By: Lee Michael Murphy
Getting closer to retirement, many are afraid that the coming recession will ruin their retirement dreams. People start questioning whether they will have enough to survive in retirement. Starting retirement planning, the importance of asset allocation and diversification become essential to a successful retirement.
Recently, we’ve seen a large increase in the volatility of the market. We’ve seen the negative effects of higher interest rates in sensitive sectors such as housing and autos. As a result, my pre-retirement clients have become increasingly concerned about whether they can retire at this time given this recent volatility. The key to retirement planning is asset allocation—the percentage of holdings in cash, stocks, and bonds.
Cash:
Many people entering retirement prefer to play it safe by holding much of their assets in cash. Holding a large portion of assets in cash may increase confidence, but it fails to consider the impact of inflation—the general increase in prices and the falling purchase power of money—and, ultimately, it is one of the most detrimental decisions that you can make. For example, the median home price in 1950 was $8,450. Today, the median home price is $200,000. Inflation is one of the primary reasons to invest your money for retirement, rather than keep a large portion in cash, because over time the purchase power of the dollar becomes less and less.
Holding a portion of your money in cash can be very helpful during a Bear Market—a market in which prices are falling, encouraging selling. Having cash, we don’t need to take withdrawals from our portfolio, and it may present opportunities to buy assets while they are at a reduced rate. Cash is an important part of asset allocation, but computing exactly how much cash is needed for retirement is one of the major components of managing retirement.
Bonds:
Many people have asked me, “Well I’m heavily invested bonds so I’m safe, right?” In the past decade, with historically low interest rates, investment in bonds was quite advantageous. Now, however, with the economy continuing to strengthen and with low unemployment, the Federal Reserve is likely to raise interest rates even further, which would drive down bond prices. Over time, bonds are a sufficient asset to combat inflation. However, during a recession, and when interest rates are rising, they can lose substantial value. Bonds can be an important component of your portfolio, but it’s important to understand how bonds respond in different economic environments to determine which bonds you should invest in for a given economic landscape.
Stocks:
Stocks are probably the most intimidating asset in the mind of most investors, but they are also one of the most effective counters to inflation and the most likely to increase in value. While it’s important to invest in index funds that mimic the S&P 500, focusing solely on the S&P 500 is a mistake. There are many more opportunities to create a diversified portfolio such as investing in international, emerging markets, real estate, small caps, mid-caps, and European stocks. When choosing which stocks to invest in, it’s important to consider a company’s size, the price of the stock, and the profitability of that stock. A carefully chosen portfolio should include both stocks and bonds that match the current economic environment to increase performance and reduce volatility.
Recessions are a volatile downturn in the market, but they are also part of a normal and healthy economy, and those who have planned ahead and taken advantage of the opportunities that a recession presents, will not only survive, they will come out stronger.