Building a Retirement Investment Portfolio: Aligning Goals, Tolerance, and Capacity

As you approach retirement, constructing a well-balanced investment portfolio is one of the most important financial tasks you’ll undertake. The decisions you make now will determine your ability to generate income, preserve your wealth, and manage market fluctuations throughout retirement. Failing to create a properly diversified and strategic portfolio can lead to significant risks—such as insufficient income, outliving your savings, or taking on excessive risk, leaving you exposed to market downturns.

A successful portfolio aligns with your income and growth goals while accounting for your risk tolerance and capacity, helping it withstand market volatility. Properly incorporating strategic asset allocation helps establish a long-term plan, while tactical asset allocation allows for adjustments based on short-term economic conditions. Failing to balance these elements effectively can expose you to unnecessary risks—such as insufficient income, outliving your savings, or being too vulnerable to market downturns—jeopardizing your financial future in retirement.

Understanding Risk Tolerance and Risk Capacity

Risk tolerance refers to your willingness to endure market volatility and losses. If you're comfortable watching your portfolio dip during periods of uncertainty and remain committed to your strategy, you likely have a high-risk tolerance. Investors with high risk tolerance tend to:

• Feel at ease with temporary losses or downturns in the market.

  
  

• Pursue aggressive financial goals, aiming for higher returns despite the associated risks.

  
  

• Possess extensive experience in investing, which can help them weather market storms with confidence.

On the other hand, risk capacity reflects your financial ability to withstand losses without jeopardizing your long-term goals. Even if you're comfortable with volatility, your financial situation may not allow for it. A high-risk capacity is indicated by:

• Stable income from sources outside your investments, such as a pension or rental income.

  
  

• Owning significantly more assets than required to support your retirement lifestyle.

  
  

• Low levels of debt and liabilities, giving you more flexibility to handle market fluctuations.

Strategic Allocation: The Foundation of Your Portfolio

Your portfolio's strategic allocation is the long-term blueprint for how your money should be invested, based on your financial goals, risk tolerance, and risk capacity. The asset classes within your portfolio—stocks, bonds, cash, and alternatives—are chosen to diversify your investments and manage risk over time.

By spreading your investments across these asset classes, you reduce your exposure to any single asset’s poor performance. While stocks are growth-focused and generally provide a potential for higher returns, bonds and cash generally offer more stability and the potential for income. The key benefit of this diversification is that different assets tend to perform differently under various economic conditions:

• Stocks typically do well when the economy is growing.

  
  

• Bonds tend to hold value when stocks suffer, especially in times of economic uncertainty.

  
  

• Cash becomes more attractive when interest rates rise, as it offers liquidity without exposing you to market volatility.

*The charts above illustrate the market activity of the S&P 500 Index (broad market) compared to the Bloomberg US Aggregate Bond Index for the timeframes indicated. Past performance is not a guarantee of future results. It is not possible to invest directly in an index.

However, diversification doesn’t provide protection in every market environment. For example, in 2022, the traditional 60/40 portfolio (60% stocks, 40% bonds) experienced difficulties due to rising interest rates, persistent inflation, and fears of an economic slowdown. In this case, both stocks and bonds struggled, leaving diversified investors exposed to losses across multiple fronts.

Tactical Allocation: Adjusting for Market Conditions

While strategic allocation focuses on the long term, tactical allocation allows for adjustments based on short-term risks and economic signals. Tactical allocation involves shifting your portfolio's exposure to asset classes depending on expected market movements. For instance, if indicators suggest a potential recession, you might reduce your exposure to equities (stocks) and increase your holdings in bonds or cash.

Key economic indicators that can signal when it may be time to consider tactical shifts include:

• The yield curve: An inverted yield curve often signals a recession.

  
  

• Yield spreads: Increasing spreads between high yield and investment grade bonds may indicate increased economic risk.

  
  

• Unemployment rates and jobless claims: Rising unemployment could suggest a slowing economy.

  
  

• Housing stats and consumer confidence: Slowing housing markets and declining consumer confidence often predict reduced economic activity.

However, tactical allocation requires caution. Inexperienced investors often fall into the trap of overreacting to short-term market conditions, either becoming overly conservative after a downturn or excessively aggressive during a market rally. These emotional decisions can hurt performance.

A well-known example of this occurred between 2000 and 2009 with the CGM Focus Fund [1], one of the top-performing U.S. stock mutual funds during that period, boasting an 18% annualized return. However, the average investor in the fund lost 11% per year due to poor timing—buying high and selling low, reacting emotionally rather than strategically.

Tactical Allocation Isn’t for Everyone

If you're considering implementing a tactical allocation strategy, keep these key rules in mind:

1. Experience is essential: Tactical allocation should be undertaken only by experienced, knowledgeable investors who understand economic trends and market signals.

2. Stay close to your strategic allocation: Tactical moves should not deviate significantly from your long-term strategy. A good rule of thumb is to limit adjustments to within 5% of your original allocation.

3. Benchmark your performance: Comparing the performance of your tactical adjustments to your strategic allocation can help you stay aligned with your long-term plan.

Remember, investing is not a game of trusting your gut—it requires data-driven decision-making and analysis. Tactical allocation can help reduce risk or capture short-term opportunities, but it must be done with discipline and knowledge.

Final Thoughts: Don’t Go It Alone

For most retirees or soon-to-be retirees, a solid approach is to stick to your strategic allocation, adjust only when necessary, and maintain a well-diversified portfolio across asset classes. While tactical allocation can enhance returns or reduce risk, it should be left to seasoned professionals who can make informed decisions based on market data and analysis. It’s important to work with an asset manager who has the expertise and resources to implement tactical shifts appropriately, without jeopardizing your retirement security.

A thoughtful, well-diversified investment strategy that takes into account both your risk tolerance and risk capacity will strengthen your portfolio for meeting your long-term retirement goals. By combining these concepts with a disciplined approach to tactical allocation, you can create a portfolio that adapts to both long-term trends and short-term market shifts, giving you peace of mind in retirement.

The concepts expressed herein represent the views and opinions of Pension Consultants, Inc., and are not intended as legal, tax, or investment advice for any specific individual, account, or plan.

Source:

[1] Wall Street Journal, “Best Stock Fund of the Decade: CGM Focus,” 2009. https://www.wsj.com/articles/SB10001424052748704876804574628561609012716