Archives for October 2012

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How (and Why) to Assess Your Economic Risk Tolerance

Last week we talked about assessing your emotional risk tolerance. Today let’s talk a bit about assessing your economic risk tolerance and how to put that information to use.

When assessing your economic risk tolerance, there are several factors to consider. For example:

  • If you are not yet retired, how secure is your job (and your spouse’s job, if applicable)?
  • Do you have any large, uninsured risks (e.g., you’re self-employed and have no disability insurance)?
  • What percentage of your monthly expenses are (or will be) covered by a pension, lifetime annuity, or Social Security?
  • How large is your emergency fund (as measured in months of expenses)?
  • Do you have any debt?
  • If you are retired, how easily could you go back to work? And how willing would you be to do so?
  • If you had to, by what percentage could you immediately cut your monthly expenses?
  • If you had to, by what percentage could you cut your monthly expenses within the next several months (e.g., you rent and could not move tomorrow, but with three months of warning, you could move to a less expensive apartment)?
  • If you are not yet retired, how flexible are you with regard to your desired retirement age?

Putting Your Risk Tolerance Assessment to Use

In the accumulation stage, your economic risk tolerance is used in conjunction with your emotional risk tolerance to determine your asset allocation. This can be done as one combined process (see this worksheet from CFP Dylan Ross as one good example), or it can be looked at as two separate questions:

  • What is the highest stock allocation that your economic risk tolerance would allow?
  • What is the highest stock allocation that your emotional risk tolerance would allow?

…with your stock allocation ultimately being set to the lower of those two limits.

In retirement, your economic risk tolerance is still important for answering the asset allocation question, but it’s also used to answer two additional questions:

  1. How much of your portfolio will you annuitize?
  2. How much will you spend from (the non-annuitized portion of) your portfolio per year?

You see, in retirement, you can only reduce risk so far via asset allocation choices. If you have a very low risk tolerance (that is, you’re particularly concerned about running out of money), the highest-impact thing you can do is not to move more of your portfolio to bonds (which would still leave you exposed to longevity risk), but rather to annuitize more of your portfolio (thereby providing you with a source of lifetime income) — or simply spend less from your portfolio each year.

Investing Blog Roundup: Last Day for Free Book Download

Just a brief reminder before we get to our roundup: Today’s the last day to get a free download of the Kindle version of Social Security Made Simple — or to get a print copy for just $5. (Click here to see the book on Amazon.)

Thank you to everybody who has downloaded and/or purchased the book so far. And extra thanks go to those who took the time to write a review on Amazon or to share the book via email, Facebook, blogs, Twitter, etc. I very much appreciate that.

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Thanks for reading!

Risk Tolerance: Assessed Through Real World Experience

A reader writes in, asking:

“I graduated this spring and found a job this summer. I enrolled in the 401-k to get the match but didn’t originally spend time considering which funds to use. Now I’m rethinking that decision. Do you know of any websites that will help me figure out my risk tolerance? I think my risk tolerance is low, but everyone says it should be high because I’m young.”

As we’ve discussed before, risk tolerance is made up of an economic/financial component and an emotional/psychological component.

I think your economic risk tolerance can be reasonably assessed with a questionnaire (e.g., how secure is your job? How large is your emergency fund? Do you have any debt? Could you significantly cut your monthly expenses if you had to?).

But I’m very skeptical of most quizzes that try to assess your emotional risk tolerance. Most such quizes ask you to consider how you would react to contrived hypothetical investment scenarios. In my opinion, the only way to really know where your emotional risk tolerance stands is to examine your real-world investing experience:

  • How did you actually feel last time the market crashed? Were you panicked? Somewhat worried? Entirely calm?
  • And what did you actually do with your portfolio? Were you able to rebalance back into stocks exactly according to plan? Were you unable to rebalance, yet not so scared that you sold your stocks? Or did you sell all your stocks and move to cash?

What If You Have No Experience?

If you’re just getting started investing, you don’t know how high your emotional risk tolerance is. And that’s OK. In fact, it’s unavoidable.

My suggestion for people just getting started is to just pick something. You won’t get it exactly right, but that’s OK. When you’re just getting started, the impact of your savings rate absolutely dwarfs the impact of your asset allocation. You have time and can afford to either a) make a mistake due to bailing out of a too-aggressive allocation or b) miss out on some years of good stock returns due to having a too-conservative allocation.

And, one way or the other, you will learn. The important thing is to not forget what you learn. For example, if you find that you get skittish when the market gets scary, remember that feeling and keep it in mind when the market is doing well and you’re tempted to move your stock allocation upward.

(Important note: As a new investor, despite having little with which to assess your emotional risk tolerance, you have all the applicable information for assessing your economic risk tolerance. So be sure not to use an allocation that’s more aggressive than your economic risk tolerance would allow. For example, don’t put any money into stocks that you can’t afford to have fall by 50% in the near-term future.)

In his recent book The Ages of the Investor, after suggesting that young investors start with a 50/50 stock/bond allocation, William Bernstein wrote the following, which I think nicely sums up what I’m talking about here:

“The young investor’s first encounter with a significant market decline serves mainly to ascertain her true risk tolerance. Her responses to the decline define the policy allocation that takes her to age 45 or 50. Does she panic and sell? Then certainly her long-term policy allocation to stocks should be less than 50%. If she holds fast but does not have the stomach to buy more, then 50% is likely about right. And if she piles in, then I say, ‘God bless.’ Perhaps she can increase her policy allocation to stocks to 60% to 80%. The next few decades should allow her to test, adjust, and repeat the process at least a few more times.”

Book Announcement: Social Security Made Simple

Social Security benefits make up roughly 39% of the income of U.S. citizens age 65 or older. Unfortunately, many retirees make decisions regarding their Social Security benefits that cause them to miss out on tens of thousands of dollars over the course of their retirement. (For couples, it can even be a six-figure sum.)

As I’ve mentioned here and there over the last 18 months or so, I’ve been working on a book about Social Security for the …in 100 Pages or Less series to help people better understand how to get the most out of their Social Security benefits.

Today, that book is finally available. (Click here to see it on Amazon.)

Free for the Next 5 Days

To get things started with a bang — and to say “thank you” to everybody who reads this blog — the Kindle version will be free and the print version will be just $5 for the next 5 days (that is, through Friday 10/12/12).

Related note: There’s no need to own a Kindle to read a Kindle book. They can be read using free software on a regular PC or Mac.

What Topics Does the Book Cover?

The book is organized into four sections, each with four brief chapters. As you’ll probably notice if you’re a regular Oblivious Investor reader, many of the topics in the book have been explored in articles here on the blog.

Part 1 covers the basic rules:

  1. Qualifying for Retirement Benefits
  2. How Retirement Benefits Are Calculated
  3. Spousal Benefits
  4. Widow(er) Benefits

Part 2 takes a look at the rules for a handful of slightly less common situations:

  1. Social Security for Divorced Spouses
  2. Child Benefits
  3. Social Security with a Pension
  4. The Earnings Test

Part 3 discusses the question of when to start taking Social Security benefits:

  1. The Claiming Decision for Single People
  2. The Claiming Decision for Couples with One Working Spouse
  3. The Claiming Decision for Couples with Two Working Spouses
  4. Taking Social Security Early to Invest It

And Part 4 covers a few related planning topics:

  1. Checking Your Earnings Record
  2. How Social Security is Taxed (And How That Affects Tax Planning)
  3. Social Security and Asset Allocation
  4. Do-Over Options

I hope you find the book helpful.

Here’s the link to the book on Amazon.

Want to Learn More about Social Security? Pick Up a Copy of My Book:

Social Security cover Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less
Topics Covered in the Book:
  • How retirement benefits, spousal benefits, and widow(er) benefits are calculated,
  • How to decide the best age to claim your benefit,
  • How Social Security benefits are taxed and how that affects tax planning,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"An excellent review of various facts and decision-making components associated with the Social Security benefits. The book provides a lot of very useful information within small space."

How Delaying Social Security (or Annuitizing) Reduces Risk

This week, a reader wrote in with what I thought was a good observation:

“You wrote in a previous email/article that claiming Social Security at a later age lets people use a smaller withdrawal rate in the rest of their retirement. I understand that, but when I run the numbers for myself, the decrease in withdrawal rate is very small…measured in tenths of a percent in fact. Wouldn’t this have only a very small effect on our likelihood of running out of money?”

It’s true: In most cases, the reduction in withdrawal rate from delaying Social Security isn’t terribly large. Still, every little bit helps — even a small change in withdrawal rates (e.g., 3.75% rather than 4%) makes a difference in terms of probability of portfolio depletion.

More important, however, is the fact that delaying Social Security (or using a part of your portfolio to buy a lifetime annuity) makes the run-out-of-money scenarios not quite so bad. That’s because increasing your level of guaranteed income:

  • Usually makes it so that if you do run out of savings, it will happen later in retirement, and
  • Makes it so that if you do run out of savings, you’ll be left with more income.

Probability of Failure Isn’t Everything

When you use a calculator (or read a study) that uses probability of depleting your savings as its measure of risk, you’re only getting part of the story. To see what I’m talking about, consider two hypothetical investors, each of whom retired at age 62, hoping to spend $40,000 per year in retirement:

  1. Sally ends up depleting her portfolio 26 years into retirement, and she is left with $30,000 of Social Security and annuity income.
  2. Susie ends up depleting her portfolio 19 years into retirement, and she is left with $20,000 of Social Security and annuity income.

Both of these scenarios would be counted exactly the same way (i.e., as a “failure” outcome) in most retirement studies and calculators. But they’re obviously very different. Even though they both depleted their savings, Sally’s retirement is going to be far easier financially than Susie’s.

Unfortunately, there’s no obvious answer as to how best to measure retirement risk. Wade Pfau’s recent paper that we discussed here last week uses a good measurement in my opinion. For each allocation/strategy, Pfau runs a bunch of simulations, then calculates the “percentage of lifetime spending needs that go unsatisfied” in the 10th percentile outcome (that is, not quite the worst-case outcome, but still a pretty unlucky outcome).

Improving Bad Outcomes

Much of the financial risk in retirement is caused by the possibility of living a very long time. And delaying Social Security (and/or devoting part of your portfolio to a lifetime annuity) improves those live-a-long-time scenarios at the expense of the die-soon-after-retiring scenarios. That is, it improves the (financially) scary scenarios at the expense of the not-so-financially-scary scenarios.

Personally, that is a tradeoff I would be happy to make.

Want to Learn More about Social Security? Pick Up a Copy of My Book:

Social Security cover Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less
Topics Covered in the Book:
  • How retirement benefits, spousal benefits, and widow(er) benefits are calculated,
  • How to decide the best age to claim your benefit,
  • How Social Security benefits are taxed and how that affects tax planning,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"An excellent review of various facts and decision-making components associated with the Social Security benefits. The book provides a lot of very useful information within small space."

Socially Responsible Investing: Expect Lower Returns

A reader writes in, asking:

“Do you have any suggestions for people who want to invest in environmentally friendly companies? Are there any good mutual funds that do that? Or is it better to research companies/stocks one by one?”

If you really want to be careful about which companies you invest in, researching companies one-by-one certainly gives you the most control. The downside, of course, is that doing so takes a lot of time and leads to a far less diversified portfolio than you could have by using something like a “total stock market” index fund.

If you’re willing to give up some control, you could consider Vanguard’s FTSE Social Index Fund. The fund tracks the FTSE4Good US Select Index, which screens companies based on an assortment of social issues, including environmental ones. The fund owns 340 stocks, which is a heck of a lot more than a person could handle via individual stock picks.

That said, using such a fund for the stock portion of your portfolio certainly has its drawbacks:

  1. With 340 stocks, it’s meaningfully less diversified than a portfolio including both a “total U.S.” index fund and a “total international” index fund, which means you’d be taking on more risk for a given level of expected return, and
  2. Its 0.29% expense ratio is slightly more expensive than non-socially-responsible index funds. (It is, however, far less expensive than most socially responsible mutual funds.)

Lower Returns is the Goal

In addition, it’s worth noting that, if the goal of socially responsible investing is to drive cost of capital down for socially responsible companies, that’s the same thing as driving investment returns down for investors in socially responsible companies.

This is easier to understand if we think for a minute about bonds rather than stocks. Consider a socially responsible company (whatever that means to you) that is planning to expand, but which needs to raise capital to do so. The company decides to raise capital by issuing bonds. As a socially responsible investor, you like the idea of lending money to this company by buying its bonds. And your hope is that other socially responsible investors would make the same decision, thereby significantly increasing demand for the company’s bonds and allowing the company to get access to capital at a lower interest rate.

Well, that lower interest rate is not only a lower cost of capital for the company, it’s also a lower rate of return for people who buy the bonds.

And an analogous thing happens with stocks. If socially responsible investors are numerous/wealthy enough to succeed in materially increasing the demand for socially responsible stocks, investors will have to pay more for each dollar of socially responsible corporate earnings than for each dollar of socially irresponsible corporate earnings.

In other words, by attempting to help out socially responsible companies by giving them lower cost access to capital, you are intentionally seeking lower returns. Of course, depending on your goals, that might be a tradeoff you’re happy with.

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My new Social Security calculator (beta): Open Social Security