Before you stop work and start drawing on your hard-earned savings, investment risk is quite a simple thing to understand.
You want to get your portfolio to grow in value over the long run, and you have to work out how much of a bumpy ride you can stomach to maximise your returns.
When you stop work and start making withdrawals from your portfolio, it all gets a bit more complicated.
There are a few reasons for this:
It’s hard to work out what success looks like
Before you retired, you simply hoped that the value of your portfolio would be higher than it was the last time you looked and if it had fallen in value, that it hadn’t fallen by more than you were comfortable with.
When you start making withdrawals, it’s not so easy.
Some people will still want or need their portfolio to grow in value, even though they have been making withdrawals, some will want it to maintain its value, and others will be happy to accept a gradual reduction in the value of the portfolio.
What one person wants won’t be the same as the next person – and what people want changes throughout their retirement.
Objectives for retirees are more varied than they are for people who are saving up for retirement.
Some people will need their investment portfolio to cover their essential expenditure as well as their discretionary expenditure, mainly if they stop work before they start to get their state and defined benefit pensions.
Others will have guaranteed income which exceeds their essential outgoings and will use the withdrawals from their portfolios to pay for the nicer things in life.
In retirement, the success of the investment strategy needs to be measured by reference to the original objectives of the plan – so what one person thinks of as success could be regarded by another as a failure.
Retirement isn’t just one phase of life
Our requirements change as we move through the stages of retirement (Go: Go, Slow: Go, No: Go), with discretionary spending usually being at its most significant in the first phase.
Our experience of the first phase of retirement doesn’t always help us in step two.
You have experience of investing
When thinking about investment risk, you can draw on your past experiences – for example, how did you feel in the Banking Crisis when the FTSE All Share index lost 45% of its value, and then took three years to recover?
While this experience is generally pretty helpful, it’s essential to recognise that you might react very differently to a sharp fall when you are relying on your portfolio to pay the bills than when you were saving up for the future.
You might take a greater interest in your investments
Many of us would be more actively involved in our investments during our working lives…if only we had the time! But work, family etc. get in the way.
In retirement, you will have more time, as you won’t be working, and many people take a more active interest in their portfolios once they stop work.
This greater interest is sometimes linked to a reduction in your tolerance for risk – when you were working; you might not have had time to notice how much your retirement portfolio was going up and down in value!
Your financial literacy will decline
It’s been shown that financial literacy declines by 1% per year from the age of 60 onwards. This decline affects us all, and it’s daft to imagine that you can buck the trend.
Planning your investments and managing risk do become more difficult in retirement, but they will also feel more difficult to manage, the longer you live.
This phenomenon is only really experienced by retirees, and you must take this into account when considering your strategy to manage investment risk in retirement.
Capacity for Loss
Capacity for loss is the term used to describe how much money you can afford to lose from your portfolio.
We use it alongside your risk personality to work out how much risk you can afford to take. Sometimes you can’t afford to take as much risk as you would like to.
However, it takes the appliance of some technical knowledge to work out your capacity for loss in retirement as, to work out how much capital you can lose, you need to understand how a capital loss will affect your income; and this will depend on all sorts of things including your life expectancy and what you are spending the money on.
Almost all of the studies of safe withdrawal rates have been scientific, and assume that we take a rational approach to our finances, ignoring any emotional aspects.
They assume that we happily continue to spend our savings until the money runs out. I’ve yet to meet anybody that rational!
There is a figure which we all have in our heads, and when our savings reduce to that level, we start to feel uncomfortable. That figure will have more of an impact as we age, particularly if our portfolio declines in value (even if the decline is planned).
While it may not be rational for someone with a three-year life expectancy and annual portfolio withdrawals of £25,000 to insist that their portfolio remains above £150,000, it is perfectly reasonable, especially if it means that they can live the rest of their life without financial worries.
So, what’s the answer?
Over the next few weeks, I’ll be taking a look at how you should manage retirement investment risk, dealing with the issues I have raised in this post, along with a few others too.
If there are any issues you’d like me to look at, feel free to get in touch.