How do you know if you’re really ready for retirement? You may want to take the leap into retirement life, but can you? Should you? Are you really retirement ready?
If you have done the following 5 things, the answer may be yes, you are ready:
- You know how much risk you are taking (typically, no one has taken a proper risk test).
- The amount of risk you are taking is appropriate for you (this is where everyone does it wrong).
- You are measuring performance against your goals, not an arbitrary benchmark.
- Your risk is allocated to the opportunity set.
- You have a strategy for reallocation.
Let’s break these down in more detail.
1. You know how much risk you are taking
Using a benchmark is a useful way to track progress. But to work, you need the right benchmark. This means you should first decide how much risk to bear (equities to own) and only then measure return and risk relative to the benchmark.
The problem is few investors know how much risk to bear because techniques for doing so are flawed. Invalid risk assessments cause investors to take more risk during good markets (when value may be hard to find) and less during bad markets (when value may be abundant). This leads to panic selling – remember the Great Recession? Studies show that investors leave about half of their returns on the table, for the big banks and life insurance firms to grab.
We recently learned that most advisors (including robo-advisors) use invalid risk assessments. These advisors are unwilling to ask their clients to spend an extra 15 minutes to take a valid risk assessment.
We do things differently at Global View. We persuade our clients to invest 15 minutes to get this right. It’s important because it’s the first step to prevent transferring your wealth to the big banks and life insurance firms.
Most investors fall into one of three risk groups:
- Moderately Conservative: Take 30% of the risk of stocks
- Moderate: Take 50% of the risk of stocks
- Moderately Aggressive: Take 70% of the risk of stocks
At Global View, instead of benchmarking to 25 percent of the world GDP (the U.S.), we use a world stock index.
- Moderately Conservative: 30% MSCI World index (world stocks), 70% U.S. bonds
- Moderate: 50% MSCI World Index, 50% U.S. bonds
- Moderately Aggressive: 70% MSCI World Index, 30% U.S. bonds
We have found that investors are generally comfortable with an asset allocation range of plus or minus 10 percent of their risk target, which means we reallocate regularly to make sure we are in bounds.
Please note: The risk you take while you are accumulating wealth and investing monthly is not the same as the risk you take when you have already accrued serious wealth. Serious wealth is wealth you don’t want to lose and not make back.
If you have serious risk, contact a financial advisor about your options.
Our goal is to make you a smart investor. Because smart investors are not the kind of people who transfer their wealth to a big bank or life insurance company.
2. The amount of risk you are taking is appropriate for you
Setting a risk budget is important.
Although we happily help qualified clients accumulate for retirement, most of the assets we manage is serious money with a focus on loss avoidance first and foremost. This does not mean we don’t want high returns. It only means we aren’t willing to take them at any price. For this reason, we need to accurately assess your risk.
Our methodology for this is simple.
First, we determine your attitude toward risk by giving you a valid risk assessment. A valid risk assessment is one that holds true over time and incorporates psychology and statistics; one that will stay the same unless a life event occurs. For instance, if a client becomes seriously ill, we would expect their risk tolerance to be reduced. Similarly, if a client inherits a hefty sum of money, this might also affect their risk tolerance.
Few investors have taken a valid risk assessment. Even Morningstar (and most robo-advisors, 401k plans, etc.) use overly simplistic risk assessments that are simply not valid. These questionnaires typically have six questions and only take two to three minutes to complete. In my opinion, this is mind-numbingly stupid, and it can be avoided.
By taking an additional 10 to 15 minutes, you can to get a valid and reliable assessment of your risk tolerance. Contact me directly if you’d like direction.
3. You are measuring performance against your goals, not an arbitrary benchmark
Why benchmark? Investors want feedback to know if their strategy is on track. Measuring performance against a benchmark is an effective way to get feedback on return and risk. However, most investors use the wrong benchmark.
First, they don’t measure risk correctly. Second, they take more risk than they should because they don’t know how much risk they are taking. This is because the pain of downside risk is not in recent memory, which means you don’t recognize an investment’s risk until after the risk happens.
Finally, most investors benchmark solely on the U.S. market. But the U.S. market represents only about 16 to 25 percent of the global economy (depending on how you measure it).
The true risk investors bear is clear only when the market crashes, like from 2000 to 2002 or from 2007 to 2009. And this risk is worst in common stock indexes because they are price-weighted or momentum based, which means they go up the most and go down the most.
We have even seen many investors tell us they are “conservative” with a 100 percent exposure to U.S. stock market indexes. They must think that “conservative” means avoiding smaller companies or overseas stocks. This is because in our world, conservative means cheap (or undervalued to be precise).
4. Your risk is allocated to the opportunity set
Most investors (86 percent) fall within one of three risk groups:
- Risk group 3: One-third the risk of stocks and lower return expectations
- Risk group 4: Half the risk of stocks and moderate return expectations
- Risk group 5: Two-thirds the risk of stocks and higher return expectations
We believe that 7 percent of people fall below risk group 3. These people make poor investors and typically should have only 15 percent of their assets allocated toward risk.
Another 7 percent of people take more risk than risk group 5. These investors are often thrill-seekers. They need education to invest well.
After establishing a client’s appropriate risk, we work with them to model their odds of winning against a future goal by learning their capacity to take risk.
For accumulators in retirement accounts who won’t be using funds for many years, we coach clients to move up to a higher risk group. The longer the time horizon, the more predictable the return and the lower the odds of catastrophe. This means that investors who tested in group 4 can be coached to take the risk of group 5, because they have the capacity to weather an inevitable drawdown.
Similarly, a retired investor taking high withdrawals for income might be coached down a notch. Because a larger drawdown could cause a retiree to run out of money, this needs to be considered. This means that even when a retiree can afford to take more risk, the odds of success doing so are less – the retiree needs to weigh the importance of leaving a larger legacy against the odds of running out of money. We ask, simulate (using quantitative methods), and discuss before we agree on a risk group with our clients.
The key point is that we start with a valid and reliable risk assessment (unlike everyone else). And then we coach to an appropriate allocation based on our client’s specific needs.
We also manage real vs. perceived risk.
Because each risk group takes a predictable level of risk, we further coach to minimize surprises. Surprises trigger emotional reactions that can cause panic selling. By minimizing these surprises, we reduce or eliminate the investor behavior gap, which is just the amount of wealth transferred to institutions like big banks and life insurance companies.
While there is some debate on the size of this gap, authorities agree that the job of an investment advisor is to reduce it. When panicked investors sell, it is essentially a transfer of wealth from the panicked investor to big bank brokers and life insurance companies (who are educated on this and take advantage of it). Don’t fall victim to this confusopoly.
It’s our job to prevent this from happening because, as a smart investor, you are not the kind of person who transfers wealth from heirs to the big banks and life insurance companies!
Showing you the expected level of risk over a short-term six-month period helps eliminate surprises.
We are exploring other ways to educate clients, because it is imperative that we do what we can to help our clients avoid losing money they can’t make back.
5. You have a strategy for reallocation
As we perform reviews, we revisit asset allocations to make sure they are in line with our client’s risk budget and, if appropriate, re-assess their attitude toward risk (retake the risk exam), their risk capacity and any life changes that may have taken place.
When investors fall below their comfort range or get above it, they are likely to become uncomfortable, which means we need to reallocate regularly. And because we spend a lot of time finding new ideas, this is a great time to implement them while also minimizing taxes and trading costs.
