There’s a lot of change when retirement hits, and your investments might need adjusting as well.
But it’s not due to your goals changing, or hitting a certain phase of life, but more due to a change in risk.
To recap on an important topic - risk tolerance determines how aggressive your investments will be. If you have a low tolerance for risk, your investments will be conservative. If your risk tolerance is high, then your investments will be aggressive. Some key factors which make your risk tolerance aggressive is how long you have to invest money, when you’ll need to start withdrawing and how much you need to withdraw.
But when you retire, it’s almost like you’re coming to the end of your investing journey. You’re done saving and now is the time where you have to withdraw money so you can live. For many people this becomes a tough transition because they don’t want their investments to go down, as that means they’ll have less money to live on in the future. With that being said many people think that their risk tolerance goes down to adjust for this – but that’s not the case.
When we’re talking about risk, we’re actually talking about two factors. One is risk tolerance which we covered above, but another is risk capacity. Studies have shown that risk tolerance it’s fairly steady across your lifetime, but risk capacity it’s something that does fluctuate over time.
What is risk capacity and how will it affect my investments?
Risk capacity is how much risk you can take with your investments before the potential losses start affecting your financial goals. When you are young, your risk capacity is high. You can weather changing market conditions, changes in income, family adjustments and there’s still a good chance that you’ll end up having the retirement that you desire.
However, when you reach retirement, your risk capacity is lower because you don’t have time to save and earn more to counteract any negative market movements. This measure of risk – risk capacity - is dynamic as it changes throughout your life. Risk tolerance on the other hand is mostly static - it’s ingrained in your personality.
If risk capacity changes when you retire should I be changing my investments?
This is a traditional rule of thumb that when you enter retirement your investments become more conservative. Different advisers have different philosophies but mostly it pertains to reducing the volatility of the portfolio and making sure that it can create income to meet a retiree’s goals. It’s a fine balance - if the portfolio is too aggressive, the volatility will be too much to stomach as portfolio balances may wildly fluctuate. If the portfolio is too conservative, then it won’t be able to support the retirement income throughout retirement and you’ll run out of money.
Finding a balance between these things is important. Making sure your portfolio is taking enough risk to grow and sustain the amount of money you need to take form it, versus not having it be so aggressive that the changing account balances means you can’t sleep at night.
By using tools to measure risk tolerance and risk capacity, you can find a sweet spot in your portfolio. I use these tools when I work with clients and we find out their risk tolerance, risk capacity, and along with their goals, build portfolios that encompasses all three things. There’s not one-size-fits-all, but having a comprehensive financial plan in place helps you understand what risk you’re comfortable with and how much you need to take.
If you have questions as to whether your investments need changing as you approach or enter retirement, you can contact me here.