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By Rich Weiss - October 18, 2017
Risk in investing is often simply thought of as volatility of returns. But in a retirement context, the concept must be so broad as to encompass an entire range of risks, up to and including the risk of running out of money in retirement. Briefly, we want to share with investors our framework for thinking about these competing risks, and explain how we see the balance of risks in the current market environment.
In managing retirement portfolios for our clients, we seek to plot a course that balances the many risks inherent in retirement investing. First among these is longevity risk, or the risk of not being able to fully fund retirement. The primacy of longevity risk provides the rationale for having high degrees of equity, and other risky asset, exposure early in one's working life.
But the necessity of having a sizable allocation to stocks must be balanced against other risks, such as market risk and tail event risk,1 which can have adverse effects on account balances in the event of market declines. It is the downside potential of equities as retirement nears, account balances grow larger, and risk tolerance is low, that explain why you want less equity exposure in your portfolio at age 65 than at age 25 or 35, for example—the balance of risks has changed, and your allocations should, too.
The crucial point that we want investors to take away is that risk is not uniform across your investing lifetime; rather, it is varied, asymmetric, and highly specific depending on your age, time to retirement, anticipated financial need, account balance, etc. In short, where you are on your own roadmap to retirement dictates the risk landscape around you. Our approach seeks to carefully manage these competing risks and maximize return for the risks we take at each point along the road to retirement.
Next, consider your unique balance of risks in the context of the financial markets at present. There are no shortage of articles and analyses arguing that stocks are expensive by many historical measures. We are inclined to agree with this analysis up to a point. Our own view is that equity valuations in the U.S. are slightly unattractive—yes, stock prices are at all-time highs, but we continue to see earnings growth in a number of sectors and industries to support prices.
Additionally, we find that the economic cycle is fully mature, with the economy well into one of the longest-running expansions in U.S. history. What's more, labor markets are tight, and the Federal Reserve is raising interest rates and gradually unwinding its massive bond-buying program. Finally, market volatility is at abnormally, historically low levels. While valuations can remain elevated and volatility low for extended periods, when you consider these factors in their totality, we have a somewhat less sanguine outlook for stocks.
As a result, we are reducing risk in our own portfolios where it makes sense to do so. Again, wealth effects are radically different at different points along the path to retirement, so we are subtracting risk exposures for investors in and near retirement where account balances are larger. But for young investors with many years to retirement and comparatively small balances, we believe it makes sense to maintain their large representation in stocks. We believe this asymmetric approach to risk management better reflects the actual distribution of risks along the path to retirement, with longevity risk predominant in youth and market risk much more important later in life.
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1 The risk of some rare, very unusual, but nonetheless expected event.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.