“Well, when events change, I change my mind. What do you do?”
-Dr. Paul Samuelson
Investment risk is a topic that worries most of us, especially when we go through life changes or market corrections. We know we need to change our retirement portfolio’s investment risk over time, but it is not for the obvious reason. Since many people are not fully aware of the financial risks to their retirement, it is easy to simply assume that risk-taking must decrease as you age just because you’re getting older. The truth is more nuanced than that, and for some people, even the opposite may be true.
We tend to think of investment risk as to the stock market going up and down (aka market volatility). Conversations with your financial professional will generally revolve around how much loss you are willing to experience in exchange for a chance at more significant gains, which we call risk tolerance. This is an appropriate conversation if you are building up your retirement savings.
Retirement savings growth is dependent on a combination of how many dollars you save and how much those dollars earn. The more money your savings make, the less you need to contribute. Rate of return is significant because as you are building up your retirement savings, there are plenty of other uses for that money. Few of us are willing to sacrifice everything today for the chance of a fantastic tomorrow.
Investment Risk while planning for retirement
Saving for retirement is a 20, 30-year, or even longer project. For that long of a time frame, historically, the earlier you start and the more aggressive you are in your investing, the more significant your results become. Although, when your portfolio is more aggressive than you are comfortable with, you are more likely to move your savings to cash every time the market goes down. You can see why this is usually not a good idea. For your savings to make anything at all, you need to stay invested. The concept of determining your risk tolerance is, in the end, figuring out how to minimize how often you panic. (For the record since we are all human, it is normal to panic from time to time.)
We know investments are going to go up and down in value, and sometimes those downs will be scary. But keep in mind, these down moves are most likely not a threat to your future retirement; historically, these selloffs have been an opportunity to buy if your time horizon is long enough. One caveat: If you are near retirement, down movements are not so benign!
During this period of saving for retirement, assuming you are making regular contributions, the real danger to your savings appreciation is a prolonged, slow decline. Accumulation strategies rely on compounding, which is the growth this year from the previous years. If there is a significant block of time when you are not experiencing growth, you will probably need to increase what you are contributing to make up for the shortfall.
The dramatic, headline-making, sell-offs are not as big of a problem since you usually have time for the market to recover and, since you are making regular deposits, you are buying at those lower values.
Investment Risk in retirement
Once you move from retirement savings to retirement income, your investing goals will change. The idea of being aggressive in your investing is a good idea while working on building up their nest egg, but not necessarily when you start using that egg.
You created a pool of money that is replacing the paycheck you no longer receive. Now, the real risk is how much income you receive each month. Retirement income planning (the “official” term for planning in retirement) focuses on finding the answer to “How much income can I receive with minimal risk of running out of money?”
Earlier I commented that a long, no-growth period is the danger when saving; however, the threat in retirement is now dramatic, gut-wrenching market drops. If you cannot or will not change how much money you take from your accounts when they drop, you will be taking a greater portion of the portfolio. Taking a larger percentage of a depressed asset is a recipe for disaster. If you typically withdraw 4% out of your account, but the market drop means you take 8% then, mathematically, that is one extra payment, AND that “extra” payment will not grow as the market goes back up.
The threat to your income is why, traditionally, your risk tolerance is lower as you enter retirement. The term risk tolerance is imprecise here. You can think of risk tolerance as the sum of two different concerns: capacity and appetite. Appetite is about you wanting the returns while capacity is protecting what you already have – the difference between wanting and having it all.
Risk capacity quantifies how much financial pain your accounts can absorb when markets go against you. When you are in your 20s, your retirement savings has a substantial risk capacity. If the stock market goes down 40%, not only do you have a long time to recover, but you likely have a minimal amount invested.
Once you’re drawing on your retirement savings, your capacity is much smaller for the opposite reasons.
Risk appetite is about your personal preference, do focus more on what you might earn or lose. Appetite is very emotional. As advisors, we would love to have a definitive measure of our client’s risk appetite. Truthfully though, your appetite moves with the market. Nearly all of us are more aggressive if the stock market is exploding upwards, and we are more restrained if the market is cratering. Also, be aware it’s possible your appetite will not change over your lifespan. As an advisor myself, I’ve known many investors who are just as interested in “hitting home runs” now in their 70s as they were in their 20s.
Determining the correct risk tolerance when appetite and capacity are at odds can be tricky, but necessary. I am not saying that you need to take less investment risk during retirement; instead, be aware of the impact on you if the downside of risk happens. You may find that you have more capacity in your early-80s than in your late 50s. Primarily, capacity increases because there is a greater certainty of time horizon – at 55, you need to be prepared to live another 40+ years; however, at 85, you’re not as worried about 40 years from now. Moreover, as you age, your expenses may decrease as you find yourself less active.
Many retirees fear to take even an appropriate level of risk because they underestimate their capacity. One way we help our clients feel more confident is the use of a withdrawal policy statement. We have found people like having, in writing, a description of what to income to expect. Additionally, we spell out how the income may change as account values change. If there is a considerable drop in value, even though the income may decrease, clients have some comfort knowing we had discussed and planned for this event, lessening the fear of the unknown.
Like most decisions involving retirement, the risk is personal. No one can tell you what is right for you. Understanding the part risk plays in both retirement planning and retirement income planning will help you make better choices. Working with an advisor may help you think through the pros and cons of each decision. In turn, this can strengthen your #2ndHalfPlan.
Determining how fast you’re comfortable traveling on your investment journey is the first step in helping your advisor develop an investment strategy that’s perfect for you. Everyone has a Risk Number, find out yours by clicking here. If you have any questions or would like to talk to a certified financial planner, shoot us an email at firstname.lastname@example.org or schedule a 20 minute phone call here.
Kevin focuses on helping people with retirement income planning. He is concerned that too many people become overwhelmed as they shift from building their retirement savings to using their retirement savings to support their desired lifestyle. By engaging in a robust planning process, he aims to lessen the financial fears we all have after we end our careers. Learn more about Kevin