There are standard narratives about investing that lead people to particular strategies. Risk, we’re told, infects all investments, and it is often viewed as potential injury or loss.
The Securities and Exchange Commission (SEC) says risk tolerance is your willingness to lose in order to gain: “Risk tolerance is your ability and willingness to lose some or all of your original investment in exchange for greater potential returns.“
The SEC goes on: “You’ve probably heard the phrase ‘no pain, no gain’ —those words come close to summing up the relationship between risk and reward. Don’t let anyone tell you otherwise: All investments involve some degree of risk. If you intend to purchases securities – such as stocks, bonds, or mutual funds – it’s important that you understand before you invest that you could lose some or all of your money.”
Is the SEC’s emphasis on loss a useful portrayal of risk?
A Better Way
The professional investment literature defines risk as variability, and for retirement investing, that seems a better approach. If you buy an investment, perhaps a stock mutual fund, for $50 per unit, then the price drops to $30 in a year, then shoots back up to $45 in the following year and to $65 in the year after that, you have purchased a risky investment.
Alternatively, if you buy an investment at $50 per unit and it goes to $51, then goes to $49, then to $51.50, you have a non-risky or conservative investment.
The first investment is riskier than the second regardless of when you sell or whether you realize a gain or loss.
Variability becomes especially important if you have specific times at which you liquidate a large part of your portfolio. You may be investing for your children’s college education or for a second home at retirement. The need for cash may be unanticipated: an auto accident or lawsuit. If the amount needed is a large part of your portfolio, you’re vulnerable to variability and may lose money if you sell when your investments are in a trough.
But if you use your investments to fund retirement, withdrawing a little each year to live on, variability or risk is arguably less important.
Stocks versus Bonds
Investors buy risky (variable) investments (stocks), because they offer greater returns in the long run. Bonds and other interest bearing investments have less risk (variability) but usually offer lower returns in the long run. (There’s debate now about whether bonds have become more risky: interest rates are expected to increase which will drive bond values down. But there are counter arguments as well. Still, if bonds trend slowly downward in value, their variability need not necessarily increase. More on this at a later time.)
A young person saving for retirement can expose the portfolio to substantial risk (variability) because the time period may be as much as 40 years until retirement, then 30 more years in retirement. That offers plenty of opportunity to take advantage of the long-term tendency of stocks to earn more than bonds.
As retirees age into their 80s and 90s, some advisers say even less risky portfolios are appropriate. That may not be wise advice, depending on the planned use of the money. If an old retiree has plenty of money relative to his lifestyle, then he probably will not be hurt by volatility and his estate may be larger for his heirs. But if he expects his investments to pay for the education of his grandchildren, most of whom will start college within a decade, then large amounts of risk are inappropriate.
Again, the prospect of selling a big chunk of a portfolio at one time gives rise to the vulnerability.
For retirement investing, perhaps the most vulnerable time is just before and just after retirement. That’s when people generally set their expectations of how much income they can extract from their portfolios each year in retirement. If the portfolio plummets in value at that time, retirees will either need to sharply reduce their anticipated withdrawals or substantially increase the probability of running out to money late in life. In the 15 or so years surrounding retirement, maybe five to ten years before and three to six years after, it would be prudent to have 40% to 60% of a portfolio in less variable investments.
When risk is viewed as variability instead of potential loss, then appropriate levels of risk relate naturally to the expected uses to which the investments will be put. Regardless of an investor’s age, if the investments will be needed for specific purchases at a particular time, then risk should be reduced. If instead the investments are intended for retirement when a little will be withdrawn every year, then large amounts of variability can be tolerated in the expectation that returns will be higher in the long run. The period surrounding retirement is the one time when a less variable portfolio is almost always appropriate.
[I’ve written little about retirement finance in the last nine months. (A guide to previous posts on finance is here.) Still, the topic is always forceful in the lives of retirees. In the upcoming months, I’ll try to write about finance in alternate weeks.]