Determining "Risk Tolerance" In Retirement?
What makes a story interesting?
You could say the setting, the characters that populate the pages, the meaning of the work, or even the writing itself. But digging down deeper than that, what makes the story interesting? It actually comes down to one thing: Change.
Change keeps the plot moving!
Your life is full of stories, and you’ve gotten where you are today through many life changes - big and small.
Retirement is a new chapter, or change, in your story. And with this new chapter so many things change: the setting (where you live) the plot (what you do) and your motivation (what you care about).
It’s important that you prepare yourself for the big changes that happen when you retire. If you ask most retirees, they will say they thought getting old would take a lot longer than it actually did! By thinking through the details, you will set yourself up to enter into retirement with your head held high and both eyes wide open.
One change in particular that I would like to discuss with you today is what financial researchers call “ risk tolerance,” and the changes it can undergo once you reach your golden years.
What is Risk Tolerance?
How would you feel if the stock market were to tiptoe to the edge of a large cliff where you can’t see the bottom? Although, in fact, nobody can predict such cliffs with any accuracy, there are lots of self-proclaimed experts who predict doom and gloom on a regular basis.
While no one would feel good about a major drop in the market, it is something that can and probably will happen at some point throughout your life. How do you think you would handle it? Is it something you as an investor would be able to withstand? 25 years ago you may have said: “Yes, of course!” But you may give a completely different answer now that you are starting to rely on financial investments for your retirement income.
The level of variability in the market that you are willing to cope with is called your risk tolerance. Interestingly, surveys suggest that most people think “risk” means losing money permanently rather than variability. Markets fluctuate randomly all the time, and those who have not been educated about the long term behavior of the market may view any drop as permanent. They are easily scared by headlines and news media know alarmist headlines usually help sell newspapers and/or gain viewers. To avoid investment blunders, it is important to maintain a long term perspective.
An investment strategy that is based on the long term is something called liability driven investing. This approach, which academics call dedicated portfolio theory, treats a retirees expected withdrawals as liabilities. These withdrawals are the income stream needed for living expenses in retirement. The stock/bond allocation is determined by the amount of income needed and the length of time the retiree wants to protect that stream from short term market fluctuations.
For example, a ladder of individual bonds held to maturity generate cash flows from coupon interest and redemptions to provide a secure income stream for anywhere from 5 to 10 years. Each year will require about 5 percent of the total portfolio, so a protected stream for 8 years would typically require about 40 percent of the overall portfolio. This 40 percent is called the “Income Portfolio.”
The other 60 percent would be invested in a “Growth Portfolio” usually consisting of stocks in mutual funds. As each year passes, the Growth Portfolio is examined to see if it has grown enough to sell some stocks to replace the bond that matured. If so, some of its holdings will be sold to buy a new bond to maintain the length of the protected stream of income being generated by the Income Portfolio. If not, new bond purchase can be delayed until next year because the Income Portfolio still has another 7 years of income left.
This protection against short term market fluctuations is a primary benefit of the dedicated portfolio strategy. Knowing your income stream is secure allows you to cope much more comfortably to the ups and downs of the market because you know your bonds will provide the income needed until the market recovers, which it always has. It gives you a much higher tolerance for variability.
I always encourage my clients to take a look at their investment strategy when they hit retirement and decide the type of changes they wish to make to best reflect their new lives. It is important to take a critical look at your finances:
Do you have a financial planning going forward?
Have you met most of your financial retirement goals?
How can your investment strategy better match your goals for retirement?
Asking yourself and talking with your financial advisor about these questions will help you understand both your personal risk tolerance and how a liability matching approach may help you going forward
Understand The Shift In Your Priorities
When you retire, many aspects of your life change. Your priorities may not look the same as they did 20 years ago, and that is okay! It is good to grow, change and allow your priorities to do the same. In terms of priorities:
What do you care most about?
What are your core values?
How do your values influence your financial and personal decisions?
These are big questions that are aimed at getting you to think about the bigger picture and how your investment strategy fits into that wider scope. For example, while working, your top priorities may have been keeping up on your mortgage payments or traveling the world. Whereas now, in retirement, it may be focused on cheering on your grandkids at their soccer match and being closer to your family. Whatever the case is for you, you need to take a look at how retirement impacts the things that are important to you and can bring to light new revelations about your priorities.
Use Your Financial Advisor
With the myriad of changes that happen when you retire, it is important to know that you have someone on your side who can give you the best advice that aligns with your values, priorities, and goals for retirement and that person is your financial advisor.
They will be able to help you navigate the changes you want to make in your investment strategy to better reflect the season of life you are in now.
We love working with people to help them manage their wealth in a healthy and holistic way. Are you ready to take another look at how you can dedicate your portfolio to your future goals?
Give us a call! We can’t wait to speak with you.