What’s the Smartest Investment Mix for Retirees Right Now?

Navigating market volatility in retirement requires more than the traditional 60/40 portfolio. This episode explores three critical risks every retiree must address to maintain financial security through changing market conditions.

The first is sequence of return risk, which can devastate a portfolio if early withdrawals align with a downturn. Listen to James share his concept of "Root Reserves", setting aside five years of stable investments to provide protection during turbulent periods without selling at a loss.

The second is inflation risk. Even modest 3% inflation can nearly triple the cost of living over a typical retirement. This makes growth investments essential, even for conservative retirees, to preserve purchasing power across decades.

The third is behavioral risk. There is an emotional side of investing is often overlooked. Understanding personal comfort with volatility is just as important as the numbers. Different types of fixed income play different roles, from providing liquidity to acting as portfolio ballast during market stress.

By analyzing cash flow needs, time horizon, and risk tolerance, retirees can create a portfolio built to weather any financial storm.

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The strategies, case studies, and examples discussed may not be suitable for everyone. They are hypothetical and for illustrative and educational purposes only. They do not reflect actual client results and are not guarantees of future performance. All investments involve risk, including the potential loss of principal.

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Episode Transcript

Speaker 0 (00:00):
In just the past five years, we have had three US
market downturns of 20% or more,we've had the worst ever
five-year time period for USbonds and we've had plenty of
headlines that will cause eventhe most disciplined investors
to get a little shaky in theirthoughts about the future.
So what can you do as aninvestor to design the right
portfolio, heading into yourretirement?
To make sure that you're givingyourself the best possible

(00:21):
chance of success.
That's what we're going to talkabout today.
Sure that you're givingyourself the best possible
chance of success.
That's what we're going to talkabout today and when we talk
about that.
Really, this comes down tounderstanding what are the three
biggest risks that you facethat I face, that every single
investor faces, that we need toprotect against.
We don't want to start withjust a 60-40 portfolio.
Traditionally, that was thoughtof as the retirement portfolio
you're going to have, becausethat has the right mix of stocks
and bonds, but that's notunique to you.

(00:43):
What's unique to you isbuilding a portfolio that
protects against the threebiggest risks.
What are those risks?
Number one volatility.
How do you ensure that you areprotecting against sequence of
return risk?
We're going to talk about thatin just a second.
Number two is inflation risk.
How do we not make sure thatwe're so focused on the
volatility risk, on protectingagainst that, that we lose sight

(01:03):
of an even bigger risk, whichis the risk of inflation eroding
our purchasing power over thecourse of our retirement?
And then, finally, number threeis the emotional or behavioral
risk of how do you structure theright portfolio to minimize the
chance of us making a badmistake by making the wrong
decision at the wrong time.
So let's dig into that Numberone, that risk of volatility.
This is probably the thingthat's on most investors' mind.

(01:25):
What do I do if I retire?
In 2008 happens again?
What do I do if I retire andthe market drops 30, 40 plus
percent and it takes five yearsto recover?
This is often the biggest fearbehind something called sequence
of return risk.
Sequence of return risk says itdoesn't matter what your average
return is over the course ofyour retirement.
If you're 65 and you're livinguntil 90, I'm not so concerned

(01:45):
about the average return yourportfolio is going to achieve
over that time.
I'm more concerned about thesequence in which you receive
those returns.
If the first few years you getvery strong returns, that's
going to give you incredibletailwinds going into retirement.
You're probably going to have avery good outcome On the flip
side.
If the first few years ofreturns that you get are less
than ideal or maybe are evenquite poor, that's going to give

(02:07):
you an incredible headwind thatyou're facing going into
retirement.
So how do you protect againstthat?
Well, you protect against thatby realizing that if you look at
the stock market the S&P 500,so a collection of the 500 or so
biggest companies here in theUS historically it's returned
about 10% per year.
If you get 10% per year, if youhave a good enough size

(02:27):
portfolio, you're going to haveno issue, meaning most of your
needs for the most partthroughout retirement.
But what happens when you don'tget 10% every single year?
Because the S&P 500 has notgiven 10% even in one single
year?
It's typically giving you muchhigher returns or much lower
returns, and it's those lowerreturns than our working years.
Those don't matter so much.

(02:50):
We're putting money into our401k, we're maxing out our IRAs.
We actually get to takeadvantage of those lower year
annual returns.
But that's not the case whenwe're retired.
When we're retired and themarket drops and we're pulling
money out of our portfolio.
That's not a good equation.
If that happens, that has theserious potential to derail your
retirement.
That is why, although the stockmarket has great long-term
returns, we have to make sure wehave enough in something that's

(03:13):
stable, something that's goingto be there for you, regardless
of what the stock market's doing.
The way I like to think aboutthis is I like to have five
years of something much morestable, much more secure, much
more predictable set aside,something that's not invested in
the stock market.
Even the highest quality stocks, the most stable stocks, those
do and will continue to drop invalue quite substantially, even

(03:36):
in some years.
So I like to have five yearsset aside.
Internally at Root Financial, wecall these our root reserves.
What is our root reserve?
Well, it's making sure that ifthe market drops on average.
We have to understand that anaverage bear market in the US
lasts about two and a half years, but that's average.
What if it goes longer thanthat?
Well, what if we have fiveyears set aside, almost thinking

(03:57):
like the emergency fund foryour portfolio?
We have the stocks, we have thegrowth engine that's probably
going to continue to do quitewell over time, but it will go
through a serious downturn, andthat serious downturn could take
several months or several yearseven to fully recover.
So by having these rootreserves, by having these funds
set aside, what it's giving usis it's giving us the ability to
say, when stocks are down, wethink they're going to recover.

(04:20):
History has showed us thatevery single time, historically
speaking, a diversifiedportfolio has recovered.
But it might take some time.
So while that's happening, dowe have funds here?
These can be CDs, these can bebonds, this can be cash, this
can be anything that's notsubject to the serious downturns
that the stock market is.
If we look at that, I almostlike to think about even

(04:41):
laddering that.
Do we have enough money in yearone for year one expenses that
if the stock market drops?
This is super short term, superhigh quality, not going to get
a huge interest rate there, butthat's okay.
The role this is playing isn'tgrowth, it's protection.
It's the moat around the restof our portfolio, it's the
protection around the rest ofour portfolio, so something that

(05:03):
we can live on.
Then maybe you have your soyear one, you've spent it.
Stock market's still down,still not going to touch the
rest of my portfolio.
I needed my year two money.
This can be a slightly longerduration bonds or CDs or
whatever the case might be foryour specific portfolio, a
little bit more in interest, butby the time we need it, we have
that available to us.
And then same thing for yearthree, year four, year five.

(05:24):
So how much do you put there?
Well, this depends upon howmuch you need to pull from your
portfolio.
If you're a retiree, let'sassume that you have Social
Security.
That is $3,000 per month, andlet's assume you need another
$4,000 per month from yourportfolio.
To use round numbers, let'sassume you have $1 million in
your portfolio.
Well, $4,000 per month is$48,000 per year.

(05:45):
I'm simply going to round thatto 50 to do simple math.
$50,000 is how much you needset aside to cover one year of
living expenses.
Well, keep in mind, we want tocover five years of living
expenses.
We want to ensure that there'ssomething set aside to cover
five years of living expenses incase there's a serious market
downturn.
So what do we do with that?
We take $50,000 and multiply itby five.

(06:06):
$250,000 in this example couldbe thought of as being set aside
to give you that reserve, togive you that stability, to say
that, even if the market dropsand takes five years to recover,
we don't have to spend down ourstock portfolio in that
instance.
We can simply draw money fromthis part of our portfolio.
That's how I like to think aboutprotecting against volatility.

(06:26):
That's how I like to thinkabout protecting against
sequence of return risk.
Sequence of return risk isreally saying that if things are
going down quite a bit, how dowe prevent ourselves from having
to sell those investments?
That's the worst case scenario.
You do that by having the rightamount of funds set aside that
are more stable, more secure,less in long-term growth

(06:46):
potential, but that's okay.
That's not the role that thosefunds are playing in our
portfolio.
So that's step one is how doyou protect against sequence of
return risk?
Define the amount that you need.
We call this root reserves.
You can call it whatever youwant, but it's that amount
that's stable and is gonna giveyou that runway that's needed
when the stock market dropsquite substantially.
Number two the second risk thatyou need to be incredibly

(07:09):
mindful of is inflation risk,purchasing power risk.
People can become so focused onhow do I protect against the
next downturn?
They put too much money intothose types of investments I
described for step one.
They put too much of theirmoney in conservative
investments.
It feels really good.
It feels really good in theshort term because you're not
seeing your portfolio balance godown in value.
In fact, if the stock market'sgoing down quite a bit, there's

(07:31):
a good chance your portfolioactually goes up in value.
So it feels really good in theshort term.
But what's going to happen oneday is you're going to go to the
grocery store and realizethings are costing a whole lot
more than they used to.
You're going to go buy some newclothes and realize these cost
a lot more than they used to.
You're going to put gas in yourcar or you're going to get
electricity for your house andrealize this costs a lot more

(07:52):
than it used to.
That's the concept of inflation.
In fact, if inflation increasesby just 3%, then over the
course of the average person'sretirement the overall cost of
your living is going to go upabout 250%.
If your money is tooconservative, it is too stable.
If it's not getting the growththat it needs, you'll be safe in
the short term against sequenceof return risk, against

(08:14):
volatility.
You're incredibly exposed.
Long term, the exposure thereis the erosion of your
purchasing power.
You will still have the nominalvalue of your portfolio, but if
that portfolio is not growingto keep up with inflation, it
could be disastrous for yourlong term goals.
So that is why, even inretirement, you do need to have
a good allocation to types ofinvestments that are going to

(08:34):
grow with you so that can keepup with inflation, so that your
purchasing power can continuethroughout retirement.
So that's how you think throughstep number two Step number one
is protect against sequence ofreturn risk.
Step number two is protectagainst purchasing power risk.
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(08:55):
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happens.
Step number three the thirdrisk here that hasn't yet been
addressed is more of thatemotional, that behavioral risk.
Let me go back to the example Igave in step number one.
I said what if you have $3,000per month coming in from social
security?
You want to spend $7,000 permonth.
So you pull $4,000 per monthfrom your portfolio.

(09:17):
Assuming a $1 million portfolio, you're taking out about 5% per
year or so from your portfolio.
That 5% is about $50,000 peryear.
Well, let's change some ofthose details.
What if you're not spending$7,000 per month?
What if you're only spending$4,000 per month?
That means you only need $1,000per month or $12,000 per year

(09:37):
from your portfolio.
If I apply the same logic asbefore, take $12,000, I multiply
it by 5, that gives me $60,000.
If you have a million-dollarportfolio and $60,000 needs to
be in bonds, that tells me that94% stocks and 6% bonds could be
an ideal allocation for you inthat scenario.
Now here's the thing From arisk capacity standpoint meaning

(10:01):
how much risk can you afford totake without being overly
sensitive to sequence of returnrisk?
That checks that box.
From a purely financialstandpoint, that could
potentially be the rightportfolio.
We're not purely financialpeople.
We're emotional people, we havefears, we have sensitivities.
We have these things that wedon't need to try to pretend
they don't exist.
That's the reality of who weare and you have to understand
that.
If you, as an investor, areretired with a 96% stock

(10:24):
portfolio, some of you listen.
This would say James, that'stotally fine by me.
I do not like bonds.
I don't want this anywhere nearmy portfolio.
Great, if you have theappropriate mix and stable
investments to ensure that youcan do that, more power to you.
But if you are listening andsaying, I've been through market
downturns, I don't ever want togo through that again, let
alone go through that againwhere I'm not actually putting
money into my 401k, I'm actuallypulling money out of it.

(10:47):
That is a very fair, a veryreal thing and you need to
protect against that risk too.
This is similar to step numberone, where you do have enough
money in stable investments.
Again, we call that the rootreserves very intentionally
defined maturities and qualitiesof the bonds or the fixed
income that we're using there.
This is a little different.
And step three it's what's theappropriate additional amount to

(11:10):
add?
More so to control for theemotional aspect of it, more so
to control for the overallaspect of it, more so to control
for the overall volatility andthe feeling that that's going to
bring when the markets are down, meaning even if you don't need
that money in bonds for theprotection they provide.
It can provide that emotionalprotection.
It can provide that behavioralprotection.
Now, if you're going to do that,it's not necessarily.

(11:30):
It could be, but not alwaysgoing to be, the same exact
types of fixed income that youuse for step one.
Step one I like to think aboutusing fixed income that is very
short-term and then increasingin duration, increasing in
maturity, almost like a bondladder or a CD ladder, to
provide that protection For thisthird step, for more of this
emotional or behavioral aspect,you might wanna think about what

(11:52):
types of investments aren'tthere for a defined maturity or
defined aspect.
You might want to think aboutwhat types of investments aren't
there for a defined maturity ordefined duration, but they're
more going to be negativelycorrelated to the rest of my
portfolio.
Ideally, if this over here zigs, this is going to zag.
Think of it as more like aballast for your portfolio
that's smoothing out the returns.
Same concept of step number one, but different in terms of its

(12:12):
application.
But as we start to wrap this upthere, this is how I recommend
you think through what should bethe allocation to stocks and
bonds, specifically in yourretirement years.
Throw out this notion of a 60-40portfolio is right for everyone
.
There is no single portfoliothat's right for everyone.
Start by understanding yourcash flow needs from your
portfolio and have enough inshort-term fixed income to be

(12:34):
able to protect against that.
Make sure you understand whatyour purchasing power risk is.
That's the risk of inflation.
Do you have enough growthassets to protect against that
over time?
And then finally, number three,understand your own risk
tolerance.
Understand your own comfortlevel with investing.
Do you need to make someadditional adjustments to your
portfolio, not for purefinancial reasons, but to make

(12:54):
sure the experience it's goingto give you is going to be
something you're comfortablewith.
That's it for today, if thishas been helpful.
Once again, please make surethat you subscribe to this
episode.
If you need help defining orcreating your own portfolio for
your retirement needs, reach outto us.
This is what we do all day,every day at Root Financial.
We are financial advisors.

(13:19):
Portfolio construction is noteverything, but it is certainly
an important component of yourlong-term financial strategy.

(13:41):
Thank you.