How do you decide how much investment risk you are comfortable taking in your portfolio? Many people start by taking an online risk-tolerance questionnaire from their advisor or brokerage firm—you know, the ones that ask a series of questions like, “Could you accept a 30% loss in a one-year period and still sleep at night?”…and then tell you how aggressive your approach should be and recommend your ideal stock-and-bond allocation.
It’s a quick, simple solution to figure out your willingness to take risk—but it is also very inaccurate, says Eric Amzalag, CPF, RICP, founder of Peak Financial Planning. Research from the CFA Institute found these questionnaires were highly unreliable in predicting how investors will behave during real-market corrections. Problem: Some investors think they have more appetite for risk than they really do, setting themselves up to panic and make poor investment choices like dumping stocks or funds they should hold long term. Other investors have such a fear of losses that they underestimate their risk tolerance and compromise their long-term returns by maintaining too conservative a portfolio.
There’s a saner, smarter way, says Amzalag. Rather than base your investment allocations on how much intestinal fortitude you think you can muster during down markets, your risk tolerance should instead be driven by facts—your time horizon…income stability…liquidity needs… goals…and lifestyle flexibility.
Here is how Amzalag helps his clients who are near or in retirement figure out their risk tolerance and improve their chances of maintaining their long-term investment plan through good times and bad.
First step, he says, is to ask yourself these three questions…
What can I control? You cannot control what the financial markets or the economy will do in the short term, so that is not an effective way to measure your risk tolerance.
The one thing you do have control of: Your goals and how much you plan to spend each year in retirement. Once you are clear on that, you can figure out the required return your portfolio will need to achieve based on how much you have saved and how much risk you need to take to get those returns. This will be different for everyone.
Example of a starting point: You have a $1 million portfolio and want to draw down $40,000, or 4%, a year. Extensive studies have shown that maintaining a portfolio of 50% stocks and 50% bonds and drawing down 4% a year results in a very high likelihood of your money lasting for the next 30 years. If that allocation feels too risky for you, you may need to revisit how much you plan to spend as a retiree.
Am I willing to make cuts to my spending during corrections and bear markets? Example: If your portfolio drops 30% in a year, you would need to draw down nearly 6% of your portfolio to achieve the $40,000 you need. That can push you to make rash changes to your portfolio, liquidate holdings and lock in losses before roller-coaster financial markets can recover. If you can’t make temporary cutbacks, you should reconsider how much risk you are taking.
Do I have the financial flexibility to draw from other sources in volatile markets? That would allow you to better withstand declines in the portfolio’s value and continue your current spending/lifestyle. Examples: Perhaps you keep a large amount of cash reserve or you have income from part-time work or non-financial investments such as real estate that you are willing to sell to make up for shortfalls. Maybe you can draw down the money you need from a Roth IRA so you won’t owe taxes on it.
Things to Keep in Mind
Big drops in the stock market can be unnerving and psychologically treacherous for any investor no matter how well-prepared you are. But if you can right-size the risk you are taking before trouble hits, you will be less prone to emotion-driven mistakes.
The advice is different for investors who have 20 or 30 years to go until retirement. Young investors have more than enough time to recover from market turbulence. What’s more, they likely have no idea what their annual spending will look like decades from now. So what can they control? How much they save for retirement. Down markets are ripe opportunities to continue contributing steadily to retirement accounts or, better yet, increase contributions.
