The less risk you’re willing to take in the stock market, the more vulnerable you make yourself to inflation risk. If you overweight your portfolio to bonds because you want to avoid market risk, you end up facing business and interest rate risk. In general, the financial planning industry lists seven types of risks all investors face: default, business, liquidity, inflation, interest rate, political and market risks.
Each risk affects the balance of your retirement portfolio, but you control the position of the fulcrum. We call that risk tolerance and we ask all clients and prospective clients to answer a series of questions to determine theirs.
Most people find that their risk tolerance decreases as the get closer to retirement for both practical and emotional reasons. They have less time to make up for any sudden dips in the market and probably should shift assets onto more stable ground as they anticipate withdrawing from them Additionally, their sleeping level decreases as they become more hyper-focused on their accounts.
Other factors influencing risk tolerance include major life changes like marriage, divorce, promotions, job loss, birth of children, inheritance, home purchase, caring for elderly parents, medical disability etc. Because these dramatic changes can have a profound effect on your risk tolerance, it is important to check your risk tolerance periodically, particularly after experiencing any of these events.
According to Finametrica, the risk tolerance surveyor to which we subscribe, the first part of the process is determining how much risk is required for you to meet your goals: What annual return will you need on your investments to meet them, given what you think you can save?
Next, figure out your risk capacity, which is different from your risk tolerance. Given your budget, retirement timeline and financial assets, how much risk can your retirement portfolio withstand?
Lastly, how much risk will you need to avoid in order to sleep soundly at night?