Retirement Made Easy: Risk Management Strategies
It's almost impossible to entirely remove risk from investing. However, there are ways you can reduce your risk profile while also earning solid returns.
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Gone are the days when a good retirement strategy involved nothing more than a simple savings account. If you are to have enough money to retire comfortably, and experts say that you will need 70–80% of your pre-retirement earnings each year to do so, then you need to start early, save as much as you can, and take a little risk.
For military members, this planning takes on an added dimension. A military pension and TSP provide a strong foundation, but they alone may not be enough to fully fund a comfortable retirement, especially for those who separate before reaching 20 years of service or those who want to maintain their current standard of living well into their later years.
Investing your hard-earned money may feel terrifying. There is always the chance that the market could perform poorly, and you could lose money. On the upside, though, the opposite is also true. To reduce the risk that you assume when you invest for retirement, there are a few strategies that can help.
What Is Diversification and Why Does It Matter?
When it comes to setting yourself up for success in retirement, diversification is important. Diversification can be used to reduce both inflation risk, the risk that inflation could outpace the rate of return on your investments, and business risk, the risk that a company will not earn profits or fail entirely.
Diversification involves investing money in several different investments as opposed to a single investment. For example, investing in stocks X, Y, and Z instead of only stock X.
The idea is that if some investments do not perform well, they will be offset by other investments that do. Buying into mutual funds or index funds composed of a broad portfolio of companies from different economic sectors is one way to diversify your retirement investments. For military members, the TSP’s C, S, and I funds already provide built-in diversification across large cap, small cap, and international stocks, a good starting point for any diversified portfolio.
How Asset Allocation Reduces Retirement Risk
Asset allocation helps mitigate multiple types of risk by diversifying a portfolio among several different asset classes, meaning various types of investments, like stocks, bonds, CDs, annuities, real estate, and more.
Different asset classes inherently have differing levels of risk. Stocks are subject to the market and therefore are considered particularly risky. CDs are considered safer investments, but they are susceptible to inflation risk.
One common asset allocation strategy is to invest more in safer investments such as bonds and annuities the closer you get to retirement. This approach decreases your exposure to stocks and other risky investment types to help protect your nest egg. For military retirees who already receive a guaranteed monthly pension, this steady income stream can allow for a slightly more aggressive asset allocation in other accounts since some baseline income is already secured.
How Dollar-Cost Averaging Works
Dollar-cost averaging is a technique used to reduce market risk, but as with all risk management techniques, it does not guarantee that you will see a return on investments or that you will be protected from loss in declining markets.
It involves contributing a set amount every month, or at whatever frequency you decide, to a stock or mutual fund instead of saving a lump sum outside of the market and then making your purchases all at one time.
This strategy will result in the purchase of more shares of the investment when the price is lower and fewer shares when the price is higher, and may result in an average cost per share that is lower than the average price over the same amount of time. Dollar-cost averaging works to reduce the impact of a volatile market by spreading out your purchases at different price points. Military members who contribute a set percentage of their pay to their TSP each month are already practicing dollar-cost averaging without even realizing it.
What Is Modern Portfolio Theory?
Many investment strategies are based on Modern Portfolio Theory, which is a term used to describe a body of knowledge developed in the 1950s that is used by companies that manage funds to create optimal investment portfolios that reduce risk while enhancing returns.
Essentially, a computer program runs the numbers and alerts investment managers as to whether returns are appropriate for a given amount of risk exposure. This helps them construct a portfolio that will maximize your returns given a certain level of risk, or minimizes risk for an expected level of returns.
Managing Investment Risk for Military Retirement
However you decide to save for retirement, it’s important to note that you cannot avoid risk completely. What strategy or strategies you should use depends on your overall asset level, age and time horizons, and risk tolerance.
For military members, the combination of a guaranteed pension, TSP, Social Security, and potentially an annuity already provides more retirement income security than most civilians enjoy. Building on that foundation with sound investment strategies can help ensure that your retirement is everything you worked for.
The ideal time to plan for retirement was yesterday, but the next best time is now.
