What’s Your Investing Risk Capacity?

Key Takeaways

• Investors have likely heard about risk tolerance, or how much risk you can “stomach” in your portfolio, but another factor to be mindful of is risk capacity, or how much money from investments you may need soon.
• As investors reach age 60 and approach retirement, for example, a general, age-based guideline for portfolio allocation is 60% stocks and 40% bonds and cash.
• However, for any investor, including those in retirement, we believe that a personalized approach to allocation that considers risk capacity (along with risk tolerance) can be more beneficial than a general guideline.

Overview

All investors accept a certain level of “risk” in their portfolio. Markets go up, and market go down, and if you have a long investing horizon, you might be willing to accept more risk in your portfolio, since you have more time for investments to potentially recover from a down market. But it’s another thing to be willing to accept a high level of risk for all investments in your portfolio when you’re in or near retirement.

A common approach to deciding if a mix of investments is appropriate for you is to determine your risk tolerance. This is the “sleep-at-night” factor. How much risk, or downside volatility, can you stomach before it causes you to take sudden, drastic, and often emotional action (for example, selling stocks when they’re down or exiting the market completely)? Those actions can often be detrimental to a portfolio’s performance as well as to an investor’s ability to fund expenses or goals.

A more nuanced way to think about risk, we believe, can be risk capacity. This incorporates two factors: when you might need money, in combination with potential downside volatility or portfolio losses within a shorter time horizon. This approach can be particularly impactful for near-term goals where you need to fund expenses soon, and you can’t afford a large market downturn. In other words, will that cash be there for you when you need it? Risk capacity is especially important in retirement, particularly if you plan to sell investments to support spending needs, after accounting for income from Social Security, a pension, business, or other sources.?

Rules of thumb versus personalization

A common rule of thumb to determine how to allocate a portfolio between riskier, growth-oriented investments (such as stocks) and more predictable, less growth-oriented assets (such as cash and high-quality bonds) is to take 100 minus your age and invest that percentage in stocks and the rest in bonds and cash. For example, if you’re 60 years old, that would mean a portfolio allocation of 40% stocks (100 – 60) and 60% bonds and cash.

This may make sense if you have a long time horizon, don’t need money from your investments soon, or prefer a general guideline. But if your finances are more complex, and if you may need to sell investments to deliver cash to support spending in retirement, a focus on risk capacity can help personalize the allocation.

What’s your risk capacity?

To allocate your portfolio based on risk capacity, start with a plan. Understand how much cash you may need from your portfolio for short-term needs within the next year, and then for intermediate-term needs in the next two to four years. In other words, what portion of your portfolio needs to be invested with short-term income and liquidity as the main objective? Then use this amount to guide a personalized allocation. This could include a year of spending in cash or cash investments with two to four additional years of spending invested in high-quality short-term bonds. Exactly how much you allocate can vary based on your needs and risk tolerance.

Having a short-term income and liquidity allocation equal to at least two to four years of spending can help you avoid selling more volatile investments in a downturn. This provides a cushion to invest the remaining assets for growth, with higher potential for volatility in the short term. The shorter your time horizon and the larger your cash needs, the more damaging volatility can be. If you need money soon, your capacity to take risk for that portion of your portfolio is – and should be – lower than if you don’t.

Why is this important??

Based on previous market performance, having a financial cushion designed to provide liquidity can help increase confidence and provide portfolio sustainability. And having that financial cushion makes sense, in our view, for most investors getting close to or in retirement.

Over the past 60 years, the average bear market (defined here as a decline of 20%+ from peak to trough) for U.S. stocks lasted a little more than one year, and the time it took the S&P 500 Index to recover from a prior peak to trough to peak again was about three and a half years.

The table below shows the “time to recovery” of the S&P 500 Index (note: we do not recommend a portfolio based solely on this index). The time to recovery for assets held in a diversified portfolio would likely have been shorter – not considering withdrawals, if any, from the portfolio. Still, the average three-and-half-year time to recovery provides us with a historical target to guide decisions about risk capacity.

Time to recovery from a market decline (in weeks)

An example: John and Nancy?

John and Nancy, age 65 and 63, are preparing to transition from work to retirement. To do so, they plan to tap their investments including retirement balances as well as other income sources such as Social Security. For simplicity, let’s assume that John and Nancy have $1 million in investments for retirement. They hold these investments in a combination of a brokerage account and a traditional IRA account.?

John and Nancy would like to spend $75,000 per year. They plan to receive $25,000 a year from Social Security. This leaves them with a liquidity need of $50,000 per year in the first few years of retirement, after accounting for any investment income they choose to tap first. We assume that they will pay taxes, if any, from this $75,000.

In considering their near-term goals, they start with their risk capacity – their ability to take risk and with how much. They expect they’ll need $50,000 in the very near future to support their lifestyle. For this one-year need, their capacity to take risk is low, and they will most likely want that $50,000 in investments that have relatively high price stability, such as cash or cash equivalents including money market funds, short-term Treasury bills, or certificates of deposit (CDs) with maturities less than 12 months.?

For their next two to four years of cash needed, they may want to consider investments with higher potential investment income (or yield) compared to cash or cash equivalents, but that historically have had lower volatility in price than stocks. Examples include high-quality short-term bonds, Treasury notes, or CDs with maturities less than four years, short-term bond funds holding bonds with similar maturities, or similar investments.

Although historically, these types of investments have been relatively stable compared to other more aggressive investments including stocks and high-yield bonds, they may still experience price volatility due to short-term changes in markets or interest rates.?

Keeping this in mind, for John and Nancy, a more personalized, risk capacity-based allocation could look like this:?

A sample portfolio for John and Nancy’s needs

Now that John and Nancy have a plan for their short- and intermediate-term goals (three years total, for a total of $150,000), based on their risk capacity, the remaining $850,000 ($1 million minus $150,000) can be invested in a long-term diversified portfolio based on their needs, risk tolerance, and market conditions. We believe that this portfolio should be constructed using a disciplined framework based on rigorous research and investment selection, while being mindful of cost, taxes, and other factors that impact long-term wealth.

Keep in mind, this is a simplification. John and Nancy should work with an advisor to determine if $50,000 a year, or some other amount, is sustainable to spend from the portfolio based on their life expectancy, risk tolerance, inflation, other goals, and details.

Also notice: John and Nancy’s portfolio looks a lot like a traditional “60/40” portfolio, often used as a guide for investors at or transitioning into retirement. The difference: This allocation for John and Nancy took a personalized approach, based on their needs, timing, and cash flow.?

Bottom line?

If you want a more personalized approach to asset allocation, start first with your risk capacity, meaning how much money you may need from your portfolio soon. How much risk can you afford to take over two to four years — about the time to weather a bear market?

Build your allocation from the bottom up, starting with the dollar amount you need for short-term income and liquidity first. Then consider investing the rest for growth, based on other factors, such as your time horizon, growth objectives, goals, and risk tolerance. Ideally, we suggest investors do this by working with an advisor to consider what you need from your portfolio, and when, taking into account all your investments and assets across all accounts and firms, to create a comprehensive wealth management plan.

Important disclosures

The information and content provided herein is general in nature and is for informational purposes only. It is not intended, and should not be construed, as a specific recommendation, individualized tax, legal, or investment advice. Tax laws are subject to change, either prospectively or retroactively. Where specific advice is necessary or appropriate, individuals should contact their own professional tax and investment advisors or other professionals (CPA, Financial Planner, Investment Manager) to help answer questions about specific situations or needs prior to taking any action based upon this information.

All expressions of opinion are subject to change without notice in reaction to shifting market, economic or political conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Investing involves risk including loss of principal.

Diversification and asset allocation strategies do not ensure a profit and do not protect against losses in declining markets.

Indexes are unmanaged, do not incur management fees, costs, and expenses and cannot be invested in directly. For more information on indexes, please see www.schwab.com/indexdefinitions.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors.

Money market funds are neither insured nor guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of an investment at $1.00 per share, it is possible to lose money by investing in the fund.

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