That’s the advice offered by Alastair MacLeod, managing director of investment service, Wheelhouse Partners.
In a recent paper, Mr MacLeod said that while it’s commonly held that “100-year storms” are infrequent, they actually occur about every eight or nine years.
This has a “potentially devastating impact on retirees”, Wheelhouse Partners said, explaining that sharp market falls can impact retirees to a higher degree because they tend to have larger asset balances, less time to recover from losses and they rely on their savings for income.
Noting this, Mr MacLeod said: “Advisers and their clients must recognise the very different objectives of retirees, and adjust their portfolios with appropriate tail risk management strategies to accommodate longevity risk.”
A tail risk is an event that occurs where there’s a chance of more than three standard deviations from the mean or normally distributed returns.
Continuing, Mr Macleod said that as people entire the retirement phase, their financial course, while unknown, is “already largely set”. As such, their outcomes depend on future returns.
“We like to think that tail risk hedging strategies will help them sleep a little better at night,” he said.
According to the report, there are three reasons why it’s important to manage tail risk for older investors; sequencing risk (the risk of large losses in the five-10 years around retirement), behavioural loss aversion (the human preference to avoid losses rather than acquire equivalent gains) and diversification and liquidity.
Mr MacLeod said that historically, risks have tended to correlate during crises while returns across asset classes have also “collapsed together”.
“Thus the benefit of diversification as a risk management strategy evaporates.
“Many asset classes such as credit and real estate have historically demonstrated a sharp decline in liquidity during these crisis periods, meaning the most available or liquid source of capital may be equities – which is, unfortunately, often the asset class that has fallen the most.”
Further, Mr MacLeod argued that “in many respects”, the customary modes of tail risk managements have “broken”.
“The conventional solution to lowering risk in retirement has been to increase allocations to either cash or fixed income, which both serve to reduce volatility and preserve capital better in drawdowns.”
Noting this, Mr MacLeod offered an alternative: derivatives.
He put that derivatives can be considered as a means of reaping higher returns from the “more volatile assets classes while delivering a retiree-friendly return profile”.
“We realise that for some people, derivatives are seen as complex or risky. However, we emphasise that this is usually only the case when leverage is used.”
Mr MacLeod proposed that investors think of how derivatives can be of benefit.
1. “Tail risk overlays mean assets can remain fully invested in the pursuit of equity returns,” Mr Macleod said.
This protection nevertheless “comes with a cost” but there are means of minimising this cost while delivering value through investment returns that are better aligned with retiree objectives.
“These objectives include being more concerned with outsized losses than outsized gains, and taking into account shorter time-horizons and the inability to recover quickly from drawdowns.”
2. Derivative overlays can be used as a means of “increasingly” protecting capital “the more markets fall”.
“This is a significant advantage over other capital preservation approaches such as retaining excess cash balances, where the loss of equity return for every dollar not invested is unpredictable, and market timing issues are introduced.”
3. Mr MacLeod said multi-asset derivative overlays can be used to “exploit pricing inefficiencies of indirect hedging”.
He explained that a diversified portfolio of indirect hedges is able to lower basis risk and cost while actually benefiting from the increased correlations and elevated volatility that often occur in a crisis. These are “the opposite characteristics to many traditional capital preservation models that rely purely on asset diversification”.