In the previous blog entry, I discussed the importance of investment returns in partially offseting the effects of inflation. You can control the level of your investment return, in part, by how aggressively or conservatively you choose your investment options.
However, there is a catch. Historically we have seen that the more aggressively you invest, the greater your returns in the long-term. In this case, aggressive means that you invest in options that have both more growth potential, but also more downside risk. Aggressive investing can mean greater volatility. What is volatility? What you can expect is greater swings to the upside and the downside. In the great recession of 2008, aggressive investment would have meant a greater plunge in the value of your savings than if you have been more conservative. It could also mean a quicker recovery once the economy improved.
Conservative investing means that you take less risk in your investment choices. This leads to less volatility in the value of your savings. The gains are not as great, but the potential downside losses are also less. I you invested conservatively at the time of the 2008 recession, the value of your savings would not have dropped as much in comparision to more aggressive investments. However, the value of your savings would probably have risen slower once the economy recovered.
This is not to say that you couldn’t select investment options that have significant risks and low returns. On the other hand, some options may have relatively low risk and above average returns. It is important that you understand the risk – benefit relationship in the investment options that you select. However on average, greater risks mean greater long-term returns and lower risk means lower long-term returns.
Your Tolerance for Risk
So, what is the point of this discussion. I will make three points that are very important to your retirement finances:
- Investment returns on your retirement savings during your retirement will be one factor that affects how long your savings will last. That was my point in the last blog post.
- How aggressive you are willing to be in your investment strategy once you retire may affect those returns directly. However, an aggressive strategy carries significant downside risks along with the potential benefits. You must determine whether greater risk and volatility is worth the potentially greater gains or whether you would rather invest conservatively with more peace-of-mind, but lower growth. This is not an easy call.
- Your willingness or unwillingness to accept investment risks is a psychological factor and different for everyone. It is very important to understand your personal risk tolerance.
There are three levels of risk tolerance worthy noting:
- HIGH RISK TOLERANCE means the potential for large gains, but significant losses plus more volitility.
- MODERATE RISK TOLERANCE reduces the downside risk, but tends to limit the upside gains.
- LOW RISK TOLERANCE means you have minimized the chance for losses, but have also limited positive gains.
When investment professions recommend a retirement savings strategy, they often take your personal tolerance for risk into account. If you are the type of person who has a “don’t worry, be happy” mentality you might be a candidate for more aggressive investment choices. If, on the other hand, you are the type of person who ruminates over each small drop in the value of your investments – if you spend sleepless nights worried about your savings, you are probably a candidate for less risky investment options. With these choices come financial consequences.
Risk Tolerance Assessment Tools
There are several on- line tools that can help you make that assessment and give you advice about what this means for you. I have found two websites that are particularly useful:
This website asks a number of questions and provides a risk profile description based on your answer. Here is an example of the output:
Score 34 : Your risk tolerance is Moderate Investors in this risk category accept possible principal loss as a natural function of investment risk incurred in the pursuit of higher average annual total returns, typically ranging from 7% to 9%. The degree of risk is normally reduced through diversification and asset allocation as well as periodic revisions to rebalance any excesses that develop.
Wells Fargo Bank runs the second website. It is much simpler in terms of the number of questions that it asks to access your risk tolerance. However, as part of the output you receive an investment allocation recommendation. I found this to be particularly useful. The link to this website is:
Here is an example of the output from this assessment:
Of course, we all want to maximize our investment returns, but not at the cost of our mental health. Consider your risk tolerance as you plan for your retirement and incorporate the resulting expectations about potential returns into your retirement planning.