Stressed Out Over the Market? Get a Measure of Your Tolerance for Risk.

NOTE: Risk tolerance is key to the design of any retirement plan. In earlier postings, readers were asked to complete the Flexible Retirement Planner (FRP) to find out how well their funds would hold up over their life expectancy, especially in supplementing their retirement incomes. Reading previous postings is important to understanding this article.

Putting market losses and gains in perspective is always important. Emotional turmoil inevitably increases when the absolute dollar amount of the loss is translated into other values.

“There goes our plans for a new car down the drain.”

Or, “No vacation for the next three years.”

Or, “We going to need to keep your mother with us, now. We’ll never come up with the money for the retirement home.”

Or, “Damn, a lot a good it did to work another year.”

Putting market losses and gains in perspective is important. Emotional turmoil always increases when the absolute dollar amount of the loss is translated into other values.

“There goes out new car down the drain.”

Or, “No vacation for the next three years.”

Or, “We going to need to keep your mother with us, now. We’ll never come up with the money for the retirement home.”

Or, “Damn, a lot a good it did to work another year.”

You may have been guilty of s statement like one of those above.  If you did, you may have been looking at things all wrong. Stay with the process we started a few posting back. There are other, more rational ways of taking setbacks in the market without breaking stride, and they will be the key to better decisions going forward in time.

A measure of risk tolerance is needed to complete the Flexible Retirement Planner (FRP). Risk tolerance is a highly personal concern and it is needed in selecting an appropriate asset allocation model.

In the previous post, the consideration of risk tolerance was divided into two major categories; namely, external factors and the psychological make up of the investor. External factors were further classified as either discretionary (subject to the investors control) or fixed (beyond the investor’s control).

Discretionary factors are taken into consideration by the FRP in a variety of ways and many have already been discussed. Life style, retirement date, retirement income from part-time jobs or jobs in the home, reducing monthly expenses and postponing the date withdrawals begin from the portfolio begin are all discretionary factors. The FRP demonstrates the impact of changes in these discretionary factors by increasing the likelihood of success of the plan.

Whenever alternative and supplemental sources of income can be found, the risk level can be increased. Reductions in monthly expenses can also allow a higher risk in the allocation. Higher risk allocations mean potentially higher returns. Whether these considerations are entertained seriously is a matter of the retiree’s goals and desires.

Non-discretionary external factors that are beyond the investor’s control include age, career stage, life expectancy, and health. Again, some simple rules apply.

Looking at age, a longer expectancy usually means that the risk level of the portfolio can be increased. Retirees often make the mistake of throttling back on their risk level when they have as much as another 20 to 25 years to live. Time is an ally. Time allows for longer compounding of returns, ample periods for recovering setbacks, and it is a mistake to inhibit the growth and earning power of the portfolio by choking down the risk level too much. You may have more dramatic ups and downs but you will earn more in the long run.

The reverse is also true. If time is limited because of the retiree’s health or life expectancy, or the portfolio will not benefit from a longer compounding period. When time is short, which means the length of an average market cycle of 3 to 4 years, portfolio allocation needs to be reduced to the lowest possible level that the FRP projects a favorable outcome to preserve capital.

The investor also has no control over market cycles. If the market is in a bull cycle, tending generally upward, the allocation can assume more risk. On the other hand, if the market is exhibiting a downward trend and a bear cycle is at work, the risk in the allocation needs to be reduced.

A discussion of market cycles is beyond the scope of this article. Many sources are available, nevertheless, to anyone who wants to get a reading of the prevailing market. Web sites, television broadcasts, and pod-casts routinely provide this information.

Time is money. When you are retired, money is time. The retiree must keep investing decisions as free of emotion as possible. One of the better ways to do that is to look at money as time. Another blog, The Finance Buff, made this point very clearly back in December 2008. They proposed a simple arithmetic formula for measuring risk tolerance. They labeled it the loss-to-income ratio.

Their loss-to-income ratio (LTI) is a quick diagnostic tool that measures the potential loss in a portfolio relative to the investor’s income. If the investor is still employed, income is considered equal to the investor’s salary. If the investor is retired, the income is the money needed for living expenses and taxes. The latter figure should equal what was entered on the FRP in the field “Annual Retirement Spending” less social security and less whatever was entered as “Annual Retirement Income” in the FPR. This can best illustrated with an example.

Assume that a retiree  a retirement portfolio of $110,000 is considering an an asset allocation with a standard deviation of 20%, a risky choice. Assume further that the retiree’s annual retirement income is $6,000 and social security equals $14,000. Finally, let’s recognize that the annual retirement spending (ARS) for the household is $35,000, which makes it necessary to withdraw $15,000 ($35,000-$14,000 in social security-$6,000 in retirement income) from reserves each year to fund the budget. To measure amount of risk the household can assume, work through following calculation:

Portfolio Total Value (TPV) of  …………………………..$110,000

Times the percent of loss (PML)………………………….        .20

Amount of market loss (AML) ……………………………    22,000

Annual Retirement Spending (ARS) Equals…………. 35,000

Less annual retirement income (ARI)…………………….  6,000

Less social security (SS)……………………………………….  14,000

Annual Withdrawal from Reserve (AWR)……………….15,000

Dividing AML by AWR…………………………………………..       1.47

The result of 1.47 represents the time in years that the household may not be able to meet expenses because of the largest loss indicated as possible by the standard deviation for the asset allocation, all other things being equal. If a plan is to run for 30 years, this loss represented in years is relatively inconsequential. A plan with only 5 years to run, is another matter.

A well designed plan will have a positive balance at the end of the life of the surviving spouse which usually represent the end of the plan. I know it would be great to have the last dollar go to the florist for the funeral bouquet, but that kind  of precision is not possible.  If the amount on hand projected at the end of the plan, as another measure, is greater than that loss, then the household has ample reserves.

If the plan runs out of money before the end point, the impact of the loss can be adjusted by changing other variables including the annual household spending amount or retirement income. If you decide to change the variables, it is better to return to the RFP and input the new figures.

Emotionally, it is much easier to cope with the loss of 4 months withdrawals from the portfolio in support of the budget than it is to look at the absolute naked loss of $33,000. But if we see money as time, a more manageable challenge draws into focus. Given the life expectancy of the retiree, a lot can happen to make up for that loss of time. Good portfolio management can help the recovery.

Losses are serious, of course, but nobody benefits from exaggerating their impact. Reactions like those depicted above drag anger, frustration, depression, and exasperation into the decision-making arena. Clear thinking then becomes all the more difficult.

If you run the FRP simulation to get a picture of how much the market loss will impact your plans, the FRP will pro rate the market loss over the period of the plan rather than isolate the amount of time the loss will be a problem. It is always a good idea, however, to run an FRP simulation whenever major changes occur in an investor’s situation.

Look for the next posting on risk tolerance that will explore the psychological side of investing and how as investors we often get in our own way.

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