Knowing Your Investment Risk is as Crucial as Knowing Your Return
Many retirees rely on their investments to generate part of the income that funds their lifestyle. Like Social Security, this portfolio income must be sustainable throughout their retirement and gradually increase over time to offset inflation. This is true even though most retirees usually have some flexibility in their yearly wants and needs and retirement spending tends to increase more slowly than overall inflation.
These ongoing withdrawals are best expressed as a percentage of the portfolio’s value; this is the withdrawal rate. Understandably, retirees want their withdrawal rate to be safe and sustainable. Here’s the risk: Their asset allocation may not be appropriate for the withdrawal rate they are asking their portfolio to sustain. And by the time they discover this, their lifestyle’s sustainability may be past its tipping point unless they make significant, and usually unwelcome, changes.
An analogy may help.
Think of your retirement income plan as a financial road trip to the end of your life with your desired lifestyle as the vehicle. Your portfolio’s size is the fuel in the tank, its performance is the engine’s output and your desired withdrawal rate is the desired speed. You likely have two goals for this journey: 1) Enjoy the ride; and 2) Arrive safely.
Of course, if the trip is too turbulent, enjoyment will suffer. However, if you don’t have enough fuel or the proper octane level for your desired speed, you won’t like it either. If the octane level is too high, you risk damaging the engine and leaving yourself stranded. If it’s too low, your speed may be too slow to enjoy the ride, or you may not reach your destination before running out of fuel. The octane level is your portfolio’s allocation to equities. If it is either too high or too low, it could be inappropriate to sustain the withdrawal rate you need for your desired lifestyle.
If you only think of risk as the short-term volatility of your investments, you aren’t considering the whole map of your financial journey. Given the withdrawal rate your desired income requires, your portfolio’s equity level may be either too high or too low. It’d be like the car breaking down just a few exits from your destination, or completely missing the exit and not noticing until you hit the border.
Either situation is a mistake that could put your retirement journey itself at risk. Therefore, having tools to measure risk are necessary. The best known risk measures include: Alpha, Beta, Standard Deviation, and Sharpe Ratio. Many popular services like Morningstar, Bloomberg, and Yahoo Finance can provide this data for mutual funds/portfolios. However, it does take some study to understand the significance of each measure. Certified Financial Planners (CFP’s) are trained to understand these measures.
Another method to help investors understand if their risk is appropriate would be good financial planning software. Some of today’s planning software can assess the statistical probability of your portfolio meeting your goals. The likelihood of not running out of money or leaving a certain inheritance can be determined. So just like having a trusted mechanic to keep your car driving safely, a qualified financial planner may help you reach your goals securely.