Investment Planning and Your Risk Tolerance
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!
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.
ask yourself these questions:
How much must the portfolio
grow to, to fulfill my goal?
How much am I willing to
commit to an investment plan, to achieve my goal?
When will I need this
investment, to fulfill my goal?
How do taxes on my
investments affect achieving my goal?
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.
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.
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.
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.)
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.
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.
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.
investment plan, with anticipated growth after taxes is looking like it
might come up short in meeting your goals, you have the following options:
Save more now. Change your current life
Adjust your goals. Lower your
expectations or future life style.
Create a less conservative investment
mix. More stocks, fewer fixed income investments like bonds and savings
Increase your current income (ok, work
harder!) to produce increased savings to meet investment needs in the