So there I was sitting in my car, stuck on a shut-down freeway. In my quest to find out what caused this little debacle, I tuned into an AM radio station. While waiting for a traffic report, I got to hear the show’s guest speaker, a “financial advisor” of sorts, tell listeners all over Los Angeles that “if they can’t handle the stress of being in stocks, they should be in bonds and CDs.” If I didn’t already have an eye twitch condition, surely it was about to kick in.
If you asked me what I dread hearing from a person more than anything else (in the spirit of investing, that is), it’s the line “I’m a conservative investor.” Such a statement implies that the rules of investing should be associated with one’s personality type, and thousands of financial advisors perpetuate this myth by allowing a risk tolerance questionnaire to dictate a person’s portfolio allocation. For those who haven’t experienced such a document, it generally asks you to answer a series of questions in order to test your threshold for pain (volatility) and, in many cases, your knowledge of how markets work! Say what? So if you don’t know a lot about stock investing, you get a lower score? Firms love these forms because they can refer back to your answers in the event you later complain about modest losses. “See right here in question #4 Miss Johnson, you wrote that you could handle 20% losses and you’re only down 15%.” I guess Volvo drivers should buy Treasury bonds and snowboarders should buy gold. Oy.
It’s no secret that people get scared about losing their money. Behavioral finance experts often point out that people feel a greater level of stress with losses in their portfolios than any level of joy they could feel when their portfolios rise in value. There are two main fears of an investor. Fear #1: Volatility – Most people hate volatility and dream of a slow-and-steady rise with their investments. This is the fear that gets most of our attention (just tune into CNBC or read any business section if you have doubts). Fear #2: Running out of money before you die. Unfortunately, the latter is often ignored because it’s so far away, and it’s easy to just sweep it under the rug.
Once upon a time, a person’s nest egg and their social security existed to deliver income to a person who was expected to live for about 5 years following retirement. Now, a person who retires at age 65 has a decent chance of living 25 more years. Today, people can reasonably assume they won’t run out of money if they limit their withdrawals to about 4-5% of their nest egg once they retire. A typical young adult knows what inflation is intellectually, but has never directly felt its wrath (despite gas prices). If you think, for example, that a $2 million nest egg is sufficient, but you’re more than 20 years from needing the money, you will need closer to $4 million. Will a portfolio earning 2-3% get you there?
Let’s get back to fear. If your feelings and perceptions of risk are steering your portfolio decisions, there may be a very real risk that you will run out of money later, unless you are able to build up your nest egg in some other way (saving more, working longer). Before you rely on a risk tolerance form to determine your financial future, do the math to see what combination of saving and portfolio return is required to get you into the end zone safely. As a colleague once said, you can design a strategy that might fail, or one that is guaranteed to fail.