Client Memo: What is Risk and How To Assess Your True Risk Tolerance

Real risk is simple—not enough cash when money is really needed—like running out of gas in the desert.  

- Charles Ellis  

We face countless risks in our everyday lives that we’ve learned, from a very young age, to manage.  Managing those day-to-day risks may seem like second nature to most by the time they are ‘seasoned adults.’   

When it comes to the stock market, risk can mean a lot of different things to different people. You may not realize it, but the word ‘risk’ is quite an ambiguous term and can carry many meanings.   

The standard definition for risk for an investor is the probability of losing your money.  Not the return on your capital, but the return OF your capital. 

For a bank or financial institution, the traditional measure of risk is the volatility or, in statistics parlance, standard deviation.  This is the amount the price or value of an asset moves in a given day relative to the index itself.   

If you recall from your statistics classes, standard deviation is a measure of fluctuation around the mean or average.  The theory goes, the move the price of an asset moves around, the move volatility and the less stability of that asset, making it more risky to hold. 

For financial advisors and the clients we serve, the main risk investors face is the risk of outliving their assets.  In the end, that is the only risk that really matters.  

When it comes to asset volatility in retirement, the real risk is that they are forced to sell low in order to fund retirement expenses, thereby permanently impairing their portfolios.  We have discussed this a lot with many clients over the years.  You may remember that from our ‘Calvin and Hobbes’ slide detailing sequence of returns risk – the risk that you have relatively poor returns during the early years of retirement. 

At Noble Wealth, we believe we focus on the risk far more than other advisors and certainly over the potential returns.  Our goal has always been to find the best returns per unit of risk while having adequate diversification measures in place. 

Today, that is through predictable income covering the majority of their expenses each month.  The logic is straightforward.  A retired individual with steady ‘paycheck income’ coming in each month has less of a chance of needing to sell assets at the worst possible time – when they have fallen in value. 

It also allows them the psychological cushion to stay invested and avoid emotional, fear-based decision-making.  We would call this a sleep well at night portfolio as the investor can feel the comfort of knowing that they have a synthetic paycheck coming in each month.    

A portfolio reliant on predictable income isn’t beholden to elusive capital gains which have zero predictability.   

That is us, doing our part.  Your part is simpler.  Keep a respectable withdrawal rate from your portfolio.  Your withdrawal rate is the percentage of your total portfolio assets that you withdraw on an annual basis.  For instance, if you take $5,000 from your portfolio each month, and your portfolio is worth $2,000,000, your withdrawal rate is 3.0% [$5,000*12/2,000,000].   

If we can generate most or all of that $5,000 each month from income rather than capital gains, that means you are never touching the principal – at least not when it isn’t an opportune time. 

A general rule of thumb is a 3.0% - 4.0% withdrawal rate is long-term sustainable.  I would argue that the number is actually slightly above that 4.0%, perhaps as high as 4.75% given where interest rates are today. 

Anything below 2.5% means that you are grossly underspending your retirement relative to your asset base.  That doesn’t mean you have to spend it – perhaps you don’t derive happiness from spending – it just means that you can spend it. 

To calculate your withdrawal rate, it is simply your annual spending assumption in your financial plan, minus any income from sources that is not your investment accounts (i.e. Social Security, pensions, rental income, annuities, etc) divided by your portfolio assets (page 8 of your plan).   

Today, we see most of our clients chronically underspend in their retirements, especially given the account value increases of the last few years.  Underspending is a form of risk mitigation – just like saving was during our working years. 

Most investors focus on downside movement in securities as their risk measure.  To a pension, a day trader, a long-term investor, a mutual fund portfolio manager, and a retiree, risk can be thought viewed to have very different meanings. 

For us, risk means not being able to do what you wanted to do in retirement because the assets aren’t there.  We will do our best to ensure that doesn’t happen. 

As always, we are here to answer any questions you may have. 

Sincerely, 

Mark J. Asaro, CFA 
Noble Wealth Management