Timing the market

Geoffrey Cooban looks at the different ways in which advisers can manage risk in a retirement planning portfolio

The word 'risk' to many people generates a multitude of negative images, from reckless driving to watching your horse take a tumble at Bechers Brook. In an investment context, risk is often seen as the possibility of losing your savings.

The risk of loss is not the only kind of risk. There is the risk of investing too conservatively and not generating a sufficiently high enough return to turn retirement plans into a reality.

In determining how much risk to take in retirement planning, the individual needs to be clear about their personal objectives. This may be to accumulate wealth prior to retirement, generating a particular income level during retirement or preserving the preserving capital. The time horizon for meeting these objectives is a fundamental consideration, as is the individual's ability to cope with the periods when his retirement pot is losing value.

The generally accepted approach is to invest aggressively when young - when there is sufficient time to recover from periods of stockmarket decline - with high equity content, then gradually move into more secure areas like bonds as retirement nears and the preservation of capital becomes increasingly important.

Whatever the particular considerations for an individual in the years approaching, and those after retirement, the focus needs to change from the drive to accumulate wealth to the management of risk.

So what are some of the main risks and how best to combat them?

Stockmarket risk

Different types of investments have unique characteristics that affect their value, while investments of a similar nature tend to gain or lose value together.

The best way to guard against this, is to ensure the retirement portfolio is well diversified, holding a range of asset classes, notably government gilts, corporate bonds, equities, property, private equity, hedge and cash. The portfolio then benefits from the fact that different asset classes tend to behave independently of each other. For example, a rising bond market often runs alongside a fall in equity values.

Further risk protection is obtained by adopting both the value and growth styles of equity investment. The value style seeks to identify stocks where the share price does not reflect the underlying assets of the business; the tobacco and utility sector during the dot com boom of the late 90s is a prime example. Conversely, growth style investors seek to benefit from companies that have above average earnings growth that promises to justify or exceed the current share price in the future. Both approaches are capable of seeing gains or losses over a given period, but not usually at the same time.

Staying invested is an important factor in managing stockmarket risk. Timing the market is notoriously difficult. Being in cash when the market dips may feel smart but when do you go back in? The statistics tell us that over the 20 years to the end of 2008, the UK equity market has produced an annualised return of 8.3%, but missing just the 40 best days in that two decades sees the return crumble to negative 0.3%.

Interest rate risk

Falling interest rates reduce retirement income by lowering growth rates on the assets held within the retirement portfolio. Consequently, more may have to be saved to produce an adequate retirement fund.

A fund containing a high proportion of gilts and bonds will benefit from falling interest rates as the price of the fixed interest content increases reflecting its increased attractiveness. Similarly, rising interest rates negatively affect the value of a bond heavy portfolio.

For the retired, buying an annuity rather than staying invested takes away this risk but generates its own problems as to yields available at time of purchase and loss of control of capital. Pre-retirement, the best weapon is to achieve an appropriate balance between fixed interest and equities. Within the fixed interest content, utilising a range of maturities and bond quality is recommended. Lower grade bonds offer a higher yield, reflecting a higher chance of default than the more secure higher grade. This risk of the bond issuer not meeting its promise to repay capital and make interest payments along the way is yet another risk that needs to be managed within the portfolio and may well necessitate employing a professional investment manager.

Inflation risk

The danger that the value of your retirement portfolio will be eroded by rising prices is a risk easy to overlook at present, with RPI in negative territory for the first time since Harold Macmillan was Prime Minister in 1960. However, the ravenous inflation beast has not gone away and with the Government currently increasing the money supply in an attempt to revive the economy, it threatens to return hungry and ready to eat into the purchasing power of retirement portfolios.

Assuming 4% annual inflation, a person aged 40 with a life expectancy of 85 intending to retire at 65 and replacing two thirds of a current £40k gross annual income, will need an income of £71,500 at retirement to maintain his standard of living and £156,500 in his final year.

Achieving the balance between the potentially inflation-reducing element of the portfolio, equities, with their prospect of rising dividends and capital growth over the long term and the more stable but inflation-threatened fixed interest element are a key factor in managing the inflation risk in any portfolio designed for retirement.

In addition to utilising equities, both indexed linked government gilts and the natural resource sector can be useful tools in combating inflation. Index linked gilts provide inflation proofing of both capital and income while natural resources have tended to rise in value during inflationary periods.

Understanding the different types of risk identified above is fundamental if their potentially adverse effects are to be minimised and successful retirement planning achieved.