When helping clients invest money, we always take their attitude toward risk into account. Some prefer investments for which they have guaranteed income; others accept a bit of market volatility with the expectation of generating higher returns over the relevant time horizons.
But evaluating risk-return profiles is just one consideration when designing an investment portfolio. Other critical risk factors must be taken into account.
This is the risk that you will outlive your assets. According to the Society of Actuaries, a 65-year-old couple has a 72% chance that at least one will live to 85 and a 45% chance of one living to 90. With this increase in the projected duration of retirement and spending, your portfolio may need substantial stock holdings to increase the probability that your assets will extend throughout your entire lifespan.
This is the risk that your income will not accelerate as quickly as your expenses. Fixed payment annuities and pension payments may not keep pace with inflation since they tend to provide a pre-specified income stream.
Although Social Security payments increase based on a cost-of-living adjustment, there was no upward adjustment in three of the last seven years. If a significant percentage of your income doesn’t provide a cost-ofliving adjustment, consider allocating resources to assets for which returns tend to adjust in response to inflation.
This is the risk that a substantial percentage of your expenses are relatively fixed and non-discretionary. These expenses cannot be deferred or avoided and require timely payment – e.g., a home mortgage (or rent), insurance, and utilities. When you reduce your percentage of nondiscretionary expenses, you gain some flexibility to incorporate higher return investments for which valuation and/or income vary. You’ll be less likely to make untimely withdrawals in down markets to meet cash flow demands. A higher level of fixed expenses may require higher income certainty and lower overall portfolio risk.
This is the risk that you may not be able to find a replacement job with similar compensation within a reasonable time period. Positions with high career security – e.g., medical professionals, technical experts – present a lower risk to income disruption and may support higher portfolio risk. Those for whom positions are scarce with abundant competition may need to be more prudent in their choices and maintain a higher percentage of cash and bonds.
Asset Protection Risk
This is the risk that you have not adequately mitigated factors that could undermine you or your heir’s financial health. Insurance provides the means to adjust for risk based on individual circumstances.
For example, if you believe you will be subject to estate taxes, but your assets are not readily liquid, such as a family farm or a closely held business, some form of life insurance to cover the estate taxes may be advisable. An appropriate umbrella liability policy makes sense if you have substantial assets and could become the target of a large lawsuit. In addition, establishing an asset protection trust may allow you to protect assets from creditors.
This is the risk that cognitive biases may prevent you from acting rationally with respect to your investment portfolio. Behavioral risks are associated with human emotions and help explain why so many investors make poor investment decisions.
Studies indicate that investors tend to sell after investment prices have fallen and buy once prices recover. This buy high/sell low cycle has historically led to dramatic underperformance relative to the commensurate benchmarks. A thoughtfully developed investment strategy and education should help reduce emotional reactions and ensure you don’t make poor short-term decisions that undermine your long-term success.
The best way to assess these and other risk factors is working with a CFP® professional to develop a financial plan. An experienced planner helps you address pertinent risks and generate a long-term strategy that incorporates your goals while mitigating the corresponding risks. The resulting investment strategy reflects your distinct circumstances and goals while protecting you from undesirable outcomes.
Meet the Author
Partner + Chief Investment Officer
Darin Richards, CFA®
Aldrich Wealth LP
Darin joined the Portland wealth management firm in 2004, bringing more than a decade of investment and financial consulting experience with him. As chief investment officer for Aldrich Wealth, Darin is responsible for developing, and implementing our investment philosophy and leading the investment committee. He works directly with some of our most complex and largest clients and also…
- Series 7 and 63 security exams
- Chartered Financial Analyst (CFA®)