What is Financial Risk Management?
According to Wikipedia, Risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability or impact of unfortunate events.
Risk management is not easy, except at a particular time in all of our lives.
When is risk management needed?
We should all move to safety as we transition from working life to retirement because losses in the Risk Zone can ruin our lifestyle in retirement.
This phenomenon is called “Sequence of Return Risk” that documents how standard of living can be diminished by losses in the Risk Zone even if markets subsequently recover.
Many near retirement in 2008 lost more than 30% of their savings, and have not yet recovered despite the recent 250%+ run-up in the US stock market.
How about market timing?
Market timing currently reinforces the need for protection because the current stock market rally is the longest on record and has led to very high stock prices.
The imminent market meltdown that many expect soon will harm Boomers much more than everyone else. Those outside the Risk Zone have a reasonable chance of recovering, just as they have recovered from 2002 and 2008, but Boomers are not so lucky, and like all of us, they only get to pass through the Risk Zone once.
In other words, risk management argues for safety for Boomers, and so does market timing.
How safe is “safe”?
We believe that no more than 30% in stocks and bonds is safe, with the balance in Treasury Bills and intermediate term Treasury Inflation Protection Securities (TIPS).
You might disagree, but we would recommend an upper limit of no more than 50% in stocks and bonds. According to a recent Fidelity study, a 50% risky portfolio has the following history over the past 30 years, so in essence we’re recommending that you limit losses to 17.67% in a 12-month period. Less risk provides greater protection.
For reference, the typical Individual Retirement Account (IRA) and the average TDF for those near retirement is 55% in stocks and 25% in long-term bonds, so 80% in risky assets. The Fidelity study reports the following history for this allocation. You could lose more than half your savings in a 12-month period.
In other words, there really is no risk management in IRAs and TDFs, but there should be.