A good investment decision generates more return than risk. When choosing between two investments with a 20-year annualized average return of 7%, risk-averse investors should choose the one with the smaller standard deviation or the degree to which that investment has historically moved about its average.
While high risk might result in potentially significant profits, taking excessive risks can be damaging.
Particularly for retirees who make frequent, ongoing withdrawals from their assets to supplement their income. The worst-case situation to avoid in this circumstance is running out of money too soon. Thus, portfolio volatility should be kept to a minimum to reduce the severity of collapses, and this must be weighed against the requirement that long-term returns outperform inflation.
Here are seven investing options for retirees with a favorable risk-return profile, particularly when combined as part of a diversified investment portfolio:
60/40 Portfolio
Bond Ladders
Certificates of Deposit (CDs)
Options Collar
Low-volatility Stocks
Series I Savings Bonds
Preferred Stock
60/40 Portfolio
The 60/40 portfolio of equities and bonds is an excellent hands-off option for retirees. Historically, this meant investing in US equities, Treasury bills, and investment-grade corporate bonds.
During bull markets, stocks deliver substantial profits, while bonds minimize volatility and provide safety during market falls. Rebalancing regularly also allows investors to purchase the underperforming asset at its lows and sell the overperforming asset at its highs.
Historically, the 60/40 portfolio has provided an excellent balance of risk and return. For example, from its inception in 2000, the Vanguard Balanced Index Fund Admiral Shares (ticker: VBIAX) has returned 6.33% annually. Inflation combined with rising interest rates is the Achilles’ heel of this approach, which results in the simultaneous collapse of equities and bonds. A combination of these variables resulted in the 60/40 portfolio posting its poorest returns in over 20 years in 2022.
Bond Ladders
Retirees frequently invest heavily in Treasury bonds and investment-grade corporate bonds.
While bonds are less risky than equities, they are highly vulnerable to interest rate risk. Bond yields grow when interest rates rise, causing bond prices to decline. This is particularly true for longer-term bonds.
Bond laddering is a strategy for protecting your PortfolioPortfolio from interest rate risk. This entails purchasing various bonds with varying maturities. Upon maturation, bonds can be redeemed for their face value, eliminating the need to sell them at a loss if interest rates rise. A bond ladder offers more predictable cash flows, which is critical for retirees making planned income withdrawals.
Certificates of Deposits (CDs)
A CD is a savings instrument offered by financial institutions that guarantees the principle and a fixed yearly interest rate for the investment term.
When you invest in a CD, you can choose a lock-up rate, the length of time you cannot redeem your investment. The CD will pay you an annual interest rate throughout this time, and you will receive your initial investment returned at maturity.
CDs are offering competitive returns over regular savings or money market accounts in 2022, thanks to growing interest rates, with some surpassing 2.7%. CDs are as safe as it gets, with the Federal Deposit Insurance Corporation insuring your money. Retirees can create a ladder of CDs with varying maturities to maintain a consistent supply of cash distributions.
Options Collar
Options Collar Derivatives-based methods are best suited for retirees with a substantial net worth, extensive financial understanding, or the assistance of a financial advisor who is knowledgeable about these products. Their primary purpose is to hedge risk, which may be utilized in various ways to limit losses.
Consider them portfolio insurance for which you pay a fee. The options collar is a common technique that includes selling covered calls in increments of 100 shares of a firm or index exchange-traded fund, or ETF while purchasing protective puts. The premium gained from selling the covered call is a credit that may be used to offset the premium subtracted by buying the put.
This technique limits your losses and profits, which can help minimize volatility in sideways or negative markets. The Nationwide Nasdaq-100 Risk-Managed Income ETF is an ETF that implements this approach for you (NUSI).
Low Volatility Stocks
According to the capital asset pricing model, a stock’s predicted future return is determined by its systematic risk exposure, often known as market risk. In a nutshell, higher risk equals higher reward, and this is why, in general, investment in stocks yields a higher long-term return than investing in bonds.
However, there is one major exception: low-volatility stocks. These equities have a smaller standard deviation and beta, or susceptibility to market swings than the S&P 500, for example.
Low-volatility stocks have historically outperformed the market, particularly large-cap businesses with strong fundamentals. As a result, retirees can reduce the risk of their stock allocation by focusing on blue-chip, dividend-paying, low-volatility firms without significantly lowering their projected returns.
Savings Bonds, Series I
I bonds are inflation-indexed US government debt instruments. I bonds, like other bonds, provide semiannual interest payments to the holder. On the other hand, their yield is composed of two parts: a fixed interest rate until maturity and a variable inflation-adjusted rate based on changes in the consumer price index.
The latter is determined twice a year, in May and November. It is now 9.62% due to rising inflation. I bonds are one of the few completely low-risk assets that ensure principal safety and inflation protection.
However, when purchasing electronic I bonds, investors are limited to yearly purchases of up to $10,000, with an extra $5,000 if utilizing a tax refund. I bonds take 20 to 30 years to mature, although investors can redeem them without penalty after five years. Between one and five years, investors lose three months of interest payments.
Preferred Stock
Preferred stock is a type of asset that combines equity and fixed-income features. Preferred stocks, as opposed to common equity, get first access to a company’s assets in the case of bankruptcy or liquidation.
They do not, however, have voting privileges. However, preferred stock frequently provides a bigger and more stable fixed dividend. This can occasionally be accompanied by stipulations that require the corporation to accumulate dividend payments in arrears if they are not made on time.
Because cash flows are predictable, preferred stock has a risk-return profile comparable to bonds. Generally, preferred stock has lower market risk than regular stock but higher interest rate risk, similar to bonds. Investors can purchase preferred stock directly or invest in a portfolio through ETFs such as the iShares Preferred & Income Securities ETF (PFF).