Ability to Tolerate Risk: Spending Relative to Asset Base

What is the percentage of spending needs relative to an investor’s asset base that would make an investor’s ability to tolerate risk above or below average, all else equal? The required reading/study guides don’t provide specific information about how to think about this and the essay questions from past exams provide quantitative reasoning on this topic. What’s more, the last 2 years of essay questions appear to differ on this topic. For example (and all else equal), in the 2008 essay questions (#1), a 5.53% real spending need or 9.75% including inflation would decrease investor’s ability to take risk while the 2007 essay question (# 1) says that a 4.84% real spending need or 7.34% including inflation would increase ability to take risk. The nominal returns required from each of these asset bases are fairly similar but the ability to tolerate risk is different according to the essay answers. Do we think about it on a real basis and everything under 5% is ok and over 5% would decrease ability to take risk?

well, i guess as a rule of thumb anything below 5% is considered as low spending needs

This is a great question - I believe someone in another thread was saying that a real after-tax return of 5% could be the “baseline.” Since several of the last exams focus on risk “ability”, does anyone have a good mental checklist they go through? Here’s the one’s I have right now. Anyone remember more of the options they talked about for #4? 1) Age/Time Horizon 2) Spending Relative to Asset Base/Discretionary Wealth 3) Nature of human capital 4) Options - go back to work/spend less

^^ nice list, nerd.

I would add reliance on portfolio for large % of spending needs. (think foundation and operating expenses) I was confused about this after grading Bk 6 2AM. After discussion I think it was the consensus that even if 1, 3, and 4 all indicate above avg… 2 is more important to ability and dominates over the others. Bk 6 spoiler… 1,3,4 were all clearly above avg and 2 was average (3% real RR, maybe 5.5 or 6 nominal, I forget), however, since the annual spending needs relied significantly on the portfolio, 116k of 150k income needed to be generated by the portfolio, this being below avg trumped 1,2,4 above avg and 3 avg… and the ability was given as below avg.

I honestly think in application on the test, time horizon trumps spending percentage when the percentage of the portfolio is between the range of 0-10%. Above 10%, spending percentage is more likely the factor in determining risk ability