“In matters of personal finance, retirement may be the single most important issue of our times.” Says Roger Shorr. Surprisingly, far too few individuals do any meaningful planning for their golden years. Contributing to a 401(k) or IRA is important, but you must do more to ensure a financially successful retirement. Most investors should be seeking professional assistance in the development, implementation and monitoring of their plans.
Planning is the essential first step toward building a comfortable retirement. Planning can not only help you determine the amount of risk you must take to achieve your goals, but it can also help you from taking on too much risk. As many investors know too well from the early 2000s’ bear market, excessive risk can be devastating. As a result of excessive risk taking in technology stocks and other speculative investments, many who might otherwise have retired are still working.
Let’s take a look at the important process of planning, with a special focus placed on risk.
Beginning With the End
In good planning, you must first quantify your goals, inventory your financial resources, get in touch with your risk tolerance and prioritize your objectives. For example, you should determine a certain dollar amount, time horizon for retirement income and the resources you have available to implement your plan. In other words, how much can you afford to save? How much do you want to save? How much risk are you comfortable with?
Your risk tolerance should never be taken lightly. In rising markets you might feel that you are aggressive, but in rapidly falling markets, you might feel that you are conservative. Therefore, any discussion of risk tolerance needs to be deliberate and you must carefully consider how you might react to highly volatile markets. One effective means of helping to identify risk tolerance is to review your behavior in the past. (Find out more in Personalizing Risk Toleranceand Determining Risk And The Risk Pyramid.)
With each of these items in place, you can calculate the return necessary to achieve your goals. These important steps can form the foundation of sound investment decision making.
Once your plan has been created, your goals identified and your risk tolerance measured, the next step is to develop your asset allocation strategy (or to have your existing asset allocation modified). The asset allocation must be consistent with your goals and risk tolerance. (For more insight, check out Five Things To Know About Asset Allocation.)
Essentially, asset allocation is how investments are divided between stocks, bonds and cash. It works on the modern portfolio theory that multiple asset classes can reduce the volatility of a portfolio. Within any given asset allocation, stocks are typically divided among small cap, mid cap and large cap, which can be growth, value or foreign. Bonds include government and corporate bonds of varying credit quality and maturities.
Proper asset allocation is the mechanism that can allow for the realization of your goals. It is a large part of plan implementation. In addition, asset allocation can help guard against at least one highly damaging investor behavior: panic selling.
The Plan and You
The planning process can uncover important information about you. By knowing what is needed to achieve your goals and understanding your risk tolerance, your asset allocation can be designed to offer an expected (not guaranteed) return of 10%. It enables your advisor to build a portfolio that has the ability to deliver the goal and has a good chance of staying within your risk tolerance. (For related reading, see Retire In Style.)
Retirement Plan Example
Assume that you want a retirement income from your investments to be $100,000 per year (in 2009 dollars) and to begin in the year 2019. You also want protection against an assumed rate of inflation of 2.5%. You assume your post-retirement rate of return to be 6%. And, finally, you want the income to last 30 years.
Now, let’s assume you have $605,000 in your 401(k) and $100,000 in your portfolio. You deposit $15,000 into your 401(k) each year and have a match of about $5,000. In addition, you invest $1,000 per month in your portfolio (assuming no future increases in investment or matched contributions).
To reach your goal, you will need to accumulate about $2.46 million. This will require you to earn about 10% per year. However, you have no other sources of retirement income (besides Social Security). You are willing to take some risk to reach your goals; but, if your account were to decline more than 20%, you would likely sell and move to cash.
Your portfolio can be designed to keep you comfortable enough to stay the course. The portfolio’s risk, meaning its standard deviation, can be measured to determine whether the portfolio is within an acceptable range for you.
The use of standard deviation as a means of measuring investment risk came from modern portfolio theory (MPT), which was pioneered by Dr. Harry Markowitz, a Nobel Memorial Prize-winning professor of economics. A portfolio’s standard deviation can change and does not offer guarantees; nevertheless, it can be a valuable tool in assisting a professional advisor to create suitable portfolios for clients.
The standard deviation can offer guidance as to the probability that returns will deviate from the expected or mean return and by how much they will deviate. This can best be seen by the use of a bell-shaped curve.
The following is a range of returns and the probability that they will occur for a portfolio in any given year:
|Range of Returns||Probability of Occurrence|
|10% and higher OR 10% and lower||50%|
|10 % to 26% OR -6% to 10%||47.5%|
|26% and higher OR -6% and lower||2.5%|
This asset allocation is diversified and, if it continues to produce its average return of 10%, the $2.46 million goal should be achievable. Third and finally, its standard deviation suggests a range of returns that does not expose the investor to excessive risk. While it is possible that the portfolio could lose more than 20%, it is more likely that it will stay in your comfort zone.
You may need to work with a financial planner to get a better understanding of standard deviation and how to get the above measures for your portfolio.
Don’t Just Hope for the Best
Taking a careful approach to designing your portfolio is far more effective than just investing and “hoping for the best” for several reasons.
First, it allows you to determine whether your goals are realistic. A realistic goal can be defined as one that is attainable within the parameters of one’s resources and risk tolerance. Had you needed a much higher return, it might have created an unacceptable risk (that is, a considerably higher standard deviation). Even worse, you might have decided to take that risk. This could have led to your being unable to tolerate substantial declines in your portfolio in a severe bear market, resulting in your selling out at the wrong time. Also, if your goals were determined to be unrealistic (such as wanting $160,000 per year during retirement), a more prudent approach would have been to determine whether you could save more or would be willing to consider a slightly lower income target.
Retirement planning is a very serious undertaking. The failure of retirement income from an inappropriately constructed portfolio is more likely to occur later in retirement than earlier. If that is the case, your ability to go out into the workforce is probably not an option and almost certainly not desirable.
Developing a plan, using a proper asset allocation with the appropriate risk parameters, and exercising proper behavior (patience and confidence) encompass investment principles that have stood the test of time. If you use this powerful approach, you may greatly increase your likelihood of achieving success and enjoying a financially secure retirement.
Final note: Remember, diversification does not eliminate market risk.