Want to canvas the consensus for considering size of spending needs relative to portfolio size sufficient to deem an individual to have a below-average ability to accept risk. I understand that ability to take risk is also a function of time horizon, imprortance of goals, flexibility etc., but at what required rate of return do you deem the person to have a below-average ability to assume risk (assume long time-horizon)?
Thanks
Spending neeeds Above 6% of portfolio size suggest below average ability to take risk…
between 1-4%…Above average
between 4-6%…need to look other factors such as time horizon, years to retirement etc.
any other views?
rahuls - was there ever any part in the curriculum that highlighted / bracketed things in this manner? I do not remember reading it so laid out in the curriculum (though I must confess I read it a couple of months ago, and have forgotten everything). But if there is some portion that lays it out so, please point it to me - so I will make sure not to miss it in my review.
From what I have seen, it is one of those areas which is quite subjective (the subject being you, and how you are able to quantify / qualify the statements you make).
It depends on
Size of investable asset base
Expenses (living expenses, regular liquidity needs)
Time Horizon (long term, short term)
Unique circumstances
Goals / flexibility.
I have not seen a number like a “rate of return” being used to quantify “risk” unless what the OP meant was a “% of portfolio size” like Rahuls has suggested (and even there my original comment holds - viz. is there any place where such a layout > 6%, between 4-6% and < 4% been shown)!.
Thanks
cpk
In SCH videos Greg Filbeck provides heuristics to discern Ability to take risk in this fashion.
Feel free to share your views if you feel otherwise!
Agree with cpk that it is indeed subjective. It may be we get some sort of hint from the tone of the passage. If they point out expenses and give an impression its not a big deal , that’s one end . If they bring in sick parent or imminent college expenses etc. that’s the other . The numbers themseles do not bracket the tolerance
They will give you enough information to infer what the ability is in an actual exam question, it will not come down to assigning an arbitrary value to a return requirement. IT is more likely that qualitative rather than quantitaitive inputs will guide you – something like – “John is retired and his salary meets his living expenses, he has no siblings or heirs, and does not live extravagantly”
Ok, thanks for the feedback. I agree that the quantitative factors are likely to be more indicative of ability to assume risk.
For arguments sake though assume the following:
"John is retired and his salary meets his living expenses, he has no siblings or heirs, and is expected to live another 20 years”
Also assume that his required rate of return based on expenses is, say 6 percent (real terms) and inflation is 2 percent.
At 8 a percent nominal required return, I’d argue that the required return is high enough to render his ability to tolerate risk below-average, I may even suggest educating the client regarding appropriate rates of return.
Any opinions?
Apologies I meant to write qualitative factors.
Also, I should clarify that I mean required spending relative to portfolio size rather than required rate of return. Although, I’d note that the two are directly linked.
If John is already retired and his salary meets his expenses, what is his investment for?
does his salary increase with expense inflation? if not is he only saving to cover any future imbalnces?
if he has no heirs, there’s no bequest motivation - or is he planning a large gift to a charity or other organization?
With just the current information I’d assume an above-average ability to take risk given that his expenses in retirement are taken care of, no explicit saving goals and a long time horizon.
Apologies, I am writting this from work in between emails, I didnt catch the angle about his income covering living expenses while retired. Let me rephrase to:
John is retired, he has no siblings or heirs, and is expected to live another 20 years … dafsf"
Assume that based on other info provided his required return is e.g. 4%, 6% or 8% - at what rate do you start to qualify his spending to be high enough to warrant a below-average ability to accept risk.
what about his portfolio? What is its size?
what are the state of his finances? What about his expenses?
With none of these - your best guess is as good as mine.It is not a vacuum that is in operation here.
from just my own subjective heuristics I would say:
anything 4% and below would be above average. this stems from the “only use 4% of your retirement portfolio for expenses in order to outlive your assets” rule of thumb.
b/w 4% and about 8% I’d say average, and above 8% I’d probably say below-average. But all of this is just subjective. I like the reply above that gives:
"Spending neeeds Above 6% of portfolio size suggest below average ability to take risk…
between 1-4%….Above average
between 4-6%….need to look other factors such as time horizon, years to retirement."
I think that sums it up the best so far. I’m not sure what anyone else does though.
Ok, assume his total assets amount to $1M and he wants to leave a an equal amount (in PV) as a gift to charity at the end of his life.
His living expenses are expected to be $30K, $40K, $60K or $80K.
At what point do his living expenses make him have below average ability to accept risk?
FinNinja & Rahuls - Thanks!