16 January 2012
My 10-year-old had a bad night last week when he did not have his homework done in time for basketball practice. In our house, your homework needs to be done prior to sports or you do not go. So he did not go. He was shocked that we would follow through and started to blame everything around him for why he did not start his homework on time. It was almost comical since he got home from school at 2:30 and practice was not until 6:30. But it reminded me that our own behavior has ramifications in life, especially on our own retirement.Warren Buffett famously said, "It's only when the tide goes out that you learn who's been swimming naked." That sums up the last decade for those who are now preparing for retirement. Stock market returns have not lived up to expectations for most retirement plans, which puts added pressure on you to save even more to reach your retirement goal. Saving enough, while difficult, is also simple since it means giving up the instant gratification that our society preaches. But not saving enough is trickier and presents a fork in the road when it comes to the decision you will need to make about how aggressive to be with your investing.
There are two types of risks to understand, and your savings behavior will dictate which one is more important:
- Risk Tolerance. This is what most financial advisors talk about when they ask you how much risk you are willing to take. Tolerance refers to your own comfort level. It is the old trade-off of return versus risk; how much are you willing to lose versus how much upside you want. Tolerance is a feeling, but many advisors confuse it with numbers. Yet make no mistake about it―the more you save in life, the lower your tolerance for risk needs to be.
- Risk Capacity. Your capacity for risk is entirely different from your risk tolerance; capacity refers to how much risk you must take to reach your goal―in this case maybe 30 or 40 years of retirement. Capacity refers less to your emotional state and more to the actual circumstance you are in (i.e. the numbers). If you do not save enough, whether you have the tolerance for a higher risk portfolio or not, you might need to take more investment risk to see your retirement dream come to fruition. Ironically, those with the most money saved have the highest capacity for risk; they can stand to lose larger amounts since they have more to start with (although this can be relative since they might spend more as well).
Where risk tolerance and capacity collide is when most people freeze up. In the best-case scenario, risk tolerance and capacity are the same. But what I see often is a low tolerance for risk, especially after the last decade, but a high risk capacity (i.e. need to take risk) since someone has not saved enough. This is what many people face today as they think about retiring sooner rather than later.
The question to ask your self is this: Is my homework done? If you cannot say with certainty that work is optional, then more needs to be done to shore up your foundation. And I urge you to hold off on retirement until you can say it will be fun, not just tolerated.
About Jon T. Meyer, CFP®
