Military Finances 201: The 3 Dimensions of Portfolio Risk
InvestmentInvestments have risk. The risk can be virtually 0 in the case of a bank account. The risk can also be quite high in an investment like penny stocks. If investments have risks, how do we determine the appropriate level of risk for a portfolio? The typical answer is to determine your risk tolerance. But setting a portfolio's risk level should include more than just risk tolerance. Let's explore.
Risk Tolerance
Risk tolerance is an important part of setting a portfolio's risk level. Risk tolerance is essentially in your head. Risk tolerance attempts to determine how big of a market downturn will cause you to abandon your plan or cash in your investments. Once that point is established, the portfolio is designed to keep losses at a point less than that break point. Typically, this is where portfolio design starts.
Risk Capacity
Once the portfolio is designed, we then want to stress test it to see how the accepted risk and the potential loss associated with it will affect your ability to reach your goals. We generally replicate the 2008 Great Recession to model that large loss. We then determine if that scenario will "ruin" your ability to reach your goals. This part is a bit subjective. In general, we like to see that your Needs still have a high probability of success. You don't want to become a burden on your family or society. If the probability of covering your Wants and Wishes is too low, then look to see if changes could bring them up to an acceptable level. Perhaps working an extra year will solve the problem. If we can't get Needs covered and if minor changes won't help with Wants and Wishes, then you might not have the capacity to accept the level of risk associated with the original portfolio design
Risk Requirement
As returns go up, risk increases. So, if the plan requires a certain level of return to reach goals, then there is a risk that comes with that, and that level of risk might exceed your risk tolerance. Conversely, in some cases the required risk is much less than your tolerance and you may be able invest in a portfolio with lower expected returns and associated risk.
Putting it Together
In a perfect world, the risk required will be below the risk tolerance and the risk capacity will be higher than the risk required. That is in a perfect world. If the 3 don't line up that way, then adjustments need to be made. Those could be:
- Investing more so that the required risk goes down
- Working longer to reduce the risk requirement
- Plan on spending less in retirement to reduce the required risk
- Finding ways to increase risk tolerance so the required risk can be accepted
- Use tools to ensure Needs are covered in order to increase risk capacity
This is the reason we design portfolios after we go through the planning process. You simply can't determine risk capacity and risk requirement without a plan and goals. Without a plan you basically have a one-legged stool (risk tolerance).
Military Finances are Different
Portfolio risk applies to all investors. But many investors don't have the have a guaranteed source of income like a retired Senior Military Officer or NCO might have. That could significantly change risk capacity. An advisor that doesn't routinely work with retired military members might not take that into account. And that's not the only way a military member's finances are different than a civilian's. That's why we think you should work with a financial planner or advisor that specializes in working with Active and Retired Senior Military Officers and NCOs. If you'd like to find out how we work with people like you, use the button below to schedule a free initial consultation.
If you found this article useful, you might like the following blog posts:
Military Finances 101: How Wall Street Measures Stock Volatility
Military Finances 101: How to Build a Bond Ladder
Retired Military Finances 401: Restricted Stock and the 83(b) Election