There is a famous picture from 1932 of steelworkers eating lunch atop a skyscraper. I’m sure you’ve seen it in a history book at one point in your life. It shows eleven men perched on an iron beam, eating and enjoying each other’s company, all while the view of the city below stresses their precarious position. There are no visible restraints or safeguards. One false step would lead to certain death.
Now despite all common sense and what we know today, steelworkers in this era often worked with little safety gear. As one historian, John Rasenberger, described it, “The pay was good. The thing was, you had to be willing to die.” Today you may be thinking, What a reckless way to live your life! But back then, that was the norm for that line of work. There was no safety net!
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Building an emergency safety net seems obvious. When it comes to your finances, most experts agree that keeping enough money to cover at least 6 months of your expenses is a smart way to protect against life’s unforeseen circumstances, such as losing your job or experiencing a sudden illness. On the same token, maintaining health and life insurance is an important part of this safety piece so that you can protect your family from unexpected financial burdens.
But how do you apply the concept of a safety net to your retirement savings? How do you protect the nest egg that you have worked so hard for in a market that is inherently risky and unpredictable?
Build a Diversified Portfolio
The first step to reducing portfolio risk is always to make certain that you are well-diversified. The less correlated your returns, or the less that your investments move together, the less overall risk in your portfolio. This makes sense. It goes back to the age-old saying of not putting all your eggs in the same basket; you want to protect all of your savings from taking a hit due to one common cause.
This usually takes the form of balancing your assets, according to your risk tolerance, between safer fixed-income securities (bonds, CDs, bond funds), more aggressive equities (stocks, mutual funds, ETFs), and non-correlated asset classes such as real estate and commodities.
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Understand your Risk to Return Ratio
The second thing you need to know is how your returns are related to the amount of risk you are taking. Generally speaking, the more risk you take, the more return you can expect to make (and on the other hand, the more you stand to lose if the market turns against you). This is why some of the safer assets in your portfolio, such as bonds or bond funds, only average about 3-5% return, and bank certificates of deposits (CDs) average just 1%!
With most bonds and CDs, your initial investment, or principal, is very safe, and therefore your return is not that high (you are trading a safer investment for a smaller return). Whereas when you buy stocks or equity mutual funds, there is no principal protection. You are taking on more risk, but in return, you can expect higher average earnings closer to 7-10% over a long time period.
Determine where you can get the best return with the least amount of risk
Knowing what you now know about the relationship between risk and return, it is important to evaluate your portfolio in order to maximize this ratio. Because we trade safety for potential profit, your safer fixed-income investments will always be a drag against the higher returns you receive from the equity portion of your portfolio when the market is going up. Obviously, we can’t abandon all safety to seek maximum rewards, but we can objectively look at the safety side of your portfolio and ask if there are opportunities to get a better return without taking on any more risk.
Many people use life insurance as an asset class and as an alternative to fixed income in their retirement portfolio. Specifically, using a properly funded Indexed Universal Life insurance policy allows you to capture most of the upside of the equity market (subject to a market cap set by the insurance company) while protecting you from losing anything if the market goes down. In retirement, you may take policy loans against your cash value (tax-free!!) to fund your lifestyle.
In this way, an IUL offers you the safety of a fixed-income investment with a return that is more comparable to equities, all while maintaining a safety net for your retirement because your cash value will never go down due to market turns. Knowing that a portion of your retirement nest egg is secure gives you the freedom to take more risk with the rest of your portfolio if you desire. More importantly, it can help you avoid the trap of feeling like you need to take more risk with your retirement savings to make up for lost time or down markets.
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