Tuning in to Your Tolerance for Risk

I enjoyed my first foray into live radio last night with an appearance on Lance Roberts’ streettalklive broadcast.  (To listen to my segment, click here:  Download Streettalk Live 2).  We chatted about retirement, and he shared his wisdom on important issues like how much money one needs to retire, and how retirees should allocate their nest eggs between stocks and bonds. 

I’ve discussed the importance of determining your own tolerance for risk in order to figure out how much of your portfolio you should allocate to stocks.   And by risk tolerance, I am referring to how much you feel like killing yourself when you see your nest egg shrink.

As I’ve mentioned before, I may have been a little too risk tolerant when I initially set up my own retirement portfolio.  When the stock market lost about half of its value in the first year of my retirement, I might have felt a little more comfortable with a slightly more conservative allocation.  Live and learn.  But what if you don’t want to learn the hard way like I did?

You already know how to target the size of your retirement nest egg.  Let’s say you are retiring at age 65 and are targeting a 4% withdrawal rate.  You’ll need a nest egg equal to 25 times your annual expenses that aren't covered by other income sources such as Social Security, rental income, or part-time work.  But how do you allocate those assets among stocks and bonds in a way that will allow you to sleep at night during a market tumble, before you actually suffer through a market tumble?  That’s where Lance has an interesting suggestion.

First, look at your projected expenses.  Then figure out how much money you will need just to cover your “Alpo diet,” meaning the absolute minimum you need for basic expenses before you have to start eating dog food.  Maybe not such an appetizing image, but you get the drift.   Perhaps some of this is covered by your Social Security or other income.  But to the extent that it is not, invest enough of your nest egg into the safe part of your asset allocation to generate the income you'll need to meet your basic needs.

Then to keep up with inflation, you will want to allocate the rest of your nest egg to equities.  This part of your nest egg will cover the wants rather than the needs.  That way, if the market runs into trouble, you’ll be able to makes some adjustments to your spending on discretionary items, while still ensuring that you get to eat normal food for dinner.

I took a look at how this approach would translate to my own allocation.  Sixty percent of my budget is for non-discretionary items, housing, insurance, utilities, groceries, health insurance--things like that.  A little more extravagant than an Alpo diet, but that represents the basic cost of operating our life as is right now.  The other 40 percent of our expenses are for discretionary expenses, things we could cut in a pinch, but really wouldn’t want to. 

That would translate to a 60% bond allocation and a 40% stock allocation.  Which is a little too conservative for my taste, especially since I’ve got potentially 50 years to cover.  But consider the same breakdown if I were 67 years old.  That would be when I am eligible for Social Security.  Social Security should cover about 20% of my expenses.  (I will not earn the maximum Social Security benefit since I did not work long enough to earn the full benefit.)  In that circumstance I would only be aiming to cover 80% of my expenses with my own nest egg.  After applying a little math, that translates to a 50/50 split between stocks and bonds.  (Since the first 20% of my budget would be taken care of by Social Security, only 40% of my expenses would remain to be covered for basics and 40% for fun stuff.)

While this approach may not exactly hit the mark for me now, it seems a pretty reasonable way to tackle the issue, perhaps with a little fine tuning to really make it your own.

Related Posts:

            My 15 Minutes of Fame

            How to Lose Money in the Stock Market:  Don't Invest in it

            A Word About Asset Alloction

 

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Comments

[Alex in Virginia]

Hi, Sydney...

Glad to see your post.

Where do you see high-yield bonds fitting in? I am gradually shifting 30% of my holdings to corporate bonds yielding 10% or better. Yes, this is in so-called "junk" territory, but there are a lot of levels of "junk". I go no lower than a B- S&P rating, and limit my holdings of any particular bond to 3% or my total portfolio (and no more than 6% in any one industry.)

Are you sticking strictly to "investment" grade bonds? Any tolerance for high-yield bonds?

Cheers :)

[Retired Syd]

Alex: I don't have an opinion on how much to invest in high-yield bonds, but that would be part of your fixed income/bond allocation. I do have a little exposure there, but in mutual funds rather than directly purchased bonds. (Although I'm not saying that's a better approach, just that I don't want to do that much work to diversify through individual stocks and bonds.)

[Joe @ Retire By 40]

That's an interesting way to look at it. I'll need to sit down, but I guess my allocation would be 10-20% bonds if I calculate it out. I still have some active income and my wife is working currently. It probably make more sense when we are fully retired to figure out.

[deegee]

I was going to ask Syd the same thing, Alex. I have a large holding of bonds (in a mutual fund) which are just below investment grade (they are mostly BB). I count this in my bond holdings.

As a fellow early retiree (Syd knows about me), I split my AA into 2 parts. One is for my taxable account (non-IRA) and the other for my IRA which I won't need until I near 60 (about 10 years from now). The former is mostly bonds while the latter is a small majority stocks.

[Canadian Friend]

Loved your Radio interview! Maybe you should take on a part-time contract doing some radio hosting? I know I'd listen. :)

[Retired Syd]

Canadian Friend: Well now that would be fun!

[Retired Syd]

deegee: Thanks for contributing those details.

Joe: Maybe that works out to be a little aggressive in your case with the working spouse factor. (Unless she's planning on working for many, many more years). When I was still working, I had a heavy allocation to equities, and eased into fixed income as I approached full-time retirement.

I guess you could figure out the ratios without her income and then slowly move toward that as she gets nearer to retirement?

[Rick]

Just some food for thought ......With respect to high yield bonds, there of course is a reason for the higher rate -- higher risk. So, a 40% bond allocation to a diversified high quality bond fund is not the same as a 40% allocation to high yield bonds (especially if they are individually owned bonds). David Swensen (Yale Endowment Fund Manager and author of Unconventional Success) advocates for only government bonds for the fixed allocation (assuming interest rate risk but essentially no credit risk), arguing that the portfolio risk should be on the equity and alternative allocations as they have the better risk/reward factors, and also that your "safe" assets should be, well, "safe." Not everyone may want to eliminate all credit risk, but it does seem valuable to know that when one takes on lower grade bonds they are exposing their portfolio to additional risk, and it is real and not just hypothetical.

Hope everyone has an awesome weekend (and for those like Syd who are fully retired, you may lose track of days, and this is your reminder that the weekend is here and the big paper comes on Sunday!).

[Retired Syd]

Rick: Or, if you only subscribe to the NY times electronically, you get to do lots of clicks. I never see a paper anymore!

[fred doe]

I'm 60 and retired but I don't think I'll ever stop investing. I'm in a bond mutual fund and it dose well. I only own four stocks and use D.R.I.P. and I'm pleased when I get my statements. In ten years time the investments will be a source of income to buy niceties. Like fine dinning? But I'll always order the Alpo pate' for an appetizer. ( you guys must not be preparing properly)?

[Leslie]

When we paid off our house 10 years ago everyone told us it was a bad investment decision. However, when the stock market tanked in 2008 and real estate took a big hit we were glad that the roof over our head was free and clear. Thankfully the equities and bonds in our retirement accounts have rebounded.

[tom sightings]

Me, I don't like bonds. The interest rate they pay is too low for the risk you take. That's my opinion. However, that being said, I do own a small amount of a municipal bond closed-end fund, and after years of being underwater, it's been doing quite well lately. So go figure. I guess that proves the argument for diversification, even into investments that you don't like, because nobody gets it right all the time.