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How (and Why) to Assess Your Economic Risk Tolerance

Last week we talked about assessing your emotional risk tolerance. Today let’s talk a bit about assessing your economic risk tolerance and how to put that information to use.

When assessing your economic risk tolerance, there are several factors to consider. For example:

  • If you are not yet retired, how secure is your job (and your spouse’s job, if applicable)?
  • Do you have any large, uninsured risks (e.g., you’re self-employed and have no disability insurance)?
  • What percentage of your monthly expenses are (or will be) covered by a pension, lifetime annuity, or Social Security?
  • How large is your emergency fund (as measured in months of expenses)?
  • Do you have any debt?
  • If you are retired, how easily could you go back to work? And how willing would you be to do so?
  • If you had to, by what percentage could you immediately cut your monthly expenses?
  • If you had to, by what percentage could you cut your monthly expenses within the next several months (e.g., you rent and could not move tomorrow, but with three months of warning, you could move to a less expensive apartment)?
  • If you are not yet retired, how flexible are you with regard to your desired retirement age?

Putting Your Risk Tolerance Assessment to Use

In the accumulation stage, your economic risk tolerance is used in conjunction with your emotional risk tolerance to determine your asset allocation. This can be done as one combined process (see this worksheet from CFP Dylan Ross as one good example), or it can be looked at as two separate questions:

  • What is the highest stock allocation that your economic risk tolerance would allow?
  • What is the highest stock allocation that your emotional risk tolerance would allow?

…with your stock allocation ultimately being set to the lower of those two limits.

In retirement, your economic risk tolerance is still important for answering the asset allocation question, but it’s also used to answer two additional questions:

  1. How much of your portfolio will you annuitize?
  2. How much will you spend from (the non-annuitized portion of) your portfolio per year?

You see, in retirement, you can only reduce risk so far via asset allocation choices. If you have a very low risk tolerance (that is, you’re particularly concerned about running out of money), the highest-impact thing you can do is not to move more of your portfolio to bonds (which would still leave you exposed to longevity risk), but rather to annuitize more of your portfolio (thereby providing you with a source of lifetime income) — or simply spend less from your portfolio each year.

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Comments

  1. Personally, up until recently, I was unsure of how to account for my pension and social security in my retirement planning (I am retired). I was figuring those as incoming cash flows and basing my desired investment returns on the net cash flow considering that income and expenses. I still do that but had little idea how this should affect the asset allocation of my investments. I therefore picked a fairly safe (low risk) AA of 60/40 bonds/stocks.

    Now to risk tolerance …

    After looking at Wade Pfau’s study (http://www.obliviousinvestor.com/retirees-should-you-get-rid-of-your-bonds/) on the affect of annuities on the Efficient Frontier, and realizing that a pension and social security are both annuities, I realized I could be significantly more aggressive in my equity allocation. In other words, looking at annuities as a component of asset allocation let me realize I had been over-estimating my overall risk exposure.

    Still being unsure of my complete understanding of Pfau’s paper, and still not sure if he is going to amend his conclusions (it appears that his study is preliminary), and heeding your comments at the end of your article linked above, I continue to hold bonds but now at about the 35% level. I feel the risk I now am exposed to is actually much closer to the exposure I originally thought I had. So, by “correcting” my risk exposure I now have a much higher expected return.

    Mike, your pointers to, and especially summaries of, recent investment thinking are of great help to me and I am sure many others. Thanks.

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