How Much Should the Middle-Income Household Risk in the Market?

Middle-income families often do not have the resources to employ financial advisors. Yahoo Finance states that middle-income households have an average of approximately $110,000 set aside for their retired years. Financial advisors and brokers at major firms like Merrill Lynch, Morgan Stanley, and UBS Paine Webber are looking for mega buck accounts—accounts with $250,000 or more to invest. Anything less is usually not worth their time. Less affluent investors may find an advisor willing to take them on, but odds are they will not get the attention that the larger accounts will.

Smaller accounts get short shrift whenever an advisor wants to upgrade his or her book of business, retires, or moves to another firm. The smaller accounts get assigned to other advisors frequently with little regard for the suitability of the match up, and clients end up working with a stranger.

Unless you have someone you know well and trust in a major brokerage firm or as an independent advisor, you may be better off directing your own investments and working with your full service bank or one of the direct marketing mutual fund companies like Fidelity or Vanguard. They will have the tools, and they will be organized to service your business very well.

A good financial advisor will keep a client from making emotional decisions that are self-defeating. An accurate assessment of an investor’s risk tolerance is basic to this effort and the construction of a portfolio. Risk tolerance helps determine the right asset allocation—the mix of stocks, bonds, alternative investments, and cash—and the selection of the individual investments within each of these classes.

Risk tolerance is very subjective. Know Thyself the ancient Greek admonished. But it is a tough job working all alone.

I found that most clients did not really understand money, or wealth, in and of itself. Too often, they saw it as dreams yet to be realized and lived. It didn’t matter that they had not planned how to spend it. The money was there. It was potential. The more money, the more potential. Potential was freedom, like a full tank of gas in the car. Or a wallet stuffed with cash. Go wherever you wanted and do whatever you wished.

Others saw money as a measure of their success—sometimes in their businesses or professions, and sometimes as human beings. Among my wealthiest clients, their portfolios no longer represented money at all. As money, it ceased being real to them once their accumulation reached a level greater than they could ever conceive of spending. Their monthly statements became a scoreboard. Higher totals meant that they were winning at something. Never mind that the something may never have been clearly defined.

Abraham Maslow established a model for understanding human nature that is dramatically applicable in understanding risk tolerance. Maslow sees human needs in a hierarchy arrayed in a pyramid. The lower needs form the base for human motivation, and they include such needs as food, shelter, clothing, and safety. As these needs are met, humans tend to focus more on the next higher level—social needs, which include the need to be accepted, to find community, to give and receive affection and love.

As a person finds acceptance from others, affirmation from the affection and love of close friends and sweethearts, he or she develops a better-defined sense of self and a degree of self-esteem. Self-esteem is Maslow’s second highest level. Without a clear image of the self and the respect and pride of self, a full realization of one’s potential and experiencing oneself as a unique person among many is limited. Maslow’s work is a major contribution to the understanding of human psychology, and I urge my readers to study his work on their own.

Middle-income households, by definition, have the resources to meet the basic needs of living each day. That said, the basic needs should never be put at risk for the sake of achieving some other goal. To a large extent, this is what happened in the recent housing crisis. Lower-income and middle-income families were encouraged to put the resources they needed to maintain the basic needs of the household at risk in the hopes of owning something that may have been beyond their means if traditional methods of evaluating their ability to pay had been used. Owning a larger home, or owning a home for the first time, was an appeal directed at their need for greater acceptance, for the approval of others and for an enhanced view of their own status. The attraction was very compelling but faulty in its conception and presentation by the government agencies, bankers and mortgagors.

The first line of defense must always be to protect the earning power of the portfolio to meet the basic needs of the household. This is even more true once retirement begins and the sources of income are finite and limited. No new automobile, new boat, second home, or Caribbean cruise is worth it, even as retirement draws near. These things are called luxuries for a reason. They are not necessities. At the same time, it can be important to review what a household is spending at the maintenance level to see if funds can be freed up for retirement savings.

Simplify! Simplify. Instead of three meals a day, eat two. –Henry David Thoreau. Squeezing the dollars needed to fund a retirement next egg is a matter of household budgeting and discipline. Perhaps it is something to be discussed later.

Important as self-understanding is in determining risk tolerance, it is only one leg of a bagged legged-racing team. Perhaps you seen those, or maybe even participated in a race. Two teammates stand side by side and allow the right leg of one to be bound to the left leg of the other by wrapping a burlap sack around both. Thus to compete, they must be coordinated in their effort as their pace will only equal the rate of the slower runner in the partnership. One free leg is the investor’s psychological make up; the second free leg is the external factors in the life of the investor.

External factors include the investor’s age, marital status, future plans, health, and career stage—to name the most obvious. Some external factors are beyond the investor’s ability to control, such as age, health, and career stage. Others are more or less discretionary. The factors that lie outside an investor’s control are the most critical to evaluating risk tolerance.

To illustrate the point, during the 1990’s, a major mutual fund firm recommended that investors put their money in an index and forget it. After all, the index always went up. History proved as much. When one of my very good friends died, I wanted to be of service to his widow. He had, however, left another in charge of his estate. My friend’s dying wishes were that the money he left for his widow remain in an index account regardless of any other consideration—he was that persuaded by the strategy his mutual fund company urged him to adopt.

What the advocates of investing in index funds overlooked in their presentations, of course, is that any index will lose value at times, whether the Dow Jones Index, the S&P, or the NASDAQ. The holder of an index fund, therefore, will lose money in down periods. When that happens, averages mean nothing. What matters is the investor’s age and stage of career. The investor may not have enough time for the index fund to regain what has been lost in the market down turn. Thus time becomes the most important variable. The amount of risk anyone can assume at any point is time should be determined by a formula that would call for the largest possible loss over the longest period of time measured against the investor’s current career stage and need for funds to maintain the basic needs of life during the time period.

Too illustrate. Assume the S&P 500 sustained a loss in the past of 40% and that it took 9 nears for it to regain the loss. Assume a retired investor has defined the minimum amount a portfolio must fund to meet the basic needs of the household. If at any point, the value of the index drops below the minimal amount to sustain the household, then the index is too risky an investment for the retiree to consider. Both the external and psychological factors are in the race on this one. Even if the retiree could stand the loss financially–could continue to meet the basic needs of the household, he or she may not be able to cope with seeing their nest egg reduced. The price of taking an inappropriate risk with the portfolio is then the retiree’s peace of mind. The dimensions of risk tolerance are very important, and I will deal with this subject in greater detail in later postings.

The older, retired investor, does not have the time to wait for the economy, and therefore an index fund, to recover. The investor who is months away from retirement, does not have the time for an index fund to come back to its average rate of return. My friend’s widow stuck with her husband’s dying wish. She saw his earnest efforts in providing for her reduced to half of what he intended because of the way the market performed after he died. The trustee of her husband’s estate, a man of enormous goodwill but limited investment experience, continued to counsel her that she should abide by her husband’s wishes. She returned to active full-time work to provide for her needs.

At any given point, what people know is not as important as what is not known.

In my next posting, I will explore both the psychological and external factors that make up the two legs of the three-legged race in developing a personal measure of risk tolerance. Both topics deserve more attention. Meanwhile, if you enjoy my postings, please consider the purchase of my novel, Deadly Portfolio: A Killing in Hedge Funds. It has earned five stars by reviewers on Amazon.com. You can learn more about it by using this link and going to the “About the Book” page of this web site.  Thanks for you interest and your comments.