Understanding What Affects Your Risk Tolerance While Saving for RetirementSubmitted by JMB Financial Managers on September 17th, 2019
It is no surprise that any type of investing comes with some amount of risk. Understanding what affects your risk tolerance and how to manage it, especially when you’re saving for retirement, can help you be more successful in reaching your financial goals.
What is Risk Tolerance?
To truly understand what impacts your risk tolerance, you need to start with the basics, what is risk tolerance anyway? Risk tolerance can be pretty well summed up in the answer to one simple question: What is your ability to withstand short-term losses?
While some people can ride the ups and downs of the financial markets without a second thought, not everyone can do that. For some people market turbulence can cause great distress.
It is important to understand your response to market changes before you begin investing, which again brings us back to the question, what is your ability to withstand short-term losses? This question is at the core of every discussion on risk tolerance and is usually addressed by financial advisors and clients when they create an Investment Policy Statement (IPS) where they will also discuss long-term goals and returns.
Interested in learning what your risk score is? Fill out our free risk assessment questionnaire and find out your risk/return preferences in just five minutes!
Life Factors That Affect Your Risk Tolerance
Your Current Age
The first factor that affects your risk tolerance is age. As your get older you have fewer years until retirement which means you have less time to recoup market losses. Taking this into account, the amount of risk you take on should decrease as you near retirement. Many firms have created investments around this premise and you commonly find them in many employer-sponsored retirement plans.
Your Retirement Age
Do you know at what age you wish to retire? Your timeline to retirement sets the tone for your risk tolerance. If you’re sure you’ll begin dipping into your retirement funds in 2022, your lenience with risky investments should look very different than those that don’t need their retirement funds until the mid 2030s.
To speak in broad terms, your time horizon for any financial goal has an impact on your risk tolerance in investing toward it.
Market Factors That Affect Your Risk Tolerance
One common measurement of market risk is standard deviation which tracks the variance of an investment’s return from its average return during a given period. Adding and subtracting the standard deviation to an average return shows the range of returns that may be anticipated 67% of the time.
If an investment has a high standard deviation, it means that its returns have varied from the average more than one with a low standard deviation.
Beta weighs volatility versus the S&P 500, NASDAQ or other broad benchmark. The benchmark is given a value of 1, and an investment with a beta above 1 would show greater volatility than the benchmark. A 1.1 beta indicates an investment that in theory should move 10% more than the benchmark does. The problem with beta is that some investments have low correlation to the benchmark used.1
The impact of market risk is magnified when an investment portfolio lacks diversification. Have more eggs in more baskets promotes more insulation against market shocks.
As you age, liquidity risk can emerge quickly. Sometimes investments are made without realizing that they’re not easily accessible later on, the investment is illiquid. This becomes increasingly important to watch out for as you get closer to retirement, as the only way to turn these investments liquid is to pay a penalty. Taking that type of risk may be more than someone trying to save for retirement can handle.
This is not the measure of liquidity but the measure of tradability. If you can quickly sell an investment its marketability is lower. If you can’t sell it quickly, its marketability risk is higher. Some investors can’t tolerate investments that they can’t easily get in and out of.
This is the risk of your purchasing power lessening over time. When you invest in such a way that you can’t keep up with inflation, you lose ground economically. If yearly inflation increases to 3%, that means that a year from now, you will need $103 to buy what you bought for $100 a year earlier. In ten years, you will actually need $134.39 rather than $130 to buy what you bought a decade back because of compound inflation. Its effect is just like compound interest.2
Look at retirees with conservative portfolios featuring a plethora of fixed-income investments. In a world where stocks are returning 10% a year or better, their returns have been a fraction of that. In addition to the opportunity cost they are currently paying; they risk struggling economically if the pace of inflation quickly accelerates.
Understand Your Level of Risk Tolerance
Do you know what kinds of risk you feel comfortable assuming? This is the big-picture question, the one to whose answer defines your investment strategy for the future. Learn what your investment risk score is by taking our free 5-minute assessment below.
If you’re ready to discuss your retirement plans and how your risk tolerance affects those them, schedule a free consultation today.