Matching your risk tolerance profile to target retirement funds
By CHM on Dec 20, 2007 in Financial Planning, Retirement, and Now!
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In Tuesday’s post I took a closer look at target retirement funds; many GenXer’s are now offered these kind of investments in company sponsored retirement plans. Of course, you can always choose to buy one for yourself in a traditional or Roth IRA, as well.
Before blindly matching up your projected retirement date with a target fund, I think it’s important to consider your personal tolerance for risk; then you can jump in head first.
Some of you may already know your tolerance for investment risk, based on past experience. If you’ve been invested over the past 7 years, you’ve seen a lot of market swings and probably have a very good idea of what you can and can not handle.
For those that aren’t as familiar, let’s explore…
Remember, it might be easy to tolerate a high-risk investment while it’s generating double-digit returns, but you need to consider whether you’ll feel the same way if the market takes a turn for the worse.
What is risk tolerance?
Risk tolerance is an investment term that refers to your ability to endure market volatility. All investments come with some level of risk, and if you’re planning to invest your money, it’s important to be aware of how much volatility you can endure. Your tolerance for risk affects your choice of investments and the overall makeup of your portfolio.
Your tolerance for risk depends on a lot of things:
- Personality - you know your self better than anyone else. Do you speed when you drive? Do you like games of chance? If you’ve ever watched the game show CashCab, at the end of the ride, the driver offers the passengers the opportunity to take a double or nothing question. Why do some people take the guaranteed money, while some risk it all to double up?
- Time Horizon - for the purposes of this post, since we’re talking about target retirement funds, I’ll assume 20 yrs+ for GenXer’s. The shorter your investment time horizon, the less risk you should expose yourself to.
- Financial position - how well off are you? Do you have other assets to fall back on?
These are a few of the factors that will help determine your attitude towards risk.
Retirement Risk Profile
For the purposes of this post, we are talking about your retirement risk profile and matching it up to the right target retirement fund. In yesterday’s post I talked about my projected retirement being somewhere around 2040.
I then went and took a look at the T. Rowe Price 2040 fund and the underlying asset allocation (89% stocks, 6.5% bonds, and 4.5% cash/other). Based on my risk profile, which I know to be growth oriented, that fund allocation matches what I’d be looking for. But again, I know what my risk tolerance profile is.
If you’re 36 years old (like me) then your projected retirement date is also 2040. But maybe you’re not as comfortable with that allocation, as I am. It’s time to figure out your tolerance for risk and then go back and pick the appropriate target fund.
How can you gauge your risk tolerance?
Thankfully, there are plenty of online tests that can help to figure out your risk profile. To make it easy on you, I found a personal finance blog that’s already done the legwork. Pfadvice compiled 5 different quizzes and put them into one excellent post.
I suggest you take 3, 4 or all 5 of these tests, and you should see a pattern begin to emerge. After completing the different quizzes, you can go back to your target retirement fund and see if it all makes sense.
(Although many people believe with 20 yrs+ till retirement, you should be heavily invested in equities, it’s important that you do your own homework (or work with a financial advisor) that can help you come to your own conclusions.)
Tags: investment risk tolerance, retirement risk profile, target retirement funds
clambelly | Dec 21, 2007 | Reply
Great topic and interesting links. I highly recommend the time horizon or lifecycle funds for all investors, but especially passive retirement account investors. A good fund will rebalance fund portfolios at least quarterly to match your designated time horizon or date you want to start drawing income from your investment with the optimal asset allocation for that target date.
For each risk level, there is one “optimal” asset allocation that provides the highest expected return. The collection
of optimal asset allocations make up the “Efficient Frontier.” Asset allocations that are below the Efficient
Frontier are less than optimal, because there is an asset allocation along the frontier that provides a higher return for the same
level of risk, or lower risk for the
actual returns received.
That said, if you are going to use a lifecycle fund for your 401k, you should put your entire
account into the fund to allow you to achieve the best expected return for
the amount of expected risk. Any other strategy (i.e 50% in 2040, 50% tracking S&P500) may result in an asset allocation that is less than optimal (i.e., not on the Efficient Frontier), or which is not suited to your investment time horizon.
I also note that 2040 and even 2030 lifecycle funds should have outperformed the S&P 500 over the last 12 months.
Now if I could just stop cracking my knuckles… Nice blog - CB
CHM | Dec 21, 2007 | Reply
Excellent comments clambelly. You make a lot of good points that I’m sure readers will find helpful.
Maybe one of these days I’ll write a post on the efficient frontier, or maybe you can do it for me:)
btw, as long as no one around you cares, there’s no harm in cracking those knuckles. Crack away…
Thanks for the kind words.
rickshaw | Dec 21, 2007 | Reply
I went ahead and took the ‘tests’ you had recommended, and it gave me mixed results.
In short, I would consider myself to be tolerant of risk. (I’m the type who would double down in Cash Cab for instance) My time horizon is similar to yours, CHM, but my financial position is not as strong as I like it to be. You can say I’m a late bloomer when it comes to investing. (Better late than never I guess!)
Anyway, I’m curious as to how you would advise someone who, while not afraid to risk, does not have a great deal to ‘fall back on’, so to speak.
Keep the blog entries coming! Learning something new everyday…
CHM | Dec 21, 2007 | Reply
I would suggest that you open up a Roth IRA and contribute as much as you can towards building a retirement nestegg. That way in the future you will have something to fall back on.
It seems, by your remarks, that a target retirement fund 2035 may be a suitable investment and match for your risk profile.
But if you’re unsure I’d suggest going back and re-taking those tests. If taken seriously, you shouldn’t be left with mixed feelings.
Those quizzes are designed to help you understand more about your relationship to risk; and they do a good job of doing so.
If you’re still confused, I suggest you seek the services of a financial professional.
Good luck