Why Retirement Investing Needs to Be Done Differently
You Are Not Solving for the Same Math Problem in Retirement
When you are in your 40’s and even early 50’s, you are focused on saving and maximizing investment returns. The goal is to get the highest potential return for a given level of risk. Risk is usually measured by volatility – the expected fluctuations your investments will go through in order to have the possibility of achieving the higher return.
Modern portfolio theory turns this goal of maximizing returns for a given level of risk into a math formula. This formula is then used to plot various portfolio allocations into a graph, so you can see which allocations (mix of stocks to bonds) has the best potential for achieving your target return. This graph is referred to as the Efficient Frontier. It also allows you to see how much risk (volatility) you might expect along the way. (This approach is based on the Efficient Market Hypothesis.)
The math formulas behind the Efficient Frontier create an effective approach while you are in the accumulation phase of your life. As you near retirement, however, the goal changes. When the goal changes, the formula needs to change.
In retirement, you are no longer solving for the highest returns for a given level of risk. Instead, you are solving for the portfolio that can generate a sustainable level of income while having a very low probability of running out of money (something sometimes referred to as shortfall risk). This is an entirely different formula to solve for. The portfolio that is best at delivering the highest potential returns for a given level of risk is not the same portfolio that is best at delivering sustainable income while reducing shortfall risk.
Many academics have conducted research on the differences between accumulation and decumulation (retirement income generating) portfolios. I've outlined four such research resources below.
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