When you’re planning for retirement, you need to address two key considerations. First, how much do your investable assets need to grow to meet your goals? Second, how much risk you are willing to accept along the way? Risk and return are two sides of the same coin. How do you determine what level of risk is right for you?
Defining Risk
The first thing we need is a working definition of “risk.” This is tricky because the way in which we define the word in the context of investments is not how we normally think of it in our daily lives. You and I probably use the word “risk” to describe a situation that should be avoided; when bad weather makes for “risky” driving conditions, we are better off staying at home.
When we analyze investments, though, risk has a meaning that can be both good and bad – and that’s what makes risk an integral part of a goals-based investment planning process. “Risk” applied to an asset or a portfolio is interchangeable with “variance” – the extent to which the returns over a period of time will deviate from their average.
Over the long term, we want assets in our portfolio that have a higher tendency to vary from their means, because that can generate higher returns over the long term. When we compare the performance of stocks and bonds over the very long term we find that on average stocks – which normally have significantly more risk than bonds – have produced higher gains. That’s why it is generally a good idea to invest more of your portfolio in equities when you are younger and have a longer time horizon to retirement.
The Nature of Downside Risk
Over the course of that long time horizon, though, you are likely to encounter some heavy weather. Bear markets are challenging environments and require investors to think carefully about two things.
First, how prepared are you if the storm hits tomorrow? This is a question about your financial capacity to absorb a sharp fall in your portfolio value. If you are about to write a giant check to pay for your daughter’s first year at an expensive private college, you may have a tough time absorbing a body blow from the bear. If you are comfortably living off your monthly salary and have 30 years before you retire, your risk capacity will likely be higher.
Next, how psychologically equipped are your for extreme market conditions? This is not an easy question for many of us to answer. We have a tendency to rate our abilities in all sorts of things as above average, whether that be driving a car or picking stocks. When answering the question “how able are you to endure potentially high short-term losses in pursuit of long-term gains?” more people are likely to answer “very likely”.
When the storm hits, though, you are in trouble if you lack the emotional discipline to see it through. When asset prices fall a lot – when they plunge by 20% or more from their peaks – the drawdown tends to be sharp and swift. If you sell out of your riskier assets in a panic, you are more likely to be selling near the bottom. That’s a surefire way to convert a paper loss to a real loss, and it can do lasting damage to your retirement plan.
An honest assessment of your own financial capacity to absorb risk and psychological propensity to endure it will stand you in good shape for making the asset choices most likely to help you reach your long term goals.
Do you know your risk tolerance? Tell us what you think.
For advice and tools to manage risk for achieving long-term goals, visit Jemstep.com.