Understand the hidden risks in your portfolio

When asked to identify what forces pose risks on investment returns, few investors recognize inflation as a likely counterpart. Yet for traditionally risk-averse retirees, increasing consumer prices often pose the greatest risk of all. Older investors have historically favored lower-yielding investments such as CD’s, money market accounts and T-bills which have a far lesser chance of maintaining purchasing power. Inflation is expected to inch upward as the economy gains its footing, therefore investment portfolios must be tailored accordingly.

Be willing to diversify

Investors must be “willing” to diversify. Diversification is necessary due to current high stock market valuations and a 40 year low point in the interest rate cycle. It is important to look beyond traditional stock and bond allocations to find steady, less risky returns. True diversification is the process of spreading investment funds across asset classes that tend not to move in tandem. While large and small U.S. stocks move in nearly identical patterns, asset classes such as REITs (real estate securities), commodities and hedge-like investments exhibit a non-similar return pattern to the S&P 500. The combination of these investments in conjunction with bonds and large U.S. stocks helps protect the overall portfolio in troubling market conditions, yet participate in market gains. Portfolios built on this premise are likely to earn returns typically associated with stocks, while exhibiting far less risk in fact almost bond-like risk levels.

Understand the relationship between bonds and interest rates

There is no doubt that fixed income investments play a critical role in the formation of a retiree’s portfolio. However, the pricing of nearly any fixed income instrument is directly related to movements in interest rates. Prices of bonds go down as interest rates rise. Unfortunately for those currently nearing retirement, this can have a dramatic effect. With rates at near forty-year lows, it may only be a matter of time before bond prices begin to crumble as interest rates rise. It is important to note, however, that not all fixed income investments have the same sensitivity to interest rate fluctuations. Some fixed income vehicles such as bank loan funds, stable value funds, and Treasury Inflation-Protected Securities (TIPS) adjust their values in the same direction as interest rates. Investors facing retirement should examine the fixed income investments in their portfolio to determine how sensitive they may be to shifts in interest rates.

Make tax-efficiency a priority

Even in retirement, the lack of tax efficiency remains one of the biggest detriments to overall portfolio performance. The following are a few tips to increase efficiency:

• Keep detailed records of cost basis – this enables investors to identify specific share lots for the tax-efficient selling of gains, and the timely harvesting of losses
• Do not reinvest dividends – this allows for an easier and more tax-efficient portfolio rebalancing as well as provides cash to live on, and spares investors from a tax-basis paperwork nightmare
• Be aware of asset location – fixed income investment, hedge-like investments and REITs, where possible, should go in tax-advantaged accounts because the majority of their return is made up of ordinary income, while equities are prime candidates for taxable accounts

Building a portfolio that takes into account both hidden and obvious risks, diversifying to minimize those risks, and avoiding unnecessary income taxes will provide a safe and secure retirement.

For further information, contact Diane M. Pearson, CFP™ at (412) 635-9210 or e-mail her at legend@legend-financial.com.