The 3 Areas of Risk Management

Comprehensive financial planning is far more than just managing investments within your financial portfolio. Advisors who utilize a holistic approach should also be looking at how your investments coordinate with your individual tax planning and your income planning.  Furthermore, no financial plan is complete without a discussion regarding risk.  In the St. Louis Park offices of Secured Retirement Advisors, we prepare a risk profile focusing on three different areas of risk with our clients: 1) Risk Required, 2) Risk Tolerance and 3) Risk Capacity.  In the course of a complete financial planning process, a discussion of trade-offs becomes a crucial part of the conversation which helps determine if a retiree should accept more risk within their investments or if a more conservative approach should be utilized. As all of our clients have unique retirement visions, goals and personalities, each ends up with a different risk profile, investment portfolio and financial plan.

Risk Required is the portion of the risk profile that determines a specific level of risk needed to keep pace with inflation or to accumulate a specific amount of retirement assets which will be needed for future income. Trade-off decisions in this area focus on balancing the need to take some risk with your retirement assets to guarantee that you will have enough buying power with your money 25 years into retirement versus the possibility that you may take too much risk and lose savings principle. Reducing the risk required by a retiree can often be achieved when predictable sources of income such as social security or pension maximization are planned properly.

Risk Tolerance is also an important area of a retiree’s overall risk profile. While most families have had a discussion around their specific risk tolerance with a financial advisor or their 401k administrator, this area is the most emotional and least quantitative of the three discussion points in a well designed risk profile. Risk tolerance can be compared to an individual’s investment pain tolerance. It helps measure how much loss an investor can “emotionally” handle within their portfolio before they may end up making poor decisions which may be based more on feelings than logic. It’s the point in which an investor may decide that they will sell out of the market, which is often near the bottom, or refuse to open their latest investment statements. Unfortunately for many retirees, risk tolerance can best be measured after the fact. It is not uncommon for even the most conservative investor to begin taking more risks when caught up in the hype and euphoria of a bull market and even the most risk adverse gambler will tend to pull back on the reins some and begin making second guesses near the bottom of a market correction.  Here is the best rule of thumb: If you found during the last market correction that your financial pain threshold was exceeded, then you may want to reconsider the risk in your portfolio.

Risk Capacity is the amount of loss that your specific portfolio can sustain and still maintain a reasonable expectation of achieving your financial success. Of all the components of a risk profile, risk capacity is often the most overlooked by the financial community. If you ignore this portion of your risk profile, you could be at risk of suffering a mortal death blow to your finances which will impact your retirement vision forever. Think of the neighbor, relative or friend whose retirement reality has been completely destroyed due to portfolio losses in 2008, completely changing their anticipated retirement experience. Risk capacity often focuses on how much money needs to be withheld outside of traditional investments.

All families should review all three areas of their risk profile on a regular basis. Often, retirees will find that one of these areas conflicts with another. For example, a client may have an aggressive risk tolerance, but not have the capacity to accept market loses in excess of 10%. On the other hand, a couple may have a solid income today and have a very conservative risk tolerance, but their preoccupation with safety will cause them to lose buying power with their money unless some risks are taken. A comprehensive planning approach will usually help a family assess each tradeoff and make the best overall investment plan. 

If you would like a complementary “Risk Analysis” of your own retirement plan, or a complementary “3 Step Review” of your own retirement plan, call Secured Retirement Advisors at 952-460-3260.  Feel free to visit us at www.securedretirements.com and help yourself to any of our free, down-loadable educational materials.