When I was young, I had a major dilemma. I could not decide if I was going to be a professional football, basketball, or baseball player. This was even before the two-sport stars like Deion Sanders and Bo Jackson proved you could play two professional sports. As the years went by, I earned many trophies such as Gentleman Athlete and the 110% club. It was years later before I learned that these awards were given to the athletes who tried the hardest but really weren’t stars.
I did have moderate success in high school athletics, but upon my graduation I realized something very telling to my life. After thousands of hours focused on my athletic endeavors, my grandest trophy of them all, the trophy standing three feet tall was, wait for it, Senior Class Outstanding Math Student. What a rally killer.
I realized that my path and God-given talents were not in the athletic realm, but instead in the world of numbers. Over the years I have discovered that numbers can be a great communication tool, even better than words, which brings us to our next topic. How to define your risk tolerance?
Investment advisors are generally required to ask you for your risk tolerance. Are you conservative, moderate, moderately aggressive, or aggressive? Over the years I have learned that people don’t understand these words, and people are aggressive when the markets do well, and they are scared senseless when they are down. I want a new model to discover risk tolerance, so let’s get back to my first language: numbers.
Based on prior chapters in this book, let’s assume an investor placed 5% of their retirement savings in cash, 10% in a basic fixed-index annuity, 10% in a fixed-index annuity, tied to stock and bond performance, 25% in a guaranteed lifetime withdrawal benefit (GLWB) product, 20% in bonds and 30% in the global stock market. What is this investor’s risk level?
Assuming bonds are flat, meaning they don’t lose value when the stock markets are down, this becomes a simple numbers problem to solve. Let’s say the stock market crashed 30% in a given year! How much would this portfolio lose?
We learned earlier that fixed-index annuities and GLWBs can’t lose value; cash can’t lose. When stocks are down, bonds are likely to gain, but we are assuming no change. This leaves the 25% in the stock market investment as the only asset that decreases in value. If this portion lost 30%, your loss would be 7.5% of your overall portfolio.
If this is too high, given a market crash, perhaps your investment strategy is too risky. If 7.5% is no big deal, perhaps you need to take on higher risk for the potential of higher return.
The point here is that it is possible to quantify the amount of risk you are taking given a market correction. Equally important is to determine the percentage increase of your portfolio given a market increase.
Let’s say the market increased 30% in a given year. Would you be okay with a 15% return knowing you were also protected against a devastating market drop? These are the critical questions when analyzing your personal risk tolerance. Also know that spouses rarely share the same tolerance for risk, and that needs to be taken into account.
It’s times like these that I’m happy I have a great big math trophy.