• Despite there being 5 distinct retirement risks, investment risk garners the most attention.
• The definition of investment risk varies, depending on investment portfolio construction.
• Three dimensions of risk must be considered: need, willingness, and ability.

What is Risk?  

The concept of risk as a whole is poorly understood, let alone managed, in the wealth management industry by most financial advisors. For starters, there are up to five distinct types of risk that need to be considered, measured, and managed. But, as is often the case, "risk" in the context of retirement planning usually pertains to investment risk. 

Investment risk is the most commonly thought of risk because it's the one that is most immediate and noticeable. What do you think of when you hear the term investment risk? Maybe flashing TV screens with red arrows or anxiety-inducing articles online?

What is Investment Risk?

Investment risk means that actual returns may differ from the expected return at any point in time. No one knows with certainty what the future holds, so we look to the past to observe how certain asset classes performed in order to get a better feel for the risk of any investment. 

By looking at each asset’s average return and how far that return has veered away from the average over time, we get a measure called standard deviation. Having this number can help you make a more reasonable long-term forecast of future expected returns.

Now let’s look at what this means in terms of the different assets you may be invested in such as stocks and bonds...

Stocks have a higher potential for return but also higher variability in the path of return. In contrast, bonds have lower return potential and less variability in the return path. 

The greater the allocation to stocks in your investment portfolio, the greater the expected return… and also, the higher the investment risk that you are taking. Some individuals can tolerate wider swings in their investment portfolios' performance in the search for higher returns, whereas others cannot comfortably stomach such swings.   

This is why it’s so important to understand your risk tolerance and create a portfolio that is aligned with that as well as your goals.    
 

Consider More than Your Asset Allocation

Advisors often explain investment risk as the volatility of return potential a portfolio presents.  Advisors are also consistent in trying to manage this risk by making an appropriate asset allocation decision between stocks and bonds.  

However, seldom is consideration ever given to the portfolio's actual construction.  How a portfolio obtains its stock and bond exposure matters a great deal when it comes to investment risk.  

As an extreme example to make the point, a portfolio whose stock exposure is made up of three large-cap stocks presents an entirely different investment risk profile than a portfolio with a single index fund representing the global stock market.

Why is that?

Because this portfolio has company-specific risks that have not been diversified away.  If one of these three companies were to go bankrupt due to unforeseen circumstances (i.e., Enron and General Motors), this portfolio would permanently lose a third of its stock value. Thus, the definition of investment risk as volatility of return potential is incorrect in the portfolio with just three stocks. Instead, the definition of investment risk in this portfolio would be a permanent loss. 

In the portfolio that holds a global stock index fund, the fund's value would decrease when times got tough. However, even if a few dozen companies went bankrupt, the fund's value would barely be affected.  

This is because all diversifiable company-specific risks have been diversified away.  

The definition of investment risk here is truly fluctuation of value at any point in time or volatility of return potential.

Although the example above may have been extreme, we routinely review portfolios that lack material potential exposures that increase the amount of investment risk a person faces given a certain asset allocation.  Having a maximally diversified portfolio at any given asset allocation level will make it less likely to experience the volatility that a portfolio with investment concentrations is expected to have.
 

Three Dimensions of Risk Evaluation

The other issue we often see is the over-simplification of the evaluation process to just tolerance.  The evaluation of investment risk (and all other risks) should consider three distinct dimensions.  It is not just a matter of whether someone can "stomach" return volatility.  Three dimensions must be considered and measured to make a proper evaluation:

1. Need: How much risk (i.e., stock exposure) is needed to achieve your goals.

2. Willingness: How much short-term market volatility can you tolerate before it starts affecting your sleep or makes you feel panicked to the point that you want to sell stocks after a market downturn?

3. Ability: Are you in a position to be able to take the risk you need to take?

Evaluation starts with understanding the amount of risk, or stock exposure, necessary to achieve your goals.  The rule of thumb is to take only the level of risk needed to meet your goals, though obviously, there is much more to consider.  

Your willingness to take on risk is known as your risk tolerance.  Your willingness measures how much volatility you can "stomach."  Once you understand your willingness to take a risk, you must check against your ability to take a risk.  

Your ability to take a risk is measured by looking at your situation to see if you have the resources and flexibility to take the risk without causing undue stress or harm.  Your ability to take on risk overrides your need and willingness to take a risk. 

Even if you are willing to take on more risk than you have the capacity for, you will be constrained by your risk capacity. You cannot bet what you cannot afford to lose.

Why Risk Management is Important in Your Portfolio

Proper risk management is a crucial aspect of retirement planning.  Risks represent the possible events that could occur and get in the way of you realizing your goals and living your best life in retirement.  

Risks are also what present you with feelings of fear. Please take the time to consider your feelings toward the five unique risks you will be subjected to in retirement.

 A proper retirement plan will seek to manage the risks you feel averse to so that you can feel at ease, thereby increasing the probability of staying on course with the plan.

As retirement planning specialists, we consider all threats to our clients’ financial goals and we strive to help reduce or eliminate them where possible. If you’d like us to help you prepare a retirement plan, you can get in touch with us here.