NEW YORK (MainStreet) — Question: In retirement, what's your risk tolerance?
Answer: Well, that's the wrong question.
A better one, according to brokerage Charles Schwab, is what is your risk capacity, a more hard-nosed look at how you could use a cash-and-bond cushion to maintain a steady income even in a typical market downturn.
The concept of risk tolerance has been around a long time, and most brokerages and mutual fund companies have online tools to help investors figure the best mix of stocks, bonds and cash. Typically, you answer such questions as: What would you do if stocks fell by 20%? Sell them all? Keep what you have? Buy more? The answers are combined with historical market patterns to devise a portfolio suitable to one's aggressive, middle-of-the-road or conservative sensibilities.
The big shortcoming: The results depend on one's investing philosophy and emotions, which can lead to bad strategy. A safety-minded retiree, for instance, might choose a conservative portfolio that won't grow enough if he lives to an advanced age.
Risk capacity also relies on historical market patterns - that returns are bigger for stocks than bonds over the long term, but that stocks are more volatile, or risky. But this approach focuses on dollars and cents rather than how investors say they would behave as market conditions change. It's not driven by emotions.
It boils down to assessing how much the investor can afford to lose in a market downturn, and how long the investor could afford to wait for a recovery while continuing to spend at the intended level. To do that, the investor needs a cushion of cash and short-term bonds that will hold their value in a downturn. It should be large enough to cover spending for two to four years.
"Over the past 50 years, the average bear market for U.S. stocks lasted a little more than one year, and the time it took the S&P 500 index [of stock prices] to recover to prior highs was about three and a half years," Schwab says.
Schwab gives an example of a couple ages 65 and 63 that needs to spend $50,000 a year from a $1 million portfolio. Schwab suggests the couple put $50,000 into cash, $100,000 into short-term bonds, $200,000 in intermediate-term bonds and $50,000 into high-yield bonds. That's 40% of the portfolio invested conservatively, with enough cash and virtually risk-free short-term bonds to cover spending for three years. The intermediate bonds would be relatively conservative as well, subject to some price fluctuation but yielding more than the short-term bonds.
That leaves 60% of the portfolio in stocks, 45% in U.S. stocks and $15% in foreign ones. Note that 60% is considerably more than the 35% to 37% recommended under the old rule of thumb of figuring the stock allocation by subtracting one's age from 100. The bigger stock allocation in the Schwab example allows more growth to cover a long retirement.
In some respects, Schwab's risk capacity approach is just an expansion of the old rule about having a rainy-day fund to cover six to 12 months' expenses. In retirement, the cushion needs to be bigger because it's less likely a retiree will go back to work after a setback.
Schwab doesn't dispense with the concept of risk tolerance entirely. That approach is used to guide the allocation strategy for the stock portion of the portfolio.
— By Jeff Brown for MainStreet