Risk and reward go hand in hand. Many people focus on the reward that can come from investing and lose focus when it comes to the chance of loss. All investments involve some degree of risk. It is important to understand the level of risk you are willing to take on, especially when you get close to retirement. In retirement, you are switching from accumulating money to withdrawing money. Understanding the inherent risk of your investments is essential in making sure you don’t outlive your money.
Risk tolerance factors
Risk tolerance is your ability to withstand losses to your investments. There are many factors that go into your personal risk tolerance.
Age is very important to risk tolerance. General guidelines are that the younger you are, the more you can risk. The closer you get to retirement, the more conservative you should become.
This makes sense, as when you are in your 20’s you should see your retirement money differently than you see it in your 50’s and 60’s since you are closer to actually using this money. The closer you get to needing to generate income from your investments, the more conservative you should be as you have less time to recover if there is a market crash.
There is a recent change to this common knowledge due to many more people living into their 80’s and 90’s. You used to plan for 15 years. Now it’s 30 years, or even more. The average life expectancy has increased significantly (you can calculate yours here).
Now, you need to make your money last much longer than you used to. That means not only making sure you are not being too risky close to retirement but also making sure you are being risky enough while young. If you are too conservative throughout your life, you also run the large risk of never making the returns you need to fund a longer life and retirement.
2. Savings Amount
Regardless of age, those with higher net worth can afford to be riskier. If you have more money to fall back on, you can put a larger portion of your money at risk. Look at your full portfolio and where you are going to be withdrawing money from in retirement.
Many people do not need all the money they have in investments to maintain their lifestyle. Usually, they are planning to leave this money to their beneficiaries. If this is the case for you, you can stand to be riskier with some of your money. You also might want to look at other vehicles, such as life insurance, that can better help you meet your legacy goals.
3. Comfort Level
Even if you are young and have millions, if you cannot stomach having an extremely risky portfolio, you shouldn’t do it. You want to make sure you can sleep at night and are not worried sick about a big loss in the market.
Make sure to assess your personal feelings towards risk and reward. If you are a very conservative person, there are investment vehicles for your money that allow you to participate in the upsides of the market without having to participate in the downsides. These are annuities.
Why you need a financial plan with risk tolerance analysis
The goal of financial planning is not to make you as much money as possible. It is to find out what you want to do in your life, calculate the amount of money you need to do this, and then choose an investment strategy that will get you there.
This is a balance. You do not have to be 100% aggressive or a 100% conservative with your investments. You need to make sure to have the right mixture for your financial situation, whether you have significant savings or not.
Our client Ross came to us in 2014 with a need to make sure he and his wife did not outlive their savings in retirement. Ross had managed his 401(k) himself, getting counsel from his buddies, research on the internet, and the goal maker program within his 401(k). At one point, he had over $400,000, but then the stock market crash of 2008 occurred. It was more than Ross could stomach since he was close to retirement. He converted his entire 401(k) to cash right away, missing the gains that would’ve come with the bull market that started in 2009 and continued.
Ross didn’t know he could lose this much this quick because he lacked a plan. We helped Ross come up with a plan for his money, one that would allow him to increase his savings while also knowing he could handle it if the market crashed again. We wanted to make sure he did not have to worry anymore about having an income, no matter what happened.
Examples of Risk Tolerance questions
When a client comes to us for financial planning, we have them fill out a risk tolerance questionnaire. Examples of questions include:
- What is the goal of your investments?
- Is protecting your money more important than high returns?
- How long do you expect this money to last?
We also give them financial scenarios and see how they would handle them. From there, we calculate the score and see where their risk tolerance lies. We use this score combined with their income needs to figure out where and how their money should be invested.
We look at your entire financial situation, not just your investments, to make sure your money is going to last you, no matter how long you live. The lesson here is that trying to time the market without professional help can put you in a bad situation. The closer you are to retirement, or if you’re already retired, the more important it is to evaluate your risk tolerance.