Risk Tolerance and Retirement Planning

The author points out that when planning for retirement, you must factor risk into potential returns in order to gain a full understanding when planning your investment portfolio.

Investments and planning for retirement are a daunting task and in this current economic climate, it is even more important than ever to have the necessary tools to make informed decisions.

If you are concerned that your current retirement plan may have too much risk or you are just plain tired of the fluctuations of the stock market and the risk associated with it, this article may provide you with some simple and straightforward guidance on how to navigate these turbulent times.

Let’s start with “the math” and explain the realities of loss.  If you have $100,000 invested into a mutual fund and that fund experiences a 20% loss, the resulting value on your next statement from the mutual fund company will show an account value of $80,000.

So, will a 20% gain get you back to even? No. Let’s crunch the numbers:

$80,000 x 20% = $16,000

$80,000 + $16,000 gain = $96,000 ($4,000 LESS than your original investment)

A 20% loss followed by a 20% gain does not get you your principle back.  In fact, to regain your original principal balance you will need to get a 25% return ($80,000 x 25% = $20,000; $80,000 + $20,000 = $100,000).

A recent Gallup poll indicated more and more American’s are worried about their investments.  As we get older, our investment time horizon gets less tolerant to market losses due to the amount of time it may take to get a significant double-digit return just to get back our own money.

Therefore, the best defense to market losses is often thought to be proper asset allocation and diversification but what exactly constitutes proper asset allocation?

Frequently investors think that they can reduce their risk through diversification.  As MorningStar suggests, they will invest their money among various asset classes in the stock market and feel adequately diversified.  Unfortunately, in today’s economic climate, all they really have done is purchase multiple funds all exposed to the same market risk that really does little to provide a cushion to the economic risks associated with investing in the market.

As a solution, many financial advisors take the traditional approach to reduce risk:  the old rule of thumb was to allocate your age to principal protected vehicles such as CD’s, Treasuries, EE Bonds, and Fixed Annuities.

By way of example, a 65 year old may put 65% of his retirement savings into one of the principle protected vehicles and the rest of their nest egg would be exposed to market fluctuations.

However, in a recent study from Putnam Institute, they put the old adage to test and they suggested that as you enter into retirement, no more than 5-25% of your assets be exposed to market risk if your goal is sustain your nest egg and the ability to make lifetime withdrawals.

Even Jim Cramer is quoted as saying:

“If you want to retire at sixty, I would put more than half of your retirement money in fixed income in your forties.  If you intend to work for years after sixty, I would put much less in those placeholders.  Your fifties begin the shift toward more fixed income.  And finally, in your sixties, unless, again, you keep working, fixed income should dominate.  Your opportunities to grow your money are now limited and the reward isn’t worth the risk.”

Source: Rick Bueter, The Great Wall Street Retirement Scam. May 2011.

Too often people make investments without clearly defining a goal for that investment.  The starting point is to understand the ultimate goal and then take the risk necessary to accomplish that goal.  Notice that it asks is the risk necessary.  That is different than what you may have experienced in the past where the question was “how much risk can you tolerate”.

As retirees near or enter into retirement, let caution take hold and review your diversification so that you don’t let a lifetime’s worth of savings be wiped out by a swift downturn in the market right before you need the money.

Michael Canet and his team at Prostatis Financial Advisors Group LLC have been providing comprehensive financial planning to their clients for more than 20 years. With a legal background in estate planning, a Masters Degree in taxation, and being a financial planner – Michael has the necessary skills to guide his clients into and through retirement by creating a simple-to-understand financial plan.