Notes on Risk Tolerance and Retirement
Published On: May 20, 2019
Written by: Ben Atwater and Matt Malick
This essay brings us to our final installment in our five-part retirement series. Thus far we’ve covered saving, spending, healthcare and income. Of course, all of these topics are interrelated. Risk tolerance, one’s ability to withstand market volatility, however, is the glue that binds together the areas we have covered. Without the proper portfolio to match your risk tolerance, you will not be able to stay invested in the market and, therefore, you won’t accomplish your retirement goals.
This essay is quite timely in that the market is yet again looking weak-kneed. Since February of 2018, the market has fallen into a pattern of slightly higher highs followed by corrections with the net result being a market that is flat (or worse) for more than 16 months.
Any period of market volatility brings to mind the potential for bad luck for those who retire right before a severe bear market. Such an event would not only test your savings, but your fortitude.
If markets fall substantially during your retirement (and they are bound to do so at least once), it’s more difficult to recoup losses because money is flowing out of your portfolio (to cover expenses). On the other hand, in your saving years, a bear market can actually prove opportunistic if you continue investing in a disciplined fashion when prices are depressed.
Investors at or nearing retirement, therefore, must be as concerned about risk as they are about return.
MoneyGuidePro, our financial planning software, allows us the ability to run a Monte Carlo Analysis. This is a statistical process of evaluating the probability of different outcomes by randomly selecting from historical market returns. The Monte Carlo Analysis estimates a “probability of success.” This is the percentage of projected market scenarios in which you achieve your goals.
Let us look at a generic scenario:
Mr. and Mrs. Livermore are 65 years old and recently retired, they each have $500,000 Rollover IRAs and a $500,000 joint brokerage account. Their combined Social Security at Full Retirement Age is about $50,000 per year and their annual after-tax spending, excluding healthcare, is $90,000. Finally, all of their various Medicare-related premiums and out-of-pocket expenses cost $10,671 annually. (All in today’s dollars.)
In the table below, you will see the different probabilities of success in this hypothetical client situation using MoneyGuidePro at various stock and bond allocations:
In this particular test case, it is striking to see how similar the probabilities are for a wide range of stock allocations from 35% stock on the conservative side to 85% stock on the aggressive side. In these tests, the probability of success was nearly identical. This is seemingly amazing when considering the difference in risk at a 35% stock versus an 85% stock portfolio.
Now, we will conduct a “Bear Market Test” for each of the three allocations. The Bear Market Test examines the risk to your plan if a historically severe bear market occurred this year, or shortly after retiring. For this test, MoneyGuidePro will select the Great Recession from November 2007 thru February 2009. This was the worst bear market for stocks since the Great Depression and it resulted in a loss of 50.95% for the Standard & Poor’s 500, peak to trough.
So, how does the above hypothetical scenario survive another bear market like the Great Recession?B
As you can see, being conservative has its benefits. If a severe bear market would occur in our hypothetical scenario and the client was invested at 35% stock, they would more than likely survive the drop and meet their retirement goals. Contrast this with an aggressive investor, whose retirement plan would need some substantial alterations given a severe bear market.
At this point in the economic cycle, where the U.S. economy is firing on all cylinders, it can be easy to lose sight of the unknown risks to markets. Nobody forecasts severe bear markets, but they happen and they happen quickly. It is only through hindsight, not foresight, that experts even identify the catalysts and causes, according to the work of Yale University economist Dr. Robert Shiller.
Identifying the level of least risk in which you can still meet your goals is a good exercise because preparation for the unknown is of vital importance – even if that means sacrificing some gains today for a more secure future, an oxymoron of sorts.
We believe we have generally pinpointed the proper allocation for each of our clients, whereby they are taking on enough risk to achieve their goals, but not too much risk whereby they can’t survive a typical market downturn.
When, at some point in the future, markets again severely slump, the key is to not panic and not be in a position where you need to liquidate stocks to support retirement. This is much harder than it sounds. When panic hits, everyone is tempted to sell.
As advisors, it’s our job to be sure you are prepared for the unexpected. Then, when the unexpected happens, it is our job to coach you to hold onto stocks, even when they seem like they will never recover.
Our most important job is to focus you on a disciplined framework for investing and to follow that framework through good and bad markets. Saving, spending, healthcare and income are very important to retirement planning, but poorly timed risk / return decisions can blow-up your retirement with a single bad decision, namely changing course at a market inflection point. This is the mistake that you must avoid because you can’t recover from it.
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