How to develop an investment strategy for retirement

When thinking about formulating an investment strategy for your journey to retirement, the task might look discouraging. How do you plan for a 40-year plus voyage?

What is an investment strategy? It is a plan of how to invest your portfolio to increase the chances of achieving your investment objectives. When investing, first define what outcomes you aim to accomplish. These could be growing your portfolio’s value in real terms (above inflation), generating income or perhaps meeting specific liabilities (such as paying off your mortgage).

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The key is that as your circumstances and market conditions change, so does your investment strategy. It should be dynamic and relevant to the current situation.

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The flipside of these outcomes is the level of investment risk you are able and willing to accept. The higher the risk, the higher the potential returns and potential loses. Based on your return and risk objectives, choose your investments. More in risky assets, such as equities and property, mean a more aggressive strategy. More in conservative assets, such as bonds and cash, mean a more defensive strategy.

Lifecycle investing breaks down the road to retirement into three phases: (1) accumulation; (2) consolidation; and (3) decumulation.

Accumulation begins when you start your working life, accumulating wealth and saving for retirement. As your investment horizon is long, you earn income from work and the size of your saving portfolio is still small, this is the time to take investment risk. Holding cash generates meagre returns. Taking investment risk by investing in assets such as equities can generate high returns over the long run. However, investing could be risky – you can lose as well as profit. Your investment style needs to match your risk tolerance.

The appropriate investment strategy for the accumulation phase tends to be aggressive, with high proportion invested in equities. However, ensure you diversify your investments. This is a proven way to mitigate risk. Beginning investors should consider starting with a more conservative strategy, not to lose confidence in investing at an early stage due to disappointments.

Saving for retirement when you are young requires discipline. Retirement seems far away and current financial needs are pressing. However, adapting to investing is a long process, so start as early as possible. This also gives you more time to accumulate wealth.

The next phase is consolidation. About 5-10 years before you plan to retire, consider starting to gradually reduce your portfolio’s risk, the so called glide path. Visualise how you would like to take your savings when reaching retirement – a mix of cash lump sum, flexi-access drawdown and annuity (as we discussed in the previous article How to access your pension pot). Over time shift some of the portfolio to cash to prepare taking it as lump sum, buy long-term gilts to hedge the price of annuity and keep the rest invested for the flexi-access.

Doing so gradually allows you to sell and buy assets at average prices over time (dollar cost averaging). It eliminates the risk of timing the market – buying when it is expensive or selling when it is cheap. This mechanical approach avoids the pitfalls of emotional decision making, such as panicky selling after a correction, just to miss a rebound. If you are a savvy investor, consider using discretion to adjust the glide path. However, ensure you know what you are doing so you do not spoil the plan.

Prices of long-term gilts and annuities tend to move in tandem. Buying gilts over time smooth the purchase price of annuity. Instead of betting on a price at a single point, you average it out over years.

De-risking your portfolio addresses two risks. First, as your investment horizon is getting shorter as you approach retirement, your appetite for large drawdowns just before needing the money diminishes. You do not have time to recoup losses. However, since some of your portfolio can remain invested post-retirement, for this part the investment horizon can still be long.

The second risk you mitigate is sequential risk. As you contribute into your portfolio, which grows over the years, the timing of drawdowns matters. Drawdowns have less impact at the beginning, when your portfolio is small, and more impact towards the end, when your portfolio is large. De-risking your portfolio mitigates this risk.

The third and final phase in your journey to retirement is decumulation. This phase begins when you retire and start to de-accumulate (spend) your savings. However, retirement is not the end of your investing life.

While portions of your portfolio are converted into cash and annuity, other portions should remain invested to hopefully many years to come. While in the accumulation phase the strategy was aggressive and in the consolidation phase you reduced risk, the decumulation phase calls for another shift in investment strategy.

Part of your portfolio should be oriented towards generating income from diversified sources, such as equity dividends, bond coupons and property rental income. Another part of your portfolio should be oriented towards capital preservation, emphasising beating inflation. As you might not have many other sources of income, you may wish to avoid risking big losses in your portfolio.

The investment strategy here is generic. You should think about an investment strategy fitting your specific circumstances. For example, if you have other sources of income, such as a buy-to-let property, you may decide to take more risk in your other investments. If, on the other hand, you do not comprehend investments well, you might be uncomfortable taking investing risk and should keep it low risk and simple.

In any case, consider taking professional advice and read a book or two on investing. Investing requires understanding, careful planning and some luck. But if you educate yourself, commit and formulate a suitable investment strategy you can enjoy the fruits of your efforts.

Yoram Lustig is the author of the new Financial Times Guide: Saving and Investing for Retirement. It is out now, priced £26.99 from FT Publishing, and available from Amazon.