Tilting at Windmills: Risk Tolerance and Post Retirement Portfolios

Risk tolerance is a personality trait. It tends to be fixed by early adulthood. It generally doesn’t change significantly over a lifetime though it might after a financial shock such as a major market crash, divorce or retirement. Risk tolerance is likely to diminish a little with age but not materially, so any change should have little impact on retirement planning.

An individual’s risk profile is made up of three components which often don’t align: First, the portfolio consistent with risk tolerance. Second, the portfolio most likely to meet the client’s needs and third, the portfolio that best accounts for the client’s capacity for loss. The planner’s role is to help the client reconcile any differences between these three components.

In retirement, a client’s risk profile may change, but not necessarily. They still need to meet their short, medium and long-term needs. They still have to deal with market volatility; they still need to take into account their risk tolerance.

A 60-year-old client could have a 20- to 30-year life expectancy. She may have structured her portfolio prior to retirement with an eye to the future. She may remain with her pre-retirement portfolio because it meets her needs. Or she may not. The investment method adopted to meet her needs may need to change. She may elect to acquire an annuity and/or acquire income generating assets rather than those with an orientation for lower income and higher growth more common in a pre-retirement portfolio.

There’s no reason for psychometric personal risk tolerance houses such as FinaMetrica to change their risk tests. What we do need to do is explain that there’s no reason to add or subtract questions for retirees.

Risk tolerance is a trait. Retirement is a stage in life. Planning is a conversation around these two issues that may result in an investment recommendation. The investments per se have no role in the construction of the client’s risk profile. The selection of investment types in the portfolio is simply a consequence of taking into account the client’s age, circumstances and needs.


6 thoughts on “Tilting at Windmills: Risk Tolerance and Post Retirement Portfolios

  • Paul – I’m curious on something. Given your interesting comments in this article, what are your views on model portfolios?

  • Interesting article, because of its surprisingly defensive tone!

    Whilst tolerance of risk may not change in retirement, the risks do change. When you are building up funds for retirement, you have different responses available to deal with the risks which emerge – you can work longer, or save more, for example.

    Because of your ability to replace investment losses with earnings, you also have greater capacity for loss. Awareness of a reduced capacity for loss does appear to have an impact upon risk tolerance.

    And, of course, it’s all too easy to imagine that retirement is a stage in life when it is made up of several different stages. The perceived risks of those in their late 60s are very different than they are for those in their late 80s.

  • Paul

    I’ve been meaning to ask, given the time your test has been around now, but what is the relationship of a client’s parent in risk tolerance or even over the past 15 years of your data?

    If we are to assume each generation has a little more education than the last, has that lead to higher risk tolerance over the generations, or at least for the same age group over 15 years?

    Thanking you in advance.


    • Hi Dan
      I’m hoping you meant Paul, not Phil!

  • Model portfolios are useful for less experienced advisers and advisers in firms where consistency of the advice across the business is regarded as a virtue.

    There’s an obvious commercial pragmatism in advisers having a reduced number of funds to research on a regular basis. And of course, it’s easier to control the quality of communication when a firm has a small number of portfolios to manage and recommend.

    Model portfolios can also be a practical way to give advisers and clients more predictable investment experiences and outcomes.

    Risk tolerance scores can be relatively easily mapped to model portfolios. This allows advisers to illustrate historical investment performance consist with a relevant asset allocation to frame future investment expectations.

    Once a portfolio has been mapped to a risk score, an adviser can then determine whether that portfolio meets the client’s future needs. In some cases, that might include cash flow modelling and even Monte Carlo testing, in others it might be simply a professional judgement.

    I can see model portfolios growing in popularity because of the pragmatic value they offer to advisers, and their clients.

    But their use will at the same time be somewhat limited because of the lack of personalisation to individual client’s investment needs if those needs are complex or have different time horizons.

  • Regarding intergenerational transfer of risk tolerances, this is what we think we know.

    Risk tolerance levels are generally set by early adult hood. They may be influenced by experiences during childhood, but they may not be.

    We have concrete evidence that risk tolerance in adults is not influenced by education. Education may change behaviour which is sometimes mistaken for changed risk tolerances, as can be changes in risk perception. Risk perception changes as news of markets behaviour, good or bad is reiterated. So in 2007 when markets were booming, the perception was there little risk in the market. In early 2015 markets are booming. So what do investors think will happen next?

    In another example we see that Millennials have a reputation for financially conservative behaviour. A millennial who reached adulthood in 2000 will have seen two major bear markets in the next decade and the GFC (the Great Recession in the US.) On the risk capacity front, there is high unemployment generally amongst young people, tertiary education debts are an issue and home ownership is problematic. This combination leads to cautious behaviour compared to other cohorts, at least for the time being.

    So is risk tolerance an inheritable characteristic? The answer is a big fat maybe.


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