Once we have made a calculation of the effect of good and bad outcomes, we need to think about how we’d react to these outcomes. That enables us to make a decision on our attitude to risk.
Eat well or sleep well? Most of us are probably somewhere between the ends of the spectrum. We’re not entirely risk-averse. Equally, we’re not willing to take enormous risk. What determines a sensible place in the spectrum?
Essentially, there are two kinds of considerations. One is financial and one is psychological.
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The financial aspect has to do with a comparison between your goals and your current situation.
The first thing is to check how much risk you need to take in order to achieve your goals. How high a return do you need? You might carry out this exercise with a financial professional, or – once it’s available – with the Personal Funded Ratio calculator.
Whatever the outcome of your exploration, it’s always helpful to look at this aspect long before you retire, when you really have a chance to do something different for a substantial amount of accumulation time, rather than leaving it until you’ve arrived at decumulation time and find that you wish you had started earlier.
Nevertheless, it’s the same financial projection exercise after retirement too, even though at that stage you no longer have postponing retirement as one of the options open to you.
The purpose of this financial exercise is to develop a range of choices, linking the goals you can choose from with the risks associated with them, that is, what might happen on the downside if the risks result in unfavorable outcomes.
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The psychological aspect is entirely subjective. Essentially, it is about saying in advance whether some pattern of outcomes will cause you to lose so much sleep that you reject that scenario. And there are two kinds of bad outcomes, one that takes place in the short term (think of this as the next year or two), and one that takes place in the long term.
The chances are that if you discuss this with financial professionals, they will talk to you solely in terms of the short term. They’ll use phrases like “how bumpy a ride you can live with.” Yes, that is relevant, if you’re the sort who loses sleep every time your investments lose value. And most of us are exactly like that. We’re afraid – particularly because we have no way of telling what will be the practical impact on our lifestyle, and so we fear the worst.
The way around that fear is to confront it soberly. You might, for example, make an estimate of the impact that an asset value fall of (say) 10% (or 20%, or whatever – perhaps a whole series of estimates) is likely to have on your lifestyle. You may find (at least, let’s hope this happens!) that the lifestyle impact is far less than you feared. In other words, that a 10% (or 20%, or whatever) fall in the value of your assets results in a substantially lower percentage reduction in your lifestyle income. There could be several reasons for this reduced lifestyle impact. For example, you may have a liquidity reserve fund that will carry you through a few years of spending, and therefore you don’t have to sell assets right after a market fall.
Even if that happens, you may still feel that asset value fluctuations are something you can’t sleep with. Fair enough. Now you know that your psychological risk tolerance is low, and you can make your choices accordingly. But if the education that comes from making lifestyle projections makes you tolerate a possible downside more easily, then the education has helped you increase your tolerance for short-term volatility.
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Even if you can sleep through short-term asset volatility, what you’re really after is some idea of what may be the long-term impact on your lifestyle. This long-term impact, in fact, comes not as a consequence of short-term volatility, but from long-term growth not being as high as you hoped for.
I regret that I don’t have room here to explain the distinction between this “deep risk” that long-term growth is inadequate, and “shallow risk” that the market is volatile in the short term – particularly as this is a distinction you may have to educate your financial professional about, as some behave as if they have not come across it. I can, however, refer you to William Bernstein’s gem of a little book, called “Deep Risk,” or to my FT Money column The Art of Investment, published on January 28, 2016 under the title “For retirement riches, you need to take risk” (but it’s inaccessible to non-subscribers to the FT).
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Two final comments.
One is that most people have a nervous first reaction to being asked whether they would rather eat well or sleep well. “Can’t we do both (ha, ha)?” And the answer is: yes, it may be possible. Guaranteeing both isn’t possible unless you have sufficient assets to buy a lifetime income annuity that provides sufficient ongoing income to support your desired lifestyle, and indexed to inflation. Above that level of assets, you do have the option of locking in your desired lifestyle, and while you’ll undoubtedly have other financial issues to ponder, your lifestyle won’t be one of them.
The other closing comment is to remind you that it’s possible to be too relaxed about the prospect of bearing risk. The thing is that risk, until it occurs, is only an intellectual concept. Yes, things may turn out worse than you hope for. The reality is almost certainly more painful than the concept. I’m reminded of my friend and colleague John Gillies who said memorably, after the global financial crisis, that we discovered that “Risk has a friend called Pain.” And the reality of Pain is going to be worse than the concept of Risk.
That reality tends to create a different set of emotions when asset prices take a dive. You tend to be frightened rather than calm and rational. The media will be preaching gloom and doom, telling you that the market hasn’t bottomed yet (no matter whether, in retrospect, it has or not). You may be tempted to bail out of the market. Only Warren Buffet will be on your side, reminding you that it’s a good time to buy.
Under those circumstances, it will be good to have done some simulations about what will be the effect on your lifestyle, because that’s the only reality that matters. It’ll help you steel yourself in the sure knowledge that your risk tolerance will be tested one day.
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Takeaway
Your risk tolerance depends partly on psychological and partly on financial factors. When considering your risk tolerance, think not in terms of how you react to a fall in market prices (which is likely to be highly emotional), but to how you react to the impact it has on your spending potential (which is a much more sober set of considerations).
4 Comments
I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.
Don, again, great comparisons. It is very difficult to sit down with private wealth individuals and determine what they consider risk (changes over time given the circumstances). My parents were born during WWI, grew up through the Depression, and my father served during WWII. Talk about life-changing events. Their definition of “risk” would be a lot different than what I might think of today. My parents took out a 20-year mortgage when they bought their home and paid it off in the 20 years — as their parents said, if the bank doesn’t hold your mortgage, they can’t foreclose. Today, sixty-year olds are taking out mortgages. Where my parents saw risk, the Baby-boomers don’t see it. The other difficulty: trying to determine what your “lifestyle” is going to be like 30 years in the future.
Most of what I read focuses on the impact on asset values and what would happen if the market declines by certain amounts. Assets provide two functions: 1) a source of value to provide some security in your later life, as well as a source to support living standards, if your income can’t; and 2) as an income-generator so asset draw-down is kept to minimum. I had one client that was worth $40MM. His income from these liquid assets was over a $1MM a year — more than enough to maintain his current and expected lifestyle. A decline of 20%, 30% or 40% in his asset base would not change the income generated from his base. Now, it would hurt on a psychological basis, and he might not sleep at night, however, his life style would not be interrupted. I really try and get private wealth clients to focus on the stability of income rather than the volatility of their asset base — as long as the income can support their lifestyle. If you live long enough, the asset base should come back.
Apologies — I published your comment and replied, and it didn’t appear. If it does appear later, you’ll find two replies that will at least (I hope) look very similar.
Thanks for sharing your wisdom and experience. A couple of thoughts … Yes, attitudes and views change over time. My family and friends laugh when I say “The parameters have changed,” and that therefore a reassessment makes sense … Even though lifestyle continuation isn’t an issue, the wealthy have other issues on which they have to make decisions. Distinguishing between what is easily sustainable and what isn’t, is a valuable service.
Forgive me, but I think you are confusing price with value. A 20% decline in the price of a publicly traded asset (e.g. stocks) does not equate to a 20% decline in value. Secondly, the assumption is that this decline in price will result in a reduction in lifestyle income. Not if you have played it smart. Price declines should have no impact on income if you have structured your investments appropriately.
Thanks for raising a subtle point, the potential difference between price and value. Let me explain my understanding (and I hope you’ll tell me if you see it differently). And then I’ll tell you why I deliberately avoided the issue, rather than confused it.
Assets have value. How much value? That’s a perception that varies from person to person, but most of the time, participants in a free market view the value within fairly narrow limits, and are prepared to trade at a price within those limits.
Sometimes (typically when market participants become emotional) the perception of value becomes volatile even when the factors that influence value are unchanged. At those times, the short-term trading price departs noticeably from long-term perceived value. (I’ve written a piece titled “Capital markets can’t possibly be efficient all the time,” but that’s a piece for enthusiasts rather than for the readership my website is aimed at. I mention it just to assure you that I don’t confuse price and value.)
Whether there’s that kind of departure, and how large it is, is a perception that also varies from person to person. For most people, most of the time, price is what signifies value. The difference becomes relevant only if you satisfy both of the following two conditions: (a) you’re pretty confident that there’s a difference, and your perception of value is right and the current market price is stupid; and (b) you don’t need to trade at the current stupid price and can wait for sanity to return.
My target readership doesn’t satisfy both of those conditions. That’s why I didn’t distinguish, in this post, between price and value. Remember, I’m assuming my readers aren’t expert (I say so, many times), certainly not expert enough to be confident that they’re right and the market is currently wrong. And risk, for them, hits home when they’re forced to trade at the current market price, and so for them it amounts to a genuine and permanent loss of value.
If you satisfy (a) and (b), good for you. If not, then a fall in price marks a fall in value.
And that’s why, in future posts, I’ll be showing exactly what you suggest, which is how to “play it smart,” how to structure your investments to reduce the chance that you’re forced to sell at a bad time. Bear with me while I cover simpler topics: you’re way ahead of my blog posts!