3 Key Risks That Retirees’ Portfolios Face in 2025

Investors are used to focusing on the future. However, there comes a point in most investors’ lives when they must use their investment portfolio to meet their income needs. This transition necessitates an approach to investing that is more focused on the risks that could prevent the portfolio from playing this role.

As investors focus more on harvesting the returns of their portfolios and less on planting the seeds of future growth, risk management should naturally be top of mind. We have therefore identified three key risks that income-focused investors should consider in 2025 and how to address them.

Risk: Geopolitical Risks and Their Spillover Effects

Numerous political, military, and macroeconomic issues mean that geopolitical risk will remain elevated in 2025. These risks can have negative spillover effects on the global economy. For instance, higher commodity prices, tariffs, and the reshoring of supply chains increase the risk of structurally higher inflation moving forward. In turn, bond investors may demand higher interest rates to compensate them for the risk of persistent inflation. Given the rise in government debt levels following the covid-19 pandemic, any increase in interest rates would make the cost of servicing that debt more challenging, forcing governments to cut spending, increase taxes, or both to bring their debt under control.

Portfolio Response: Lean Into Shorter-Dated Government Bonds

We believe that inflation and the fiscal deterioration of the US pose considerable risks to longer-dated bonds, and we therefore recommend that investors favor short- to intermediate-term government bonds. This may sound counterintuitive when the Fed is poised to deliver a series of rate cuts going forward, but market movements in the wake of the Fed’s first rate cut in mid-September (short-term rates have fallen while long-term rates have risen) demonstrate that long-term interest rates are primarily driven by expectations around growth and inflation, and to a lesser extent by monetary policy.

Risk: Rich Equity Valuations and a Strong US Dollar

US equities have handily outperformed international equities for over a decade. What’s more, the US dollar has strengthened against a basket of major international currencies for over 13 years, accentuating the return differential between domestic and international stocks from the perspective of a US investor. It is a fool’s errand to predict when these dynamics will reverse, but our valuation models suggest that US equities—especially large-cap technology-related companies—are richly valued. Put simply, there are lofty expectations embedded in the prices of these assets, and their investment returns may suffer if these expectations are not met over the coming years.

Portfolio Response: Dig Deeper Into the Market and Consider Non-US Stocks

As returns are strongly linked to the starting valuation of an asset, investors would be well served by emphasizing relatively unloved areas of the US market in their portfolios, areas such as smaller and midsize companies where valuations are less demanding. Furthermore, investors shouldn’t abandon non-US stocks. Today, we see opportunities in areas such as Chinese technology firms, Latin American equities, and European consumer cyclical stocks. Not only are these asset classes attractive on a local basis, but currency effects could provide further tailwinds to their US-dollar returns in the event of the dollar weakening.

Risk: Disappointing Growth or Recession

Although a recession is not our base-case scenario for the year ahead, investors should never rule out such an occurrence, especially after a prolonged period of heightened interest rates and disappointing economic data. Furthermore, the low odds of recession implied by today’s credit spreads and equity valuations leave investors particularly exposed to market reversals and negative surprises.

Portfolio Response: Focus on the Quality of Your Bond Portfolios

When seeking protection from a recession, high-quality government bonds remain one of the most reliable assets to hold for diversifying equity risk, especially at current yield levels, as they provide the safety needed to protect investors' cash flows and portfolio value. Other assets with less sensitivity to real rates, such as liquid alternatives, can provide additional diversification in recessionary environments, but implementation via manager selection remains key.

For those investors employing private strategies to reduce volatility during selloffs, some words of caution are in order: Private equity is still equity, and private debt is still debt. Both have the same economic drivers as their liquid counterparts (often with much more leverage), and their reduced volatility relative to public assets is mainly illusory, as they are simply priced less frequently.

Building Robust Portfolios Through Diversification

This background on risks is important because it sheds some light on how we think about building portfolios looking forward to 2025 and beyond.

We have been calling for a while on the need for investors, especially those focused on income, to prepare their portfolios for different outcomes via robust portfolio construction. We define a robust portfolio as one that can withstand different market environments without undermining its ability to deliver ongoing returns. Studying the historical behavior of each asset and understanding the underlying risk factors is essential to ensure that portfolio robustness is attained and maintained over different time horizons.

The chart below shows the average annualized performance of asset classes in different scenarios from 1975 through 2022. The highlighted values show the asset classes that have historically outperformed.

Prediction is a dangerous exercise, as it is extremely hard to anticipate changes in correlations across assets and where risks will materialize in the future. Diversification is much more than just spreading your bets; it has to do with visualizing future risks and preparing for them by buying assets with attractive valuations and different underlying drivers.

Viewing investment through the lens of risk may appear counterintuitive, especially in a year when equities have risen so sharply. However, it is a necessary part of the transition from seeking future returns to reaping the returns of previous investing decisions.

This article includes contributions from:

• Michael Budzinski, Associate Portfolio Manager
• Nicolo Bragazza, Associate Portfolio Manager