What type of investor are you? Are you conservative, moderate, or aggressive?
These qualitative descriptors are how most think of risk. But what is conservative to you may not be conservative to another.
Rather than using non-measurable descriptions of risk, your customized retirement plan needs to be the foundation to measure risk. A good retirement plan starts with carefully modeling your lifestyle goals, optimizing your income sources from Social Security and pensions, and stress-testing investments against your plan. Once this is done the three types of risk below can be more accurately discussed.
Required return is your need to take risk. Think of it as your hurdle rate to reach your goals. Fall short of what is required and you will have to make changes to not outlive your money.
The maxim risk and return are related should always be remembered. There is no silver bullet to tame stock market risk yet earn stock market returns. A higher required return generally means a higher level of risk even with proper investment planning.
Conversely, investing in “conservative” cash or bonds may be a safe way to go broke, if your hurdle rate is higher than what these types of investments can reasonably provide.
Risk capacity is your financial ability to take risk. If your plan has a low required return and low risk of not meeting your goals, then you have high risk capacity. The reverse is also true.
Stress-testing your retirement plan against hypothetical investment portfolios of increasing risk and expected returns will allow you to measure your risk capacity. Stress tests can be done in several ways. Often used is a simulated worst-case scenario – a 2008-like decline – and show how the decline will or will not affect your ability to meet your goals. If the decline does not impair your goals, then your plan likely has the capacity to take that level of risk. If, however, important lifestyle goals are not met in the stress test, your plan may not be able to support that level of risk.
After you have measured your required return and risk capacity, then you can transition to the qualitative or attitudinal aspects of risk – your tolerance or willingness to bear it. Investments may fall in value from time to time. Your risk tolerance describes your level of comfort in waiting through the downturns.
Risk tolerance can be measured with psychometric testing similar to statistically valid and reliable personality tests. Having hypothetical conversations or examining prior experiences and responses like “What did you do in 2008-09 when the stock market fell by 50%,” may also be helpful.
Jane is in her early 60s and recently became a widow. She receives a survivor pension and Social Security income that is more than what she needs each month. In addition, she has more than a million dollars saved.
Jane’s required return is low and her risk capacity is high. However, her husband handled their finances for decades. She has had modest financial experience and perceives the stock market and its volatility as risky. So while Jane could be more financially optimal in favoring riskier assets with higher return potential, she favors an investment portfolio with more bonds.
Lesson: start with your plan, math, and objectivity, but be pragmatic.
John is 65 and his retirement plan shows a net return of about 4% is required to meet his goals over time. While this may sound low, given today’s low interest rates, a 4% return is a near mathematical impossibility without taking stock market risk.
John is comfortable taking risk. Yet, his plan also shows that if he takes too much risk and experiences a 2008-type event early in retirement, that too will likely cause him to veer off course and require some cutbacks to his lifestyle goals. After all, he doesn’t want to outlive his money.
Lesson: you may require a minimum level of risk but may also have a maximum level you can reasonably bear even if you are emotionally comfortable bearing a higher risk level.
So put aside the conservative, moderate, and aggressive descriptors. Also, throw away most of the risk questionnaires you completed over the years. They’re often designed to provide legal protection to the company, agent or broker providing the product or used as a sales tool.
Rather, start with your plan, measure required return and risk capacity, and be pragmatic. Ensure the three types of risk are aligned to suit you and your financial life.