The common perception is that as you age, or more specifically as you approach retirement, you should reduce the risk in your investment portfolio. In most cases, this means reducing exposure to the stock market and increasing exposure to fixed income (i.e., bonds). The goal is to dampen the ups and downs with the understanding that the potential upside is limited.
The reason this reduction in risk often makes sense is straight forward: As one approaches retirement the time horizon gets shorter, which means the portfolio has less time to recover in the event of a market decline. Further, if one is drawing on their portfolio (which is usually the case in retirement) during a down-market, the returns necessary to get the portfolio back to even are even greater.
A great example of how this risk adjustment can be made overtime can be seen in the popular Target Date funds available in most company 401(k) plans. These mutual funds are actually set up to adjust risk automatically overtime, for a fee of course. Here is a helpful chart showing the changes to Vanguard’s Target date fund allocation over time. As you can see, the stock exposure is reduced as the “Target Date” approaches. Target Date funds are designed to adjust risk as the investor approaches a “Target” retirement year. The reason these types of funds are popular is because for a large percentage of the population it makes sense to reduce risk as they approach and ultimately move into retirement for the reasons mentioned above.
However, reducing risk is not the right solution for everyone. Ultimately, there are four factors that should affect the decision, and “what makes sense for most people” isn’t one of them. So what are the four factors?
1) Your financial objectives and goals
At Cordant, when we say “financial objectives and goals” we are talking about what our clients want to do with their wealth.
The investment portfolio you have accumulated is a resource (more on this in #2) and before you can determine the right amount of investment risk for that resource, you must identify its purpose so that the two can be aligned. Take, for example, two different employees of a corporation that both have $2MM in their portfolio and plan to retire in 5 years. If one employee has an objective to leave $1MM to her children when she’s 90, but the other just wants confidence she won’t run out of money before she dies, the acceptable risk for that resource is likely to differ greatly, all else being equal.
Your financial objectives and goals are the purpose for the resource you’ve accumulated. Before you make any adjustments to how that resource is invested, answer the question: What do I need this for?
2) The resources you have in place to support your objectives
Once you have identified your objectives, the next step in determining appropriate risk is to identify the resources you have in place to achieve them.
Your investment portfolio is likely not the only resource you have in place to support your objectives in retirement. You will likely have Social Security but in some cases, there may be real estate assets, a pension, an inheritance, etc. Anything that you would use to support your lifestyle should be accounted for. At the beginning of this post, I mentioned the danger of a down-market when you are drawing heavily on your portfolio, but if you have other resources on which you can draw in the event of a down-market, then protecting against that volatility could be much less important.
3) The likelihood your resources can support objectives and goals
If your resources can support your financial objectives and achieve your goals with investment gains, then you don’t need to take on any investment risk (of course this could mean that you have the ability to take on even more risk). But in most cases, some growth is necessary to meet one’s objectives. Bottomline, you need to determine the likelihood your resources can support you given different assumptions for return and volatility.
Generally, growth overtime comes with the tradeoff of short-term volatility. So the question to answer is how much volatility your resources can withstand and still have a high likelihood of meeting your needs. At Cordant, we use probability analysis to determine the likelihood that available resources can achieve a client’s objectives and goals based on historical risk and return assumptions (you can read more about how we do that here). Regardless of the methodology used, increased risk, will come with a greater range of outcomes and the bottom of that range is what is going to matter.
4) Your comfort with risk in retirement
For many, it just feels different when the income faucet is turned off. While it’s difficult to know for sure how you will feel about your investment risk when you are retired, most people I talk to have a sense for this. In some cases, they know they can withstand a great deal of risk while they are working, but once they have made the decision to retire, they know that market volatility (the fluctuations in the value of their resources) will keep them up at night. If anxiety over the day-to-day value of your assets is going to cost you sleep over the next 30 years, that matters! Even if you can afford to take on a great deal of risk in your portfolio and not run out of money, it may not be worth it.
There is no one-size-fits-all risk profile for any investor at any age, but there is a solution to solving for the right risk: identify and understand these four factors so you that can determine the right amount of risk for you. And if you need help, ask for it!