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The difference between how much risk you need to take and how much risk you're capable of taking

Written by Preet Banerjee

Wednesday, November 16th, 2016

The Bugatti Veyron sports car is capable of hitting over 400 km/h. At that speed, the tires are rated to last for 15 minutes. But according to James May, previously of Top Gear fame, that's not a problem since the fuel would run out in 12 minutes.

This is a very capable car. But just because it's capable of driving at 400 km/h, it doesn't mean you need to go 400 km/h.

Why do I bring this up? Well, part of the reason is that I'm a gearhead, and I think it's cool. But it also nicely frames the importance in the difference between how much risk investors need to take in their investment portfolios versus how much they're capable of taking.

When you're not capable of taking on more risk

Let's say you've had a financial plan drawn up. You've considered your age, how much you're putting away right now, when you want to retire, and the lifestyle you want in retirement, and you conclude that your investment portfolio would need a rate of return of 7% to make this plan work. This kind of return would fall into the very aggressive end of the risk-vs.-return spectrum. But then you fill out a risk profile questionnaire, and it turns out you're only capable of handling a less risky portfolio, one that might only be expected to return 4% per year over the long run.

In other words, what you're currently doing isn't going to work. Unfortunately, you can't simply select a riskier portfolio to fix your problem. If you're not capable of handling the extra risk, you could actually end up even worse off if you bail out of your portfolio during a severe market downturn. It's buy low, sell high, remember? Not the other way around.

In this case, you have some other options worth considering:

  •          start putting away more money
  •          plan to work longer and retire later
  •          plan to spend less in retirement

To kill two birds with one stone, saving more money reduces your expenses (assuming you don't incur debt elsewhere), which means the transition to retirement would be helped not only by saving more money, but by getting used to spending less.

When you're capable of taking on more risk than you need to

Now let's look at the opposite situation. You're an aggressive saver with potentially sizable assets to fall back on, and based on your desired spending level in retirement, you only need a rate of return of 2% in order for your plan to work out. But when you complete a risk profile questionnaire, it suggests you're capable of handling an aggressive portfolio, with higher risk and a higher potential return of 6%. What do you do?

You could start putting more money into the more aggressive portfolio, but I'd put that at the bottom of my list of options. I would much rather continue saving at the same clip regardless of what level of risk I decide to take on.

If I opted for the lower risk, lower return option, I'd get more stability in my portfolio.

If I opted for the higher risk, higher potential return option, I might increase my odds of retiring earlier than planned, or increasing the level of spending in retirement.

A good compromise is to split the difference. I could aim for a portfolio that's somewhere in the middle and benefit from a smoother ride than I'm capable of handling, while aiming for a return higher than what I need to be successful.

In practice, long-term planning needs regular monitoring and readjustment. As you get closer to retirement, things start to become more clear as to when you'll be able to retire and what kind of lifestyle you'll be able to support. Knowing the difference between how much risk you need to take and how much risk you're capable of taking can help you think about what variables in your financial plan you want to adjust as you track towards your goals.

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