Lots of people approach their investments in a way that pegs their entire financial future on how they view stock market volatility. In an attempt to avoid the risk that some of their investments might lose value, some people put their entire retirement nest egg into assets they perceive as being low risk. But without careful planning, this approach could lead to some disappointment down the road. Outliving your money might be a bigger risk than stock market volatility.
Asset Allocation and the Desire to Avoid Risk
Okay, this is serious. Research has shown that losing money can make you neurotic.1 No wonder people are risk averse. But risk comes with the territory. It’s in all investments and cannot be avoided. You can mitigate it. But sometimes, you just have to bite the bullet and accept it. Risk is necessary to earn a return.
Still, lots of people use risk tolerance as the sole basis for determining their portfolio’s asset allocation. They almost ignore the return part of the equation.
Now, there’s nothing wrong with including risk tolerance – your willingness to take investment risk or your desire to avoid it – as part of the portfolio planning process. Heck, if you can avoid investment risk and still achieve your financial goals, that’s great!
But in the absence of that monumentally important caveat, using risk tolerance as the sole determinant of your long-term investment structure is probably a bad idea.
What Does Risk Have to do With Your Lake House?
Understanding your risk tolerance is critical to helping you avoid unwelcomed and unnecessary investment risk. It definitely needs to be part of your investment planning. But it may be even more important to acknowledge the economic substance of your financial goals, beyond intangible expressions, like “I want a lake house.”
You want a lake house? Where? How big? On how much land? Now, the most important question. How much is that going to cost?
Understanding the economics of your consumption goals – the stuff you want to own or the legacy you want to leave behind – is a very concrete way to approach investment planning. It is actually better suited for the purpose.
This is because avoiding investment risk doesn’t help you identify – let alone quantify – anything. Estimating the future value of your consumption goals gives you a target that your investments must reach.
It’s pretty simple math after that.
A + B = C ?
A is your portfolio’s present value.
B is the expected return on your portfolio.
C is the future value of your consumption goals.
The question is, do A plus B actually equal C? If they do (or they exceed C), then the asset allocation that drives your portfolio’s expected return is on track – even if it’s configured with low-risk assets that deliver very low investment returns.
The important takeaway is that a low risk tolerance (hence low investment return) doesn’t necessarily mean you’ll outlive your money! But sometimes it might.
If A and B don’t add up to C, then either your risk tolerance or your consumption goals need to be realigned. An adjustment has to be made somewhere.
Either you’re going to have to reconfigure your portfolio to try to achieve a higher expected return (i.e., add more risky assets to it), or you’re going to have to ratchet down your consumption expectations. If neither of these options works for you, then you risk the very real possibility of outliving your money.
Don’t Outlive Your Money
Okay, we have a great tool to help you see if your investments are in line with your expectations. Use our Nest Egg Calculator to help determine what size your retirement portfolio should be. Call us at (800) 235-8396 if you need help.
1 Haocheng Wang, Jian Zhang, Limin Wang, Liu Shuyi, Emotion and Investment Returns: Situation and Personality as Moderators in a Stock Market, Social Behavior and Personality: an international journal, May 15, 2015.