4 Steps for Creating a Pre-Retirement Investment Strategy

So, you want an investment strategy with almost unlimited upside but limited downside risk? Let me tell you about the LowVol Retirement Income Maximization Investment Strategy. It is a covered call option strategy in which we use the income from selling the call to buy a put. Selling the call allows us to realize almost all of the upside and the put option limits the downside. Also, we have created a proprietary trading strategy based on Fibonacci retracements.  This market timing strategy allows us to invest while the market is going up but protect you in the case of a market correction. Did I mention we also utilize a tactical investment strategy? This allows us to be nimble and only invest in areas of the markets that go up and avoid any asset classes that go down. Unfortunately, we can’t provide actual performance numbers but I can show you a backtested chart which shows how this strategy would have worked going back 10 years.  As you can see, the result would have been double digit gains with barely any volatility. Is that something that I can interest you in Mr. Client?

If your answer is yes, unfortunately you have come to the wrong website. If you are looking for an investment manager who uses a sexy investment strategy that consistently “beats the market”, I have bad news for you. You aren’t looking for an investment strategy, you are looking for a marketing strategy. Have you ever met with a financial advisor? We are almost all the same. We promise comprehensive financial plans, quarterly meetings, in-depth retirement and tax planning. Heck, we almost all look the same; middle aged, white men with lots of confusing letters after our name which must mean we are very qualified for our jobs. So, how do we set ourselves apart? Proprietary trading systems, market timing and tactical investment strategies, and sexy sounding investments which you certainly could never find on your own. You sign up with someone which may or may not work for a short period of time and then when this exotic investment strategy lags the market, your search for the holy grail investment advisor continues.

If the scenario above sounds like yourself, I have a better option for you. The first sign that you are working with a true financial planner is the creation of an Investment Policy Statement (IPS). Think of an IPS like a budget for your investment strategy. Your IPS shouldn’t be predicated on market timing or tactical asset allocations based on technical indicators. Instead the IPS lays out your goals, and the investment strategy that you will use to reach your goals.  It helps you stay on track during tough times in the market and guides investment decisions no matter what the stock market is doing. This article discusses the main components of creating an IPS and putting together an actually actionable investment strategy to meet your financial goals.

Your Goals

The first issue that I see with most investment strategies is not knowing the actual goal in which you are striving. The reason this is usually overlooked, is because knowing your goals is very difficult. For example, for a retirement goal you need to know when you want to retire and how much income from your investments will you need to comfortably live. Unfortunately, too few financial advisors skip doing a comprehensive plan, and therefore the goal is simply to have as much money as possible so that you can retire at some point. How can you invest your money if you don’t know the goal you are trying to reach?  Do you need to be more aggressive with your investments in order to meet your retirement goals? Can you afford to take on less risk so that you can hit your retirement goals with more certainty?  An Investment Policy Statement should layout how much you want saved and by what date. For example, at age 65 you will have $1 million saved.  You will then be able to withdraw $50,000 per year, inflation adjusted, for the rest of your life.  In order to have $1 million at age 65, you will need to save $20,000 per year and generate 6% annual returns.  

Risk Tolerance

There are typically two factors that affect the amount of risk that you can take on with your investments; your ability to take on risk and the time horizon until withdrawals are needed.  The longer your time horizon until you need to start taking withdrawals, the riskier you can be with your investments.  I recently met with a couple that needed to take roughly a 7% withdrawal from their retirement accounts each year for a comfortable retirement, and currently they are sitting in cash fearing a market correction.  I ran the numbers for them, and at their current investment strategy, cash, and a high withdrawal rate, 7%, they would be out of money right after they turned 75.  The couple either needed to get more aggressive in their accounts to have a more comfortable retirement, or a lower withdrawal rate.  They chose the more aggressive investment strategy.  Sometimes, meeting your financial goals requires you to invest more aggressively than you feel comfortable.  A financial planner isn’t just here to tell you what you need to do to hit your goals, he should also be able to help you get through those tough times in the market when your account may drop more than you feel comfortable.  

Your Investments

Once we have discovered the amount of money you need in retirement and the rate of return and savings needed to hit this goal, you then need to layout the type of investments that you will use to reach your goals.  For example, will you use individual stocks and bonds, mutual funds, ETFs or annuities to help get the 6% mandatory rate of return.  Any of these types of investment products can help you get to your goals, but you do need to know the differences and pros and cons of each.  One big surprise to me, is that when a new client starts with me, very rarely do they ask the type of investment that we will use.  The type of investment, and most importantly, the fees that are involved in these investments are key to hitting your goals.  

Also, your asset allocation needs to be defined and also when the allocation should be modified.  This has nothing to do with market conditions or dealing with a market correction.  The asset allocation needs to be defined upfront so that you aren’t changing it because you think the market is “due for a correction” or “is about to move higher”.  There is nothing more important to the success of your investment strategy than maintaining a consistent asset allocation.  Changing your asset allocation will also mean a change to your IPS and will put your retirement plan in jeopardy.  Here is an example of defining your investments and asset allocation.  In order to generate a 6% annual return, we will use low cost index ETFs.  The allocation will start as 50% U.S. stocks, 25% international stocks, and 25% fixed income.  At age 60, five years before the planned retirement, we will shift the allocation to 45% U.S. stocks, 15% international stocks, 35% fixed income and 5% cash.  

Rebalancing The Portfolio

If  asset allocation is the most important aspect of achieving your desired rate of return, the rebalancing strategy is a near second.  Rebalancing the portfolio ensures that you are consistently buying low and selling high no matter the market conditions.  Also, it makes sure that the risk of the portfolio is not straying from your comfort level.  For example, if you start out at a 60% stock and 40% bond portfolio and the stock market does very well but the bond market struggles, it is easy for the allocation to get to 65% stock and 35% bond.  Therefore, your allocation is more aggressive and if there is now a market correction, your account will see a bigger drop.  On the other hand, during a market correction, you are rebalancing back to the target portfolio, which means buying stock when the market is lower.  This allows the portfolio to rebound more quickly when the market comes back up.  Here is an example of a rebalancing strategy.  Each quarter, we will rebalance back to the target portfolio of 60% stock and 40% bond, no matter market conditions.  

ING Commercial

Do you remember those old ING commercials, asking what’s your “retirement number”?  Admittedly, they were kind of stupid but the concept makes sense. Essentially, “your number” is the amount you need to save to live a comfortable retirement. This is really what an Investment Policy Statement is meant to accomplish. First, we need to determine the amount of income you will need to draw from your retirement accounts each year. Next, we calculate the amount of retirement savings you will need to save in order to meet your yearly distribution requirement for the next 30 or so years of retirement. Last, we develop an investment strategy to help meet those goals. This investment strategy involves the type of investments you will use, the target allocation based on risk tolerance and time horizon and finally a rebalancing strategy.  If your current strategy is to blindly throw a bunch of money into your 401(k) and randomly choose investments based on your belief of what the market will do next, you need to consider creating an IPS. Are you are currently relying on financial advisors who are selling sexy investment options to “beat the market”?  If so, please call me when you realize the holy grail of investment advisors is really just using a marketing strategy and not an investment strategy.

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