It might be time to abandon the idea of a balanced portfolio.
Traditional wisdom holds that investors should diversify their assets. While working and saving, you should invest in a mix of assets weighted toward stocks and growth. In your retired life, you should invest in a mix of assets weighted toward security and income. In both cases, though, you should hold a healthy balance, with some secure assets during your working life and some growth assets while in retirement.
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BlackRock recently suggested that investors should throw the common wisdom out the window in favor of a black-and-white approach to retirement.
In your working years, the investment company argues, you should invest entirely for growth. Over 20 years of savings, an investor who holds a single S&P 500 fund will have more money than someone with balanced assets, even after accounting for recessions and volatility.
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Then in your retired years, BlackRock argues, you should shift that portfolio entirely toward income. Over 20 years of drawdowns, a retiree who holds a mix of bonds and dividend stocks will have more money than someone with balanced assets, even after accounting for stock market growth.
The reason for this recommendation has to do with sequence risk and how it does (and doesn’t) affect your portfolio.
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What Is Sequence Risk?
Sequence risk is the inherent risk of timing investments, particularly withdrawals, poorly. Essentially, this is the risk that you will be forced to sell assets during a downturn. With the effects of compounding, even a small downturn can have a massive impact on the overall longevity of your funds.
For example, say that you have 100 shares of stock trading at $25 per share. This will give you $2,500 in overall portfolio value. Now, say the shares dip to $15 per share at the same time that you have to sell half the portfolio. You receive $750 (50 shares x $15 per share), taking an immediate loss relative to what those shares were worth.
Now, say the stock climbs the following month to $35 per share. Your portfolio is worth $1,750 (the 50 remaining shares x $35 per share), but it could have been worth $3,500 (the 100 shares you once had x $35 per share). You have both lost money on the stocks you sold and lost potential growth on the portfolio overall. Basically, this is sequence risk.
In general, sequence of returns risk only applies to assets that you sell. When you can hold assets, short-term volatility poses little risk to your portfolio’s long-term value. For this reason, income investing is generally seen as one of the best hedges against sequence risk.
A financial advisor can help you understand various risks to reaching your goals.
What Is Income Investing?
Income investing is the practice of building a portfolio that generates cash without selling assets or otherwise drawing down on the underlying principal. Bonds are a common example of income investing. When you hold a portfolio of bonds, you will receive regular payments based on those bonds’ interest rates. This happens without selling the underlying bonds, so the portfolio is largely insulated from market volatility.
For retirees, the benefit of income investment is security. In theory, a fully income-oriented retirement fund can last indefinitely. Assets that generate payments without drawing down on principal theoretically don’t run out, significantly mitigating the risk of outliving your retirement savings. While the reality is more complicated – bonds, for example, mature and must be repurchased – income investments overall are much less exposed to market volatility.
That includes protection from sequence risk. Since you don’t have to sell assets to collect their yield, a downturn won’t affect your withdrawals. You collect money from your portfolio while leaving your assets in place.
The downside is that secure, income-generating assets don’t tend to pay very much. This is why financial advisors tend to recommend against income investment during your working life. For most people, assets like bonds, annuities and other secure, income-oriented investments don’t to grow wealth fast enough to secure a comfortable retirement. This is where BlackRock’s advice comes in.
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BlackRock’s Accumulation/Decumulation Strategy
In their article, BlackRock recommends that investors think about their retirement portfolio in two stages: accumulation and decumulation. Accumulation is the period in which you add money to the portfolio, your working life, while decumulation is the period in which you take money from it, your retirement. Each phase handles sequence risk differently.
During your working life, your retirement portfolio has little sequence risk exposure. You aren’t making withdrawals, so there’s little chance of being forced to sell assets at a loss. Almost by definition, you can wait out any downturns or recessions. This allows investors to focus on higher-growth strategies despite the volatility of that approach.
In fact, BlackRock argues that an investor who put all of their money into the S&P 500 between 2000 and 2023 would have more money than one that hedged their bets with a traditional 60% stocks/40% bonds portfolio. This is true even after accounting for recessions and downturns, because the portfolio rebuilt its value during each recovery.
On the other hand, retirees have quite high exposure to sequence risk. Where a worker can wait out a bad market, retirees cannot. They need to make withdrawals for basic income regardless of market conditions. BlackRock argues that this means retirees should focus on income assets, which can generate withdrawals without needing to sell assets.
In their model, a hypothetical retiree who shifted entirely into bonds and dividend stocks between 2000 and 2023 would have more money than one who hedged their bets with a mix of growth-oriented investments. This is true even after accounting for the periods of growth during those years, because the long-term losses of taking a withdrawal during recessions outweighed the growth of each recovery.
This is the origin of their advice. Investors should, they suggest, consider a black-and-white approach to their retirement portfolio. In your working life, invest for growth. Leverage time as your security, knowing that recessions are short and your working life is long. In your retired life, invest for income. Mitigate sequence risk with a portfolio that doesn’t to sell assets when you make withdrawals.
Determine the proper income level needed for your retirement with a financial advisor.
Mitigating Sequence Risk Can Create Other Issues
A black-and-white approach can allow investors a best of both worlds approach to savings, growing their portfolio during earning years and maintaining once they retire. However, other financial professionals suggest that there’s more to consider than just safety and growth.
“An income-based portfolio appeals to the psychological side of investing where spending income doesn’t feel as bad as spending principal,” says Hao Dang, an Investment Strategist with Consilio Wealth Advisors. “[But] focusing a portfolio on income comes with several risks that could be harder for investors to account for… Higher yielding investments typically come with exposures to leverage, derivatives, or lower grade credit. All these components take time to unwind in the event of a sale and will typically carry higher management costs.”
These risks, as Brandon Renfro, a CFP in Longview, Texas, who specializes in tax-efficient retirement planning, include volatility. In order to maintain a strong enough cash flow, most income-oriented portfolios rely at least in part on dividend stocks. But dividends are unreliable.
In addition, says Renfro, it’s important to remember the tax implications of switching to income-oriented assets.
“Portfolios focused on generating the most income are often concentrated on high dividend stocks and fixed income investments,” he says. “These are inefficient from a tax perspective because they are taxed at income tax rates (except for qualified dividends) rather than more favorable capital gains rates. Systematic withdrawals from a diversified portfolio can be more tax-efficient in part because you may be able to take more advantage of favorable long-term capital gain tax rates.”
In other words, a black-and-white approach to investing can have value as one perspective, and one part of your overall financial plan. But remember that there are many different risks and issues out there, and a good financial plan will anticipate all of them.
Talk to a financial advisor to make a plan today.
In a recent report, BlackRock investing suggests a new way of approaching your retirement. During your working years, focus on growth assets and count on time to smooth out market volatility. During your working years, focus on income assets and mitigate market volatility by not having to sell your investments at all.
Income Investing Tips
- Many investors consider income investing to be the holy grail of retirement portfolios. If you can get enough money in your portfolio, then shift it to something like bonds, dividend stocks or annuities, you can simple eliminate the issue of longevity altogether. It’s a good idea, but it will take a lot of planning and saving to execute.
- A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.