Understanding Risk

Most people who are new to investing have no appreciation of their risk tolerance. They glance at decades of history. They see spectacular growth from beginning to end without looking at the middle. They don’t pay attention to the shorter periods in which we live. They don’t appreciate what it is like to see your portfolio’s balance fall in half.

You have to live through it.

When it comes to retirement planning, everything is magnified. Very few of us are comfortable with large downward fluctuations. Such fluctuations occur frequently in the stock market.

Stock prices always recover. Eventually. But it can take longer than two decades for stock prices to recover after adjusting for inflation. If your dividends are high enough or if you are dollar cost averaging to accumulate stocks, this is fine. If you are already retired or close to being retired and need to sell stocks, it is not.

I calculate three rates, which I call the Calculated Rate, the High Risk Rate and the Safe Withdrawal Rate. The HAZARDOUS REGION consists of withdrawal rates above the Calculated Rate. The PLANNING REGION consists of withdrawal rates below the Calculated Rate.

Interpret these regions correctly. You should start in the planning region very close to the Safe Withdrawal Rate. You should never start anywhere close to the hazardous region. Nor should you base your primary planning on anything close to the Calculated Rate.

The Calculated Rate is our best estimate of the maximum that you can withdraw for a specified number of years. Withdraw more and your retirement will go bust. Add another year and you will not make it.

Our estimate has close to a 50%-50% chance of being right. It is a coin toss (with an honest coin) as to whether you will make it at the Calculated Rate. You need something safer for your primary planning.

It is OK to base your secondary planning on a coin toss.

For example, you might wish to leave a sizeable inheritance but still allow yourself to dip into your funds should you outlive your plans. You might center your primary planning actions on maintaining at least of one-half of your portfolio’s initial buying power at age 90. You would use Half-Failure Rates for those calculations. You might then establish a secondary planning requirement of not running out of money before you reach age 110. You could use a Calculated Rate for this secondary objective.

You need to monitor your financial condition routinely. You can monitor your portfolio‘s progress in terms of how well it compares with a coin toss. You will not need to act as long as your portfolio stays in the planning region. Remember that a large fraction of portfolios that start out in the planning region will experience some bad years early, drift toward lower levels of safety and then recover. You can be comfortable as long as your finances remain in the planning region.

But even when starting at the Safe Withdrawal Rate, there is a 5% chance of failure.

You are warned if your portfolio drifts into the hazardous region. That is when you need to act.

Your urgency increases if your investments do poorly and your finances advance farther into the hazardous region. By the time that you hit the High Risk Rate, your failure is almost assured.

When you do your initial planning, start with something close to the Safe Withdrawal Rate. Then look at all of the things that are unique to your own, personal circumstances.

Many retirees make several retirement portfolios.

You should put some of your money into the safest possible investments to meet your minimal needs. These would have the safety associated with Safe Withdrawal Rates or, possibly, be even safer. You should set the safety of your other investments closer to that of the Safe Withdrawal Rate than to the Calculated Rate. You should label whatever you invest less securely as hobby funds, entertainment expenses, play money or gambling stakes.

Have fun.

John Walter Russell
I wrote this on May 30, 2005.