of being in cash and out of the market, McCaw says.
While options are available for sophisticated retirees, McCaw suggests the most effective way to access this type of risk control is to invest in funds using options to manage risk. "These days there are quite a few retail offerings that make use of options," he says.
A key metric to manage risk
McCaw says a common mistake when retirees manage risk is to leave it too late. "They start to control risk after markets have blown up and a rebound has started."
Retirees also need to be patient when using risk management tools. “Patience and risk control go hand in hand," McCaw says. "It means missing out when the market rises sharply but you realise the benefits over the long term."
But with risks currently heightened, now is a good time for retirees to be focused on risk management. That means implementing strategies such as incorporating options, commodities and alternative assets. But it also means using risk management strategies as a key metric when deciding if a fund is suitable for their needs.
"Retirees should look closely at how funds control risk," McCaw says. "But they also should try and find funds that control risk in a more sophisticated way, rather than funds that just move allocations between cash and risk assets [like equities]. They are there to be found."
Disclaimer: The information contained in this communication is general in nature and does not take into account your objectives, financial situation or needs. You should consider whether it is appropriate for your personal circumstances prior to making any investment decision.