Investment risk is good in that it accompanies greater long-term wealth but it is bad if investors sell during a downdraft. Stocks are riskier (more volatile) than bonds yet offer more long-term gain.
Should retirees dial back their risk exposure to, say, 30% stocks, as is sometimes recommended, or can they carry much more risk, perhaps up to 70% stocks? The answer follows their goals and plans.
Some common retirement goals or plans are listed in the nearby table.
Each element in the table exists in dozens of variations. For example, retirement itself may be gradual—a person retires and takes another less stressful or maybe part-time job. Significant health events may be sudden and unexpected, or they may accumulate gradually. Once one occurs, however, certain levels of spending may become unavoidable.
Other retirement goals are optional or flexible. Retirees with good pensions and Social Security may not need annual withdrawals; foreign travel may be postponed or scaled down to less expensive options; children can save their own money for a home; old cars can be replaced with pre-owned, less expensive models. The options are endless.
Some extremes are clear. Retirees free of expense obligations yet with large portfolios may carry significant risk in hopes of long-term gain for heirs. But retirees who still pay a mortgage, who want to buy a motor home after retirement or who have promised to pay tuition for two grandchildren starting college in a couple of years, may want only a small amount of risk.
Four relevant attributes of every goal or plan can help retirees sort through the options:
- Is the goal near in time, say within four or five years, or is it more distant?
- Is the goal certain in time? Will it occur at a specific time that cannot be easily advanced or postponed?
- Will the goal require a known, specific amount of money, or can it be funded at flexible levels?
- Is the amount a large part of the portfolio?
Spending plans that are near in time, certain at that time, and specific and large in amount should not be exposed to much investment risk. But plans that are more distant, flexible in time and/or amount, and relatively small, can be exposed to risk. That’s the general rule.
Consider retirees who commit to helping a grandchild through college that starts in three years and goes on for four more years. The event is near and certain in time, and may be a fixed and relatively large amount, like tuition at a university. If this commitment is a significant part of their portfolio, then they will want the needed money in low-risk investments.
But if the grandchild can work during college, has a good chance for a scholarship, can be funded by her parents, or is planning a career in a high-paying profession that may support student loans, then although the time may be certain, the amount may be flexible. In this case, the grandparents/retirees may expose the planned amount to more risk, hoping to catch an updraft before the event.
In yet other cases, the time may be flexible but the amount fairly certain. The cost of long-term care may be accurately estimated, especially if a person has a specific facility in mind, but the timing of the need could be uncertain. Retirees in good health in their early sixties may expose that part of their portfolio to reasonable risk.
And readers must remember that a general desire for long-term gain is always in the shadows. Investors for whom long-term gain is not a priority need not accept much risk.
Risk Tolerance Is Subjective
With a little effort, retirees can assess each of their retirement goals in these terms, coming up with an appropriate risk level for each, which can then be translated into a portfolio allocation between stocks, bonds, or other investments. In a future post I’ll describe a heuristic model that might help retirees through this translation.
The process is subjective, just as other risk assessments are subjective. Nevertheless, retirees who identify retirement goals or plans and assign the four attributes to each will be relating their portfolios to their chosen retirement paths. That can only build confidence in their abilities to manage their lives.