Risk Tolerance
What allocation is right for me?
The idea is to invest in an allocation/strategy that you will not abandon in extreme times. We have found that people feel compelled to sell their investments once they decline a certain amount in value because they are convinced that the market will continue to decline.
No questionnaire alone is capable of predicting an investor’s tolerance for portfolio losses at some future point. You will not know for certain at what point you will feel compelled to abandon your investment strategy until you actually reach that point.
Research has shown that people are highly influenced by the people and the situations that surround them. In addition, people’s perception of risk depends in part on when they are asked. Therefore, a person’s risk tolerance (as it pertains to their investments) is not fixed, but varies from one set of circumstances to the next. Since both markets and people change over time, predicting how you will react to a set of unknown circumstances at some point in the future is impossible.
Our experience has been that people tend to be less tolerant to market fluctuations as they age and especially at the point of retirement or when they experience a substantial reduction in income. We respect the flaws that using a plug-and-play risk profile present, so we take a different approach. First, we believe there is a certain amount of capital each investor needs to satisfy their lifestyle in retirement. Second, we believe that number can be easily calculated with basic math.
Most of the planning that I have seen that solves for the amount of capital required seems to completely ignore the concept of risk. You need to be able to quantify the risks in the assumptions you use – remember standard deviation? If the planning you do uses assumptions that you can not quantify, then the planning is not going to be very meaningful.
A look at some facts and examples will make this more clear. The majority of stock market returns come in concentrated time frames. If you were to review the returns from the DJIA over the last century (1900 – present), you would see the worst 20 yrs had an average return of about 2.5% per year and the best 20 yrs had an average return of 18% per yr.
Since there is no way of knowing if stock market returns during your retirement will be close to their historical high, low, or average, using that data is not very meaningful to the problem you are trying to solve. To learn more about why stocks are poor investments for retirement planning, click here.
By using investments whose returns have greater certainty (lower standard deviation) to calculate the amount of money you need, you get a much more reliable number for the amount of capital required. So why don’t people do this? We have found that most investors don’t do this for two reasons. Either they are not aware of the negative effects using stock returns could have on their planning or they don’t like the answer they get when they use the lower returns of more certain investment classes.
For example, let’s say you plan to spend $200,000 per year over 25 years in retirement. If you were to overlook inflation and just stick your money under your mattress, you would need $5 million ($200,000 X 25 yrs) to meet your objective. If you were to invest in short term treasuries (let’s assume a 3% risk free rate of return), you would need about $3.5 million. That is $1.5 million less.
If you are like most and you use historical stock market returns (say 10% per year) you would only need about $1.8 million. People tend to like hearing that they only need $1.8 million to retire vs. $3.5 million or $5 million – especially if they haven’t even accumulated the $1.8 million yet. Do not fall in the trap that you need to take more risk to compensate for an under funded nest egg. This is HUGE mistake! This is likely to take you from bad to worse.
We don’t believe it is wise to ignore inflation any more than we think it is wise to stick millions of dollars under your mattress. We also believe that most investors are capable of some degree of risk greater than the risk free rate of return. Therefore, we suggest investors calculate the amount of money they need using historical data from a globally diversified portfolio of 30% stocks and 70% bonds. A 30/70 portfolio has what we believe to be the prudent combination of investor return per unit of standard deviation for a sound retirement plan. Click to see our Returns Matrix and note the annual returns and standard deviation of Portfolio 30. Pay particular attention to the down years and the magnitude of those down years. Click here for an example of why this matters. In cases of the most conservative investors, we suggest using an average of the risk free rate of return to calculate the amount of capital required.
Once we identify the amount of money you need for retirement, we employ a risk tolerance profiling system by FinaMetrica. We use the results along with your input to suggest an allocation for any excess monies you have but don’t need to fund your retirement. These monies can be used as an extra hedge against inflation or to fund lifetime gifts to family members or charities.
We believe this two tiered process is a much wiser way to address an investor’s risk tolerance and implement an investing program that they are less likely to abandon in tough times.