Ralph Bovitz, CPA, PFS

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Investment Planning and Your Risk Tolerance

By Ralph Bovitz, CPA, PFS

     Attorneys about to invest for the first time, and those already investing, are often asked by investment advisers: “What’s your risk tolerance?”  What the adviser really wants to know is: “how much are you willing to lose before you can’t sleep at night!” 

      Most investors are not risk averse, they are loss averse. After all, you don’t ask yourself in a trial, “What is my risk of winning?”  You are more concerned about your risk of losing!

      Nevertheless, knowledge of your risk tolerance is needed before such advisers select any investments for you.  The adviser might help you answer the question by presenting a series of statements about investment risks and ask whether you strongly agree, agree, disagree or strongly disagree with the statements.  You’re scored with so-many points for each statement, depending upon your response. The total score determines if your risk tolerance is high, low or in-between.

      However, there is a more effective way for attorneys to create or adjust their portfolio than exploring their risk tolerance:  Determine the financial needs the portfolio must satisfy. 

      Specifically, ask yourself these questions: 

q       How much must the portfolio grow to, to fulfill my goal?

q       How much am I willing to commit to an investment plan, to achieve my goal?

q       When will I need this investment, to fulfill my goal?

q       How do taxes on my investments affect achieving my goal?

      Let’s address each of these questions, assuming, for example, the goal is accumulating enough money to have a comfortable retirement.   It will take some homework to determine how much you want to spend in retirement, to be happy, but that’s the first step.

      Now identify the amount of money you already have invested and the amount of money you are willing to save each year, until retirement, to achieve your retirement fund.  How much to save each year is a very difficult decision.  You don’t want to sacrifice living comfortably today, to live comfortably tomorrow.  And yet, you may have to or should sacrifice today to achieve your goal for tomorrow.  Keep in mind that saving a little more, over a longer period, will grow into a larger amount, due to compounding.

      The next step is determining when you need your retirement money.  Traditionally, you may need it at age 65.  Or, perhaps you seek early retirement, such as 55, or late retirement, say 70.  The age you need the money, less the age you are today is called your time horizon, in investment planning.  If you are age 40 and desire to retire at 65, your time horizon is 25 years.  If you are age 55 and desire to retire at 65, your time horizon is 10 years.

      To recap: determine your likely living expenses in retirement, determine how much your investment portfolio needs to be at retirement to provide an income for a comfortable life style, decide how much you are willing to save annually and how long you have before you need this money – your time horizon. 

      Let’s look at an illustration.  Assume a 40-year-old attorney, married, wishes to retire at 65.  For a couple, assume annual Social Security benefits of about $30,000.  The couple has little or no savings and will need about $51,000 annually from retirement investments, in addition to Social Security, to live comfortably; also assume a 5% rate of return on the investments, until retirement, a 25 year time horizon.  (Conservative financial planners have used an 8-10% return in constructing a portfolio these past years; the same planners are using 5% currently.)

      Considering these assumptions, annual savings should be about $15,000.  Changing one or more of these assumptions will affect the outcome.  For example, if you are willing to invest more in stocks, recognizing the added risk from stocks, the return might be higher, based on their historically superior returns, compared to money market accounts and bonds.  Then the annual savings required would be lower.  Conversely, investing more of your portfolio in lower earning savings accounts, compared to stocks, would require more annual savings, to achieve the same financial goal.

      Remember, if you invest too much in fixed income securities, you risk the loss from inflation.  If you invest too much in stocks, you can expect to experience the ups and downs of the stock market.  Stock volatility, those ups and downs, however, has been compensated by a higher return than savings accounts and bonds.  When investing in stocks, you must keep in mind that, over the years, stocks have produced the growth to offset inflation.  Of course, even among individual stocks and stock mutual funds, there is a wide range of conservative versus risky choices.     So, rather than quantifying your risk tolerance, focus on a goal for your investment plan and select a diversified portfolio of investments that are likely to achieve your goal.

      The final step in dealing with risk in your investment plan is taxes.  To what extent are your investments going to be taxed until you need them?  Ideally, if your employer has a retirement plan offering a good selection of investments, participate, especially if the employer matches your contributions.  Set up your own individual retirement accounts, if your employer does not provide a retirement plan or your income permits it.

      If your investment plan, with anticipated growth after taxes is looking like it might come up short in meeting your goals, you have the following options:

q       Save more now.  Change your current life style.

q       Adjust your goals.  Lower your expectations or future life style.

q       Create a less conservative investment mix.  More stocks, fewer fixed income investments like bonds and savings accounts.

q       Increase your current income (ok, work harder!) to produce increased savings to meet investment needs in the future.







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