Reframing Investment Risk – TheStreet
By Zac Pohlenz, CFP
In my interactions with clients, perhaps the most discussed risk is volatility risk. More specifically, the risk of investments underperforming or going down in value significantly at the wrong time. Clients worry about the ill effects on their portfolio of a bear market or recession, and rightfully so. These events can pose a serious and legitimate risk to retirees.
Zac Pohlenz
However, while volatility risk certainly poses a legitimate risk to retirees, I believe many of us (clients and financial advisors alike) tend to give too much weight to this one particular type of risk. After all, it is not the only type of risk retirees face. I would argue that being too conservative in their investment allocation also poses a significant risk to retirees. To dig deeper into this, let’s consider how advisors typically combat investment risk in client portfolios.
To protect client assets from volatility risk, we generally have two main strategies to employ. The first strategy we can utilize is diversification, which in laymen’s terms is simply a way of saying “Don’t put all your eggs in one basket.” Diversification helps spread investments out across multiple business sectors and regions of the world. If a retiree’s portfolio consists of only XYZ stock, and XYZ company stock goes to $0, their portfolio goes down with it, plain and simple. On the other hand, if the portfolio holds pieces of hundreds of companies (including XYZ stock) spread out across multiple sectors and industries, the negative impact of XYZ stock falling to $0 is greatly limited. Many investors are familiar with the concept of diversification, so I won’t spend any more time on it.
The second strategy we can employ to protect client assets from volatility risk is choosing an appropriate risk target, given the client’s goals, time horizon, risk capacity, and risk tolerance. Risk capacity is an objective measure of a client’s ability to incur financial risk, whereas risk tolerance is the client’s subjective experience of risk. Part of my job as a financial planner is to help clients align their risk tolerance to their risk capacity through education and accountability.
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It is not uncommon to have a client whose risk tolerance is far lower than their true risk capacity. To put it differently, this client may be able to emotionally tolerate only a low level of risk, but the objective facts of their financial situation show that they have the capacity for a higher level of risk. The opposite of this can also be true. A client may desire a high level of risk in their investments, but the facts of their financial situation show that such a risk level is irresponsible.
The first type of client I mentioned above (lower risk tolerance, higher risk capacity) might believe that their overly conservative approach to investment risk is smart. They still have some of their assets in the stock market but experience less of the volatility. This is a win-win scenario, right? Perhaps, but there are real-life situations in which a client’s overly conservative investment approach can be detrimental to their long-term financial outlook. This risk of being too conservative in the investment allocation is a real risk, especially for retirees who rely on their portfolio for income throughout retirement. Let’s look at an example to illustrate this risk:
Bob is retired. Bob’s financial situation is simple. His only asset, other than his home, is an IRA worth $650,000. His only fixed retirement income is $1,800/month of Social Security benefits that he will receive for the rest of his life. Bob’s living costs total $4,000/month. This leaves a gap of $2,200/month that needs to be covered by his IRA. Bob is conservative and has a very low tolerance for market risk. Because of this fear of market volatility, Bob puts his entire $650,000 of retirement funds into a fixed investment, earning only 2% interest per year. Having his funds in the fixed investment makes Bob feel better, as he has a very low risk tolerance, but his true risk capacity is higher. By dodging one type of risk (excess volatility risk by being too aggressive with his investments), Bob is taking on a different type of risk that he is unaware of: the risk of being too conservative with his investments, which puts him in danger of spending down his assets too quickly. This is because his withdrawal rate of $2,200/month is much higher than the interest being earned on the fixed investment. In other words, Bob went too far to the conservative side of the spectrum of investment risk, and this poses a real risk of him depleting his retirement resources quickly.
This example has been simplified greatly to illustrate the concept, but the point still stands. I have personally run into real-life client situations similar to this hypothetical. Bob needs someone to help him align his risk tolerance (subjective feeling about risk) to his risk capacity (objective ability to take risk).
This is where a trusted financial advisor could coach Bob through his feelings of risk, help him weigh all the risks, and not focus solely on the risks posed by a volatile market. In Bob’s scenario, the advisor could help Bob transition out of the fixed investment, into a diversified portfolio of stocks and bonds tailored to Bob’s true risk capacity, while coaching Bob to align his risk tolerance to his true risk capacity. Doing so could be very beneficial to Bob’s long-term retirement outlook.
This is a balance retirees have to walk. They have to find the “sweet spot” somewhere between not taking enough risk and taking too much risk. It’s rarely as cut-and-dry as Bob’s example, but it’s important for retirees to be aware of all the types of investment risks, including the risk of being too conservative in investment allocation.
About the author: Zac Pohlenz, CFP®
Zac Pohlenz is a Wealth Advisor at Clayton Wealth Partners, a fee-only investment advisory firm in Topeka, Kansas. Zac works with clients from all walks of life, covering all facets of their financial lives. Zac’s areas of expertise include retirement planning for young professionals, employee and employer plan benefits, and estate planning
