Daniel Satz, CFP®, MPAS® CRPC®, AWMA®
Do You Have Enough Risk in Your Portfolio?
Updated: Oct 28, 2021
Flying is an anxiety-inducing activity for many people. I admit I’m a nervous flyer myself. However, whenever I’m in a plane, I rely on facts and statistics to keep myself “grounded” and my anxiety in check. Plane crashes are horrific, but I reassure myself with the knowledge that 100,000 flights a day land safely at their destination and statistically, flying is the safest form of travel you can take. When the pilot warns us on the PA system that we’re headed into some turbulence, I know we’ll have a bumpy ride. What I don’t know is how long and how severe it will be, but ultimately, I know we will get to our destination safely, and we’ll get there a lot faster than if I had taken a bus, train or my car.
If you think about it, air travel is a great metaphor for investment risk. Some may think of stock market risk as wildly unpredictable due to the longstanding stockbroker mentality of picking individual stocks. However, when you engage in asset class investing and diversify your portfolio globally, your likelihood of suffering a total loss in any asset class holding is virtually nonexistent. Instead, we go through periods of volatility and market decline (i.e., turbulence), but ultimately, we get to our destination safely and successfully.
When it comes to one’s relationship with risk, no two clients are alike. That’s why we ask new clients to fill out a risk tolerance questionnaire when they come onboard with our firm. We use a variety of qualitative measures to understand how they have viewed risk throughout various stages in their lives. We also use a variety of quantitative tests that assess how they deal psychologically and emotionally with a wide range of market conditions. Contact me any time and I’ll be happy to tell you more about these assessment tools we use.
Essentially there are three types of risk when it comes to portfolio allocation that clients should consider. Let’s break them down one at a time:
1. Risk Tolerance is about how much volatility in your portfolio you are comfortable with emotionally. We find people’s inherent risk tolerance doesn’t change much throughout their lives until they approach retirement age. That’s when they no longer have a paycheck and must rely on their portfolio to meet their income needs. Clients sometimes ask me if they can take the risk assessment tests at different points in time when the market or economy are in better (or worse) shape. We prefer not to do this because the answers may indeed by swayed by those exogenous factors. That’s one of the reasons we provide qualitative risk assessment tests because they help us get an unbiased view of a person’s risk tolerance without asking questions directly related to current market conditions. The goal is to embrace the fact that we will endure many recessions and periods of extreme volatility during our lifetime and understand the best course of action is to take on as much risk as you can handle knowing you will remain seated, as there is no good place to go when this happens.
2. Risk Required is the type of risk that is needed in your portfolio at a minimum to ensure that you can reach your goals given the amount of assets you have in your portfolio. To determine your required amount of portfolio risk, we use a complex formula that considers several variables including how long you expect to live, what your monthly expenses are in retirement, major purchases you plan to encounter like weddings, second homes, boats, etc., travel goals, your sources of guaranteed income such as your pension or Social Security, and how much you have in your investment portfolio. We also consider which of your assets are qualified and which are non-qualified (taxable or non-taxable). This is important because all qualified money will be taxed at your ordinary income rate upon distribution. We run each of these variables against 1,000 different stock market simulations to determine the absolute minimum amount of risk you need in order to meet your retirement needs--without running out of money later in life. Even if your personal risk tolerance would place you in a more conservative model than your required risk threshold, it is imperative that you invest in a portfolio that at least meets the minimum amount of risk required to generate sufficient returns to prevent you from running out of money.
3. Risk Capacity. This describes the maximum amount of risk your portfolio can handle from a non-emotional, mathematical standpoint to reach your goals given the assets you must work with. NOTE: your risk capacity is not the same as your risk tolerance, which measures your emotional risk threshold. To determine your risk capacity, we use the same metrics that we use to determine your risk required. However, we push the risk level to the most aggressive portfolio you can sustain without impacting the likelihood that you will still reach your retirement goals during extreme market conditions. Your individual risk capacity is determined by calculating the point at which the amount of money remaining in your portfolio at the end of your retirement is maximized without reducing your probability of success. Typically, we find that our clients’ tolerance for risk is lower than their capacity for risk. Closing this gap is part of our job, and we do so by educating our clients and helping them reduce the emotional aspect of investing. Many of our longer client relationships no longer focus on the daily headlines or bear market conditions. These clients understand that these temporary storm clouds are a necessary part of long-term investing and the volatility these events produce was already taken into account when their financial plan was built.
Whether you’re flying or investing, severe turbulence is never comfortable experience. However, we need to engage in potentially risky activities such as flying and investing in equities, to lead a fulfilling life. Research consistently shows that flying is the safest way to travel and that investing in a globally diversified portfolio is the safest way to maximize long term growth in your portfolio.
Being more aggressive with your portfolio can provide more income and growth over time. Further, it will increase the likelihood that you’ll reach important financial goals such as having a comfortable retirement, traveling the world, and being able to gift generously to children, grandchildren, and the causes you believe in. If you or someone close to you has concerns about the longevity of their money or the risk level of their portfolio, please don’t hesitate to reach out. We’re happy to help.
DAN SATZ MS, CFP® is a Wealth Manager at Novi Wealth