Making Sense of Risk Tolerance

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Earlier this week I had an interesting and constructive conversation with a potential client. He’s nearing retirement age with an investment portfolio valued just over $3 million. He’s using margin to leverage it up to $4 million worth of exposure to stocks, including a $1.8 million position in one company and $1 million position in another.

That’s pretty far from any strategy we would recommend to our clients, but some people thrive on risk and are not happy unless they have a chance for huge returns. If no one had that mentality, America wouldn’t be such a fantastic place. Still, based on this individual’s wants and needs, I feel pretty strongly the portfolio does not make sense for him no matter his appetite for risk.

How To Assess Your Risk Tolerance?

At some point, you’ve probably been asked what your risk tolerance is regarding investments. Risk tolerance is critical to constructing an appropriate portfolio for each individual, but the industry in general does a poor job of using it. The first problem is a lack of standard definitions. Being “Aggressive” or “Moderate” or an “8 out of 10” can mean very different things to different people. A second major problem associated with risk tolerance is inappropriate application of it. Your willingness to take risk is only part of the equation. Your objectives for taking risk are just as important as your stomach for it.

The key is finding the right combination of need, desire, and ability to take risk.  In the following two sections, I illustrate examples of how a 40-year old and a 60-year old answer these questions to come up with the appropriate risk level.

A 40-Year-Old Discovers She Needs a Moderately Aggressive Portfolio

Our first example is a 40-year-old woman with the following financial profile:

  • $400,000 invested for retirement
  • $120,000 annual spending
  • $20,000 annual saving

With this profile, she actually needs a fairly aggressive risk tolerance. Why? Assuming a 4% real return (after inflation), she is projected to retire at 63 with around $1.7 million. Also assuming $24,000 in Social Security, a modest 15% tax rate and a generic “4% withdrawal rate”, she will be able to spend roughly $82,000 per year in retirement. That may sound ok, but still represents a 30% reduction from her current spending rate, which may be tough. But wait, a 4% real return doesn’t sound aggressive. Historically it is not, but given current bond yields, you should expect to have to be quite aggressive to achieve a 4% real return.

Given her need for growth, her desire to come close to her current standard of living and her ability to take some risk given her long 20+ year investing horizon, at least a moderately aggressive portfolio is important.

A Retiree Discovers He Can Afford a Conservative Portfolio

Our second example is an individual who is 63 and retired with the following financial profile:

  • $1.7 million saved for retirement
  • $24,000 in income (Social Security)
  • Desired annual spending of $60,000 per year

Given his profile, his expected withdrawal rate is 2.5%. The math there is = (($60,000 – $24,000)*1.15)/$1,700,000 = 2.5%). The 1.15 represents a 15% generic tax rate on withdrawals.

A withdrawal rate under 3% is considered low. In this scenario, not only does he not need to take high risk, it would be foolish to do so unless spending more would provide significantly more happiness or leaving a large legacy is very important to him. A few bad years in an aggressive portfolio could raise the new expected withdrawal rate above 4%. For most people, it does not make sense to risk losing the game when they’ve already won.

Spending In Retirement

One thing I’ve learned is by the time most people reach retirement, they tend to be somewhat stuck in their ways regarding spending. Most retirees have a set level of spending that is very important to them to be able to maintain, but relatively few have a strong desire to significantly increase it. This isn’t always true, and there is absolutely nothing wrong with wanting to spend more money, but it simply isn’t a high priority for most people. This is usually not the case for younger people with rising incomes.

How much you want to spend has significant implications for using risk tolerance correctly. Specifically, risk tolerance must encompass a combination of both tolerance and objectives.

Getting Down To It: Identifying The Right Risk Level

In designing strategies for our client’s wealth, we’ve been careful to define risk levels using both risk tolerance and objectives. Using standard language helps us to stay on the same page as our clients. So first, I’ll share our definitions, and then I’ll share some data that can show how your portfolio’s risk compares to others. Here’s how we define risk tolerance:

How_to_Assess_Risk_ToleranceThe Real Trick: Designing a Portfolio to Reflect Your Risk

The step after identifying your risk tolerance is designing a portfolio that properly utilizes it – and that you will stick with.  It turns out, a mismatch between stated risk tolerance and portfolio design is widespread.  To see, we took a look at Personal Capital user data.

Using data from a large sample of those who have aggregated at least $50,000 of investable assets on our Dashboard and indicated their risk tolerance, here are average asset allocations for each risk group:

Personal_Capital_Portfolios

Hopefully these numbers provide some context about how you are investing relative to others who say they have the same risk tolerance. Please note these are not intended as recommendations of any kind, just an interesting reference point.

The trends in the sample are about what one may expect, but I was surprised to see the following:

  • The differences in average portfolios between risk levels are modest—even those who are Highest Growth actually only have about 80% in stock.
  • Cash is universally higher than we would recommend. There could be legitimate liquidity needs for this cash, but we are only looking at brokerage accounts here, and not including bank cash.

Also, while the averages look reasonable, there is huge dispersion within each group. For example, of those who say they have aggressive risk tolerance, 20% have less than 40% invested in stocks. As we said earlier, an aggressive risk tolerance doesn’t always mean you should have an aggressive asset allocation, but this kind of allocation likely signals some kind of disconnect.

In Sum, Selecting the Right Risk Level

Higher returns come with higher risk, and being too conservative over time can be just as big of a mistake as taking too much risk. Risk tolerance is an important, but often misunderstood aspect of investing. If you are going to lose sleep if market declines erase 30% of your liquid net worth, then you do not have an “aggressive” or “8 out of 10” risk tolerance. Then again, just because you can handle this kind of volatility doesn’t mean you necessarily should subject yourself to it.

Not sure about your asset allocation? Aggregate your assets on our free Financial Dashboard. You’ll find out in minutes.

Photo credit: Wikipedia

 

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Craig Birk, CFP®

Craig Birk, CFP®

Craig Birk is a member of the Personal Capital Advisors Investment Committee. He also serves as Vice President of Portfolio Management. Prior to Personal Capital Advisors, he was an integral leader within the portfolio management team at Fisher Investments. During Craig’s time there, the company increased assets under management from $1.5 billion under management to over $40 billion. His responsibilities included risk management, portfolio implementation oversight, and management of all securities and capital markets research analysts. Mr. Birk graduated from the University of California at San Diego and has earned the Certified Financial Planner® designation.
Craig Birk, CFP®

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2 comments

  1. Financial Samurai

    Craig,

    Nice article on risk tolerance. Categorizing risk with words seems a little arbitrary given we all have different definitions of risk.

    It’s always better to see what people DO with their money than what people SAY with their money. The chart with the examples of asset allocation is pretty fascinating.

    The chart looks much more conservative on every category than I would have thought.

    Sam

    Reply
  2. richard newman

    Thanks for youre article on risk tolerance. I am just where you’re second case is ,61 years old 1.7 portfolio. No debt , college and mortgage paid for. ss plus a pension , wife works. I have a very low risk profile now and all the planners i speak to tell me i need more risk. I refuse. Thanks for at least letting me know im in the ballpark. Rich

    Reply

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