Asset Allocation Mistakes in Retirement: Failing to Understand Risk Capacity
When making asset allocation (investment) decisions, many retirees rely on the amount of risk they are comfortable with, rather than the amount of risk they can (and should) afford to take. According to the Bankrate Money Pulse survey, just 47 percent of Americans ages 52 to 70 are willing to invest their money, while 53 percent stay far away from stocks, bonds, and mutual funds.
This is the difference between choosing your risk tolerance over your risk capacity, which frequently causes a conflict between your retirement income goals and your retirement investments.
For example, retirees with aggressive investment personalities were heavily invested in the stock market in 2006 because they were comfortable doing so. When the 2007-2009 bear market hit during the financial crisis, their nest eggs were injured severely, compounding the monthly withdrawal plans from their portfolios. Between the losses, the withdrawals, and the long period of time it took for the markets to recover, these retirees have seen their lifestyles negatively impacted, perhaps for the remainder of their lives.
Conversely, retirees with conservative investment personalities have been heavily invested in money market funds, certificates of deposit, bonds and the like. They gleefully avoided the big drawdowns of the stock market during the financial crisis. However, interest rates have gone to zero in response to the crisis, and these safe investments have returned next to nothing for years, causing these retirees to begin drawing down on their principal – leading to a race with time.
Understanding the difference between risk tolerance and risk capacity before making asset allocation decisions is, therefore, paramount when planning for retirement.
While it is possible to arrive at your risk capacity alone, doing it yourself can be a very dangerous place, and I don't recommend it. My advice for investors is to hire a coach. An investment representative or a certified financial planner will coach you through choppy markets, resist temptation, develop a game plan, and stick to your stated investment philosophy for a lifetime.
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Investments in securities do not offer a fixed rate of return. Principal, yield and/or share price will fluctuate with changes in market conditions and, when sold or redeemed, you may receive more or less than originally invested. No system or financial planning strategy can guarantee future results.