Almost everything in life worth having requires risk – that’s what they say, right? Whether it was moving somewhere to start a new job, starting your own business, starting a life with your significant other – at some point you must close your eyes and take the plunge.
In addition to the everyday risks, there are financial risks that must be considered as you approach retirement and ultimately retire. Part of navigating these risks is determining your risk tolerance and risk capacity, and then harmonizing them to achieve an effective financial plan.
What is Risk Tolerance?
According to Investopedia.com, “Risk tolerance is a measure of how much of a loss an investor is willing to endure within their portfolio” to achieve their goals. Simply put: if your portfolio experienced a major decrease in value, could you sleep at night? Even though history has taught us these periods of negative volatility are temporary and markets eventually recover, most investors have a “panic point,” and it is important to understand where that line is.
For better or worse, we all need some risk in our investment portfolios. If your assets aren’t growing at least at the rate of inflation, the real value of your portfolio is decreasing. Over a long enough timeline investment returns average out, but the market is notorious for wide swings up or down with very little notice. And the rules are different for retirees in “decumulation mode” who must take money out of their portfolios, regardless of the market’s direction, to pay the bills.
Risk tolerance lives primarily “between one’s ears.” As such, it’s largely a product of personal psychology and can be explained in part by behavioral economics. HCM has technology-based tools to assess one’s tolerance for risk. The relevant concept here is something called “loss aversion.” Loss aversion is the observed phenomenon that the pain of losing something is greater that the corresponding pleasure of gaining that same thing. Roughly speaking, it is thought that the pain of losing something is twice as large as the pleasure of gaining that same thing, although a number of personal and demographic features (gender, age, education, social class, employment status, income, and savings) can increase or decrease that ratio. This is important to consider when determining your risk tolerance. Logically, you might say that you can tolerate +/-10% swings in your portfolio’s value for the next few years, but in reality, your emotional tolerance for contraction, when it is actually happening, may not be as high as you think.
Risk Tolerance vs. Risk Capacity
While risk tolerance is determined by your personal feelings toward risk and reward with regards to your current wealth and the goals you’d like to accomplish, risk capacity is a more objective value. Risk capacity is the amount of risk that you can afford to take in order to reach your financial goals. Risk capacity is a constantly evolving value determined by your financial goals and your timeline for achieving them. In general, risk capacity is determined by comparing the present value of your future investment cash flows to the total value of your investments in the present. If you’re mid-career and still in the asset accumulation stage, your plan is to contribute to your asset base for the foreseeable future, meaning it should increase significantly, making your risk capacity higher. HCM’s planning tools also help clients evaluate their capacity to take on investment risk. As you get closer to retirement, your risk capacity starts to decrease, as the ratio of future increases to total current value begins to decline. After retirement, when you enter the decumulation stage, cash starts to flow in the opposite direction, further decreasing capacity for risk.
Risk Tolerance Factors
There are many factors to consider when determining your risk tolerance.
- Age and Life Stage: Younger people who have higher human capital values due to their remaining working years generally have a higher risk tolerance than people closer to retirement. This has to do with how a person’s risk capacity changes as they age: younger people have more time to earn income and invest toward retirement, increasing their ability to take investment risk. It also has a lot to do with the structure of the stock market. Over a long period of time, the stock market has historically provided a consistent positive return; however, that’s not how individual investors experience it on a daily basis. Missing just the best five days of the market over the past 40 years would decrease your returns by a third; missing the best 50 days would decrease it by over 90%. From 1957 to 2018 the S&P 500 has given annual returns of +30% four times, but it’s also yielded returns of less than -20% three times; if one of these slumps happened right before you retired (or while you’re in retirement), it could cause serious negative consequences for your financial future. This is why HCM maintains the HCM Safety Net™ for retirement-oriented planning clients. For someone with decades left in their career, this type of volatility is a small bump in the road.
- Net Worth: Defined as total assets minus total liabilities. Those with higher net worth relative to their income needs generally have a higher risk tolerance (and certainly have a larger risk capacity), as they have a bigger financial cushion to soften the impact of poorly performing markets.
- Amount of Risk Capital: Related to your net worth, risk capital is the amount of money you have that’s available to invest in volatile asset classes that won’t negatively affect your lifestyle if it declines in value for a period of time. It’s important not to overestimate the amount of risk capital you have; investing with money you need to pay foreseeable expenses can cause you to invest emotionally, leading to mistakes. Moreover, when that bill comes due, you could be forced to sell out of that temporarily depressed asset regardless of its potential to recover. This could result in booking a loss that one could have ridden out had you invested with true risk capital.
- Retirement Goals: When do you want to retire, and what kind of lifestyle do you want to live once you do? How many years do you plan on spending in retirement? Do you see yourself moving to a new locale, travelling the world, or keeping things the way they are? Do you expect your cost of living to increase or decrease? How much do you want to set aside for potential future healthcare needs? Mapping out the answers to these questions will help determine both your capacity and tolerance for risk.
- Personal Outlook and General Demeanor: Would you say you’re more of a glass-half-empty or half-full type of person? The point of investing for retirement is to be financially secure so that you are able to live a satisfying and fulfilling life. If your investment strategy works well on paper, but you are constantly nervous thinking about your finances, then it’s not delivering the quality of life you deserve. Investing isn’t just academic; it is very personal to you and the people around you. Make sure the investment risk you take on “feels” right.
Achieving Your Financial Goals
Hopefully, after having considered the factors outlined above, you now have a better sense of what your risk tolerance is. Think about how your risk tolerance and risk capacity compare to each other. If you have less risk tolerance than capacity, your investments may not be able to fund our maximum potential lifestyle. In this case, you may want to reevaluate your spending plans, reconsider your goals, or take an action that would increase your risk threshold. Conversely, if your risk tolerance is higher than your risk capacity, you might engage in excessive risk taking. It’s possible this could work out to your benefit, but the possibility exists that you could experience a market contraction and take a bigger loss than you can afford, jeopardizing your financial future. If this were to happen, make sure to reevaluate your circumstances, so that another such loss won’t endanger your plans for the future.
Be mindful of how your risk tolerance changes as you go from the accumulation phase of your investing life to the decumulation phase. While the goal during accumulation is to make sure you build enough wealth to live the retirement you’ve planned, the decumulation stage is where the rubber meets the road. Not only do you need to maintain a nest egg that can go the distance, but you must do that while drawing down your asset base to fund your retirement expenses. Adding this responsibility can alter one’s risk tolerance and capacity.
Our HCM Advisors have been helping people retire for decades and are well-versed in the complexities of changing intuitions and perceptions as you embark on retirement. Give us a call if you’d like to talk.
| Mike Hengehold, CPA/PFS MST RICP®
Mike is the Founder and President of HCM Wealth Advisors. Over the last 30 years, he’s provided financial planning guidance to a myriad of families to help them realize their financial dreams. Mike is an avid homebrewer and animal lover, and when he’s not at work you can often find him on the golf course working on his short game.