The level of financial risk we can tolerate depends on our savings: The less money we have the more risk we can afford to take on. If you have worked with a financial advisor before then you’ve probably seen a risk tolerance chart like the following.
Each portfolio from A to D represents a different risk tolerance of maximum expected returns and losses. Choosing a model portfolio can help one’s financial advisor determine the best funds for the client based on his risk assessment. Conservative portfolios tend to hold more bonds, GICs, and T-Bills. Aggressive portfolios may hold more technology and energy stocks, which are more risky but also more potentially profitable.
If we are currently in our working years and only have $100,000 of savings, then we should have an aggressive investment plan that mimics the expected rate of return as Portfolio D in the image above. High risk, high reward. Like Ms. Frizzle always says, “take chances, make mistakes, get messy!” This is because losing $20,000 in the worst case scenario is no big deal since we are still actively working. $20,000 is only 6 months worth of salary for many people, so the loss can be quickly recouped 😀 But if things go well then hot diggity dog! we’ll make a $50,000 profit. The key to compound interest is to start as early as possible so if we can make our portfolio value 50% higher at a younger age it will give us a huge advantage over the long run.
But if we have recently retired and have $1,000,000 in savings then our investment goals would be different. We can’t be in Portfolio D because a potential $200,000 loss is a lot of money, and could prevent us from having a comfortable retirement. At the same time the potential return of $500,000 doesn’t sound that appealing when we’re already millionaires. At a certain level of wealth any extra money we save will face diminishing marginal utility which means the lifestyle of a senior who is worth $1.5 million isn’t going to be drastically different from another senior with only $1 million. So in this situation it would be better to choose the more defensive Portfolio A.
When we’re young our spending often depends on the product of our human capital and time, both of which we have an abundance of. But when we’re retired our human capital becomes diminished, so lifestyle needs to depend on our savings instead. This is when capital preservation takes priority over investment returns and we have to decrease our exposure to risk in order to make our portfolio last as long as possible 😉
Random Useless Fact:
Humans don’t have natural enemies. So we fight with each other.