The meaning of risk? It depends on whom you ask.

Risk means one thing for an astronaut and another for an investor. For an astronaut, the meaning of risk might be an engine failure at liftoff or long-term health effects after a long time in orbit. It’s pretty clear that the engine failure is the more immediate risk and deserves more importance. For individual investors, their primary notion of risk is pretty consistent and clear: The risk of running out of money before they die.

Certainty is comforting but almost always expensive.

 

According to a widely publicized survey from June 2010 by Allianz Life Insurance Company, 61% of people in or near retirement fear running out of money more than they fear death. For those in, or about to go into retirement, running out of money could mean moving back in with children, never taking another trip or even something as drastic as living on cat food.

Having established running out of money as the number one risk, then the next logical leap is that all other risks must be subordinate to this risk.  What does that mean?  Let’s say an investor (with their advisor) has determined that a 60/40 allocation is the right plan for them as it best minimizes the risk of running out of money.  Then every other risk preference of that investor is secondary to this plan.  Owning 60% equity will not always be a lot of fun.  The daily headlines can cause sleepless nights, especially in a volatile market environment.  The challenge is that very often investors’ desire to manage the pain of these sleepless nights in the short term can lead them to make changes that actually increase the odds of running out of money in the long term.

Certainty is comforting but almost always expensive.  Most investors can’t afford the certainty they would like and must balance that need with their longer term goal.  Case in point, for years the default option when investors enrolled in a U.S Defined Contribution (often called a DC or 401k) plan was a cash or cash equivalent investment (money market fund).  In 2006, the Pension Protection Act stipulated that these options could no longer be the default.

Why?  Although cash equivalent investments offer great certainty that an investor preserves their capital, they offer such low returns (with correspondingly low risk) that it is virtually guaranteed that an investor would not be able to retire with any confidence that they would not run out of money before they die.  The government made the decision to force participants to take on greater investment risk in the default option to better address the risk of running out of money.  In other words, the government wanted investors to have a fighting chance to live a comfortable life in retirement and if that meant more return volatility, so be it. 

Understanding and talking about risk may not be the most enjoyable aspect of planning for retirement, but in the investment world it’s a very real and necessary consideration. Just like an astronaut might spend months studying the circumstances of a potential spacewalk before venturing into the void, investors of all kinds need to study and understand the risks they can tolerate in pursuit of their goals.

My colleagues will have more to say in a couple follow-up posts on risk from the perspective of institutional investors specifically in the coming weeks.

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