How much of your retirement savings can you afford to lose?
Investment risk and potential investment returns are closely linked to each other.
The more risk you take, the higher the potential return; sadly, it is only the potential return which is increased by taking more risk, and it is possible that taking more risk does not always lead to the desired performance.
It is highly unlikely, however, that a low-risk investment can produce a high return.
It isn’t possible to make an investment and take no risk at all; if you invest in a bank deposit, it’s likely the spending power of your investment will decline over time, due to the effect of inflation.
When you invest money, for any reason, you will need to choose how much risk you take, as opposed to whether you take any risk at all.
Before we design an investment portfolio with a client, there are two measures of risk that we need to agree upon:
-tolerance for risk
-capacity to accept losses.
Tolerance for risk is emotional – it’s about how much loss you are prepared to accept before you lose faith that the risks you have taken will pay off.
We often describe tolerance for risk as “risk personality”; like personality, it varies from one person to another and can change over time, but outside events or your mood shouldn’t influence it.
Tolerance for risk tells us how much you are prepared to lose to generate higher returns.
But it doesn’t tell us how much you can afford to lose.
Capacity to accept losses does tell us how much you can afford to lose, and it is an essential part of the design of any investment portfolio.
Unlike tolerance for risk, the capacity to accept losses is factual. Describing it in monetary or percentage terms should be possible.
It’s easy to describe capacity for some investment portfolios – for example when the portfolio is needed to pay one or more known lump sums in the future, such as part of an outstanding mortgage, or school fees.
But it isn’t easy to describe when the portfolio is needed to provide a regular income for an unspecified period – which is what is needed for retirement income.
Your capacity to accept losses for your retirement savings will depend upon some different factors:
-how much money you need to withdraw from your retirement savings every month
-the extent to which the withdrawals need to go up every year
-how long you (and your partner) live. You are unlikely to know the exact number of years in advance!
-what the withdrawals are paying for – essential expenditure like council tax and utility bills, or discretionary items, like holidays; or the extent to which the portfolio is funding both
Let’s consider two different individuals:
Stan is 65. He has retirement savings of £500,000 and needs to take an annual withdrawal of £20,000 to cover the cost of essential spending.
Olly is 90. He also has £500,000 in retirement savings, but only needs to withdraw £10,000, and that money is to cover discretionary items.
With these two extreme examples, it is easy to conclude that Olly can accept greater losses with his £500,000 of retirement savings.
After all, Olly is only expected to live for another six years, while Stan is supposed to be around for 21 more years.
And if Olly’s portfolio performs poorly, he can put off his discretionary spending, but Stan can’t put off paying his council tax and electricity bill until his portfolio recovers from a fall in value.
Next week, I will set out how we would calculate capacity for loss for the likes of Stan and Olly.
I promise not to make “another fine mess” of it.Unlike tolerance for risk, the capacity to accept losses is factual. Describing it in monetary or percentage terms should be possible. Click To Tweet