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.
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.
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.
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).
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.
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).
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.