C.A.N. You Handle It? Dialing in Your Investment Risk
Your risk tolerance can be boiled down into three words: capacity, attitude and need. Getting a grip on those concepts is the key to designing an appropriate portfolio for your retirement.
“In investing, what is comfortable is rarely profitable.” So says investment adviser to PIMCO, Robert Arnott.
While there’s certainly truth to this, most investors would be wise to consider just how uncomfortable they’re willing to be before the markets get rough. After all, an investment strategy that’s too uncomfortable may lead to abandonment of the strategy altogether, causing unnecessary losses and diminished confidence.
So much is said about “risk tolerance” in the investing community, but what does that even mean? How does one determine the amount and types of risk that are appropriate when building a portfolio? What works best for one investor may be wildly inappropriate for another, so let’s take a closer look at how to choose a portfolio that meets your objectives effectively and with minimal discomfort.
Consider three lenses through which to view investing risk: capacity, attitude and need — or C.A.N. for short.
Capacity measures your ability to experience declines in your portfolio without it having a devastating impact on your retirement lifestyle.
If an investor is young, they have the benefit of time to recover portfolio losses, while a person nearing retirement may not enjoy that same opportunity. Therefore, investing time horizon is a critical element in determining capacity for risk. Capacity can also be greater for an investor with a higher amount of discretionary assets. If a person is able to live their chosen lifestyle on $4,000 per month and has millions of dollars, they naturally have a greater risk capacity than a person with the same lifestyle and a $100,000 portfolio. Risk capacity, therefore, is often a function of time and available funds.
Attitude takes into account the emotional disposition of the investor. Attitude hinges more on worries than wallet size.
Back in 2008, energy investor and business magnate T. Boone Pickens was facing a $2 billion decline in his investments. When asked how he felt about it, he simply and confidently told 60 Minutes that he’d eventually “get the money back.”
This is an attitude that not all investors possess, and that’s OK. This is where we need to know ourselves.
Knee-jerk decision-making can potentially lead to insurmountable investing mistakes. Everyone is susceptible to buying high because of greed and selling low because of fear. Because a successful investing strategy requires patience and perseverance, taking stock of your attitude toward investing risk can literally pay big dividends over the long run.
Need requires us to determine how much income your portfolio will have to generate during retirement when employment paychecks are replaced with portfolio income.
Calculating need is much more of a math exercise than capacity and attitude. Simply put, what does it cost to live your life? Assigning a monthly cost to your lifestyle allows you and an adviser to plan the level of income that’s needed from your investments and income sources, whether through the use of pensions, Social Security, guaranteed income annuities or market-based investments like stocks and bonds. When you know your income need, the portfolio design can be tailored to satisfy your unique needs for a decades-long retirement.
When you approach retirement planning with the C.A.N. approach, you’re able to design an investment portfolio and income plan to allow you to meet your objectives, with a healthy attitude and well-thought-out game plan. Of course, life will be as dynamic in the future as it has been in the past, so adjustments will be necessary. By knowing who you are and what your objectives are, you’ll be much more likely to identify and implement the advice that’s best for you.
If you’re like most aspiring retirees I’ve met over the years, you’re asking yourself, “Do I have what it takes to invest and retire successfully?” With some thoughtful and prudent planning, you sure C.A.N.
Kim Franke-Folstad contributed to this article.