Responding to Member Feedback About Assessing Risk Tolerance

Last week, we introduced a worksheet for assessing your risk tolerance as part of The AAII Way project we’re working on. The worksheet included a grid. Timing risk ran horizontally across the grid, while contributions/withdrawals relative to wealth ran vertically. The logic behind the grid was that risk is a function of when you will need the money and how much you will need relative to your wealth.

Upon publishing the grid, we asked for feedback. A few members pointed out the challenge of having to select just one box for retirement. Jim I., for instance, wrote, “In the case of continual drawdowns I’d want to put X’s across the entire bottom row.”

It’s an interesting point to bring up.

It’s also a challenging one from the standpoint of creating a grid an investor can use to say, “I have a moderate level of risk tolerance.” On the one hand, retirement requires withdrawing from the portfolio to cover living expenses. This implies a more conservative allocation. On the other hand, it requires additional portfolio growth as someone in their late 60s or early 70s could live for an additional two or possibly even three or more decades. This implies a more aggressive allocation.

New parents face a similar challenge when determining how to allocate their child’s college savings. A time horizon, of say 15–18 years, calls for a more aggressive allocation stance in terms of saving. Once the child is close to starting college, the spending period is short (four years if the child graduates on time and post-graduate studies are excluded from the plan). This implies switching to a conservative allocation as the goal approaches.

To address this challenge—and other feedback given to us by AAII members—we’ve modified the grid. It now plots timing risk against financial/psychological tolerance.

We’ve also added a questionnaire to help you better assess where on the grid you fit. I’m going to walk you through three of the questions to illustrate what we’ve done.

I’ll use the hypothetical couple Bob and Jane. They are in their 60s and recently retired. Their primary goal is funding their retirement. They are fortunate to be affluent and have both pension and Social Security benefits.

Timing question #1: How many years away is the goal?
Answer options:
Now or in the short-term future (five years or less)—Score: 1
Intermediate—Five to 10 years—Score: 3
Long-term—More than 10 years—Score: 6

Since they have recently retired, they choose the first answer, which is “now.” This gives them a score of 1, indicating short-term timing.

Timing question #2: Over what time period do you anticipate spending money on the goal?
Answer options:
Short-term (five years or less)—Score: 1
Intermediate—Five to 10 years—Score: 3
Long-term—More than 10 years—Score: 6

Assuming they are in good health, they could be looking at the possibility of their retirement spanning three decades or more. So, they choose the third answer, which is “long-term” and has a score of 6.

Timing question #3: Relative to your wealth, how large of a withdrawal will your goal require over a period of five years or less?
Answer options:
High—More than 25% of wealth—Score: 1
Moderate—10% to 25% of wealth—Score: 3
Low—Less than 10% of wealth—Score: 6

Whereas question #2 focuses on when the money will be spent, question #3 considers the proportionate amount spent over a short period. Bob and Jane choose the third answer “low” because they will be limiting the size of their portfolio withdrawals. This answer has a score of 6. (Note: Even if they used an inflation-adjusted withdrawal rate of 4%, growth in the overall portfolio should be enough to keep the impact on wealth proportionately low.)

The combination of possible points ranges from 3 (short-term for questions #1 and #2 and high for question #3) to 18 (long-term and low, respectively). We’d put Bob and Jane at the bottom range of scores for long-term timing risk since portfolio growth will continue to be a priority for them.

Now, let’s assume a younger couple, Frank and Sue, have a goal of paying for their child’s college education. If this child is still young, say three years old, the answers to questions #1 and #2 would be reversed. They’d have a long time horizon (15 years) until the goal of paying for college would be reached, but a short time horizon for spending the money they’ve set aside (four years). In this case, the combined scores for the first two questions is still the same, but the timing is reversed.

How Frank and Sue answer question #3 could differ from Bob and Jane. We’ll assume Frank and Sue will spend a moderate level of their wealth paying for college, given their younger age and comparatively fewer years working. This would lower their total timing risk score to 10, which is still considered long-term.

If their health were in question, they’d opt for a shorter spending time horizon. Alternatively, if Frank and Sue’s child was about to start high school, then their investing time horizon would be shorter. Either way, their risk tolerance would be more conservative than the options shown because they’d have less time to recover from any market downturn.

In the revised risk tolerance worksheet, we’ve included an expanded version of this questionnaire to prompt you to consider not only your timing risk, but also your financial and psychological tolerance. The changes reflect the feedback we’ve received from members. Try it out and let us know if it works better for you.

We’ll address how answers to the risk worksheet translate into portfolio allocations on the next new worksheet.