If you enjoy roller coasters, then perhaps you’ve enjoyed the last few days and months of the stock market. However, if you’re like many others, then watching the seesaw of events affect your portfolio could be causing you some sleepless nights. With the Christmas Eve drop and the after Christmas rebound of the market, now may be a great time to check your risk tolerance.
What exactly is risk tolerance? I know you've heard that term. In fact, you may have even taken an online assessment to help you determine your own risk tolerance. Simply put, risk tolerance for most people boils down to this:
"How much should you have in stocks versus how much should you have in bonds?"
Now, that’s the ultra-simple definition. Many times terms are interchangeable with equities, which are stocks, and fixed income, which are bonds. With that being said, there are a couple of misnomers out there when it comes to using the internet for guidance in this area.
Risk Tolerance Balance Calculations
When I did a search for a basic risk tolerance calculation formula, I found many times people suggesting crazy ways to determine the balance within a portfolio. Here’s an example, let’s say you determine 100 as the number of years you’ll live, then subtract your age. That would mean if you’re 60, then you’d take 100 - 60 to end up with 40... meaning you should have 40% of your investments wrapped up in stocks.
Here’s another method I read on the internet. It suggested whatever your age is, that's would be what you use to determine the amount you should have in stocks.
So, one method, you are getting 40% as the percent of stocks for your portfolio. Or the other method you should have 60% of your portfolio in stocks. Those are drastically different numbers you are playing with. Confused yet? As a financial advisor, neither one of those things makes sense to me.
To muddy the waters even more, yet another piece of advice I read suggested if you are wealthy that you should invest ultra conservatively. Does that mean like if you had a "gazillion" dollars that you don’t even need to invest anything? To that I’d ask, “If I don't have a lot of money, does that mean I should invest everything? Or should I invest nothing?”
Again, more confusing advice. After all, if I really want to be aggressive, I can just go down to the local convenience store and invest everything I own in lottery tickets? I mean, that's pretty aggressive, right?
The truth is none of those formulas make sense, and one of the biggest reasons why is they completely disregard a key factor—risk tolerance.
Let me explain this to you with a real-life example. We had a client that was 55-years old with roughly $500,000 in investment accounts. They come in and tell us they want to retire at age 65. Now, that tells us we have 10 years in order to get them to retirement. They told us, "Justin, I want to retire by that time with $100,000 a year in income." So they laid out their goal, which is fantastic. We can now help them determine what they need to do to make that a reality.
Realizing that we have roughly about 120 months in those 10 years, to get them to where they want to be we ran a few calculations. We knew they would receive roughly $25,000 a year in Social Security Benefits. That let us know that the number we're trying to pull from his retirement investment accounts was $75,000 a year. Add that amount with the $25,000 and he could reach his goal of $100,000 in yearly income.
However, the client then informed us, "I'm super, super, super conservative. I don't want to lose anything.” When we asked him to divulge the amount he was saving each month, I was expecting to hear $4,000 to $5,000 or $6000 a month. However, he tells us he is putting away $2000 a month.
I said, “Let’s run the math to see what rate of return we need to make off your current savings to get you to your goal.” So I ran a couple of scenarios and determined if we made a 7% return on our investments, then he would end up with $1.35 million. Additionally, with that bucket of money, we plan to pull out 4% a year for income. At that rate of return, all we could get was $54,000 a year. So if we add $54,000 to our Social Security Benefits of $25,000, it’s easy to see we are missing the $100,000 mark. That means if we're using this assumption, we need to earn more than 7%. We actually needed to get an ROI of 10% plus in order to get that client the $75,000 they need.
Now, I want you to think about this. The US Stock Market, the S&P 500 has averaged right about 10% for most of its existence. We all know that past performance is not indicative of future results. Whatever happened in the past is not a guarantee what's going happen in the future.
However, does it make a lot of sense for us to take a 55-year-old with only 10 years left and throw them 100% in stocks? See, that's where risk tolerance comes into play. So if I took a pure calculation method, to get them to $75,000 a year in income, then we need to invest pretty aggressively. Additionally, with only 10 years left and bull market that could be on the verge of turning into a bear at any given moment, that’s probably not one of the wisest things to do.
I already know they are über conservative, so they probably aren’t going for that. And if I’m investing based on that statement alone, then that’s not even at a 7% rate. That is actually way back here at a 2% and 3% rate of return. So what do we do?
Well, we build a portfolio, and we adjust the parameters. So essentially risk tolerance is no more than a guide to help you identify what your goals are and how you can best reach them. In this particular case, we ran a couple of different scenarios, and the client could increase their savings rate. So, instead of saving $2,000 a month, they could save $4,000. That allowed us to drop our rate of return back from 7% back to 4% or 5%. Now, not everybody can do that; not everyone can instantly double the amount of money they're saving for the next ten years of their life. However, this person could and helping them achieve their goals was really an easy fix.
So what happens if you can't double your savings rate? Well, you can change your goals. Maybe instead of age 65, we could’ve proposed that this individual wait till age 67 to retire. Just moving it back two years means we don't have to invest with the hope of earning an ROI of 10%. We can slide that rate back and invest more conservatively. Another thing we could do is we can change the $100,000 income assumption per year. We can say, "You know what? I know you want $100,000, but could you live off of $90,000 instead?”
So, risk tolerance is simply a measurement of what you want to accomplish in your life and the style portfolio you need to have in order to help you reach your goals. Where the misnomer is and the Internet cannot help you adjust the various parameters, such as increased savings, reducing future expenses, or extending the dates.
Let's run a different scenario. Let's say they had $1 million versus $500,000. At that point, they could be ultraconservative given all the parameters.
Your advisor is simply using risk tolerance as a method to look at the bigger picture and say, "You know what? Mr. Client, Mrs. Client, based on these parameters, I believe we can bring your risk down to this level. And I believe we can scale your portfolio back a little bit if you're willing to save a little bit more money." And that's all we did in this case. Now some people can't save the money so we get creative and start chaining the parameters all around.
Do you need help understanding your personal Risk Tolerance? Let's sit down and discuss it.
I hope that gives you an idea of how a professional would use your risk tolerance in making decisions. Your personal risk tolerance is simply looking at the percentage of stocks to bonds and how they best help you reach your goals. If you’re still not sure where your risk tolerance stands, contact us today.