We ask Tom What to Consider Risk-wise for an Investment Portfolio
Transcript:
Katie Nealis: First question. All right, Tom. So before we get into the very first question, it’s talking about risk. Can you explain what that is?
Tom Vaughan: Yeah, risk is an interesting term in terms of investing, there’s kind of two risks. One, of course, is just, you know, losing money. So if I put $100,000 into something is worth $60,000, well, that I took a risk and I lost. And so you can measure the risk of an investment by many different ways a standard deviation is one method, or I like to look at how much it fell in different time periods. I’ll compare that to the market and see, you know, what has happened with that. So it’s kind of a volatility risk. But there’s another risk also. And that is not having enough money to pay all of your bills at some point in the future, especially in your retirement, because of inflation. And so that usually means you need to take a little bit of risk. So there’s kind of this teeter totter that we all end up on, you know, in terms of what you know, what we do with risk, but that’s essentially what risk is, in my opinion, the risk of loss and the risk of not having enough to keep up with inflation.
Katie Nealis: Thanks for explaining that to your viewers. So the first question we had from our question bank is, how do I figure out how much risk to take during my retirement?
Tom Vaughan: Okay, well, that’s a really good question. Actually, it’s very common, you know, you got to think about somebody who is retired, you know, they’ve gone through their whole life built up, this assets worked and had an income coming in, and all of a sudden, there’s no job any longer and they’re living off this assets. And so it can be sort of feel like flying without a net. And you want to make sure you’re taking enough risks to have enough money for the long term, but not so much that you get wiped out. So actually, let me show you, I’ll share the screen here, and show you some examples of kind of how we analyze risk. And it’s pretty interesting.
Alright, so what I’ve got in front of me here is a program called money guide Pro. And this is a financial planning program that uses a technique called Monte Carlo simulation. So I’m going to push this button and it’s going to run through the sample plan. This is Joe and Jane sample that I made up for this. So when I push this button, you’ll see here, it ran through their life 1000 times 960 times it was successful. So it just means that there was still some money left, in this case by 2050, which is the target. And what it’s doing here, it’s the plan has everything in it, all of their assets, all of their incomes coming in Social Security, those types of things, pensions, and all of their outflows, you know, what they’re planning on spending a travel, you know, what they need to pay their basic bills, you know, the gifting to the kids, whatever it might be that they’re trying to do. So this is actually a very good number 96%. So one of the things that we look at here is the structure of the current portfolio. How does it look overall, so not bad 960 successes means that the structure is not terrible. But we do some additional pieces here, or we do a little stress testing.
So this is called What are you afraid of? This is really fascinating, because it’s going to run through Monte Carlo simulation again, but based on different scenarios, so the first one, I’ll click on here, it’s just great recession loss. So what what the program is doing is it’s saying, okay, tomorrow, the great recession is going to start, which is what we had back in 2008. You know, the s&p 500 dropped about 53%, it took five years to come back, what would happen to Mr. Mrs. Sample in that scenario, so when I click this, we can see, you know, it’s running it 1000 times again, but the first thing it tells us is that their portfolio on a projection basis would drop about 14%. So that’s not bad, actually, considering the market was down 53%. And obviously, they’ve got a fairly conservative portfolio. But their overall success rate went from 96%, with all of their goals included back to 82%, that’s still actually pretty good still in the green. It’s not a real big problem as far as that goes. So that’s something you know, that we look at as far as that goes. And so, but I also look at inflation, because inflation is the opposite is sort of the Ying and Yang. If you are doing poorly in this great recession loss, then you actually need less stock because that was a stock market downturn. If you’re doing poorly versus inflation, you actually need more stock. And so look, if I pull this out to say 5% So here we’re looking at a situation or Mr. Mrs. sample and up with a higher inflation than expected 5% a year on all their expenses. And now you can see actually drops all the way back to 54%.
So they, they they have some vulnerability here, in terms of inflation incurring into their portfolio, which means that they’re actually a little bit too conservatively invested as far as that goes. So that’s, that’s a huge piece right there that we would want to look at. But then you run into the other side. Have a scenario, this program will show you what risk you need to take. And so what it’s telling me is that they need to take a little bit more risk. But then each person has their own risk tolerance that they are essentially have developed over their whole lifetime. And so I’ll share here with a document that I made to kind of demonstrate, we use a program called riskalyze. And I just took a couple of screenshots here, again, for Mr. Mrs. Samples portfolio, it’s a riskalyze, I think allows the client to see what might happen in some of these kind of bad case scenarios, and how much money they might lose.
And they need to be able to absorb that and accept that. So for example, it gives a risk number 45. So 100 would be really aggressive, one would be virtually no risk. And so right near the middle, right, a 45. And so that kind of gives an overall flavor for where the risk is, in terms of total bond and stock market. But what they’re showing here, and this might be a little hard to see, but you would have projected over the next six months 95% chance you’re gonna be between negative 8.3% and positive 12.9. So this is one thing I focus on. Look, if this if you got a statement, and you were down 279,000. In their case, they have about 3.2 million, you know, what would you think, how would you react because you can’t get, you know, the positive 431,000 that’s up on the screen side unless you can absorb and hang in there on these downturns.
So if we’re going to move your risk up to handle inflation, we’ve got to make sure that you’re not bailing out at the, you know, next big downturn. And then this actually shows some of the stress test pieces, you know, how it would do in an up market. So the s&p was up 32. In that same market, this portfolio been up 1.7. So again, pretty conservatively invested in a down market, you can see here, you know, the 2008 bear market or the full financial crisis, from top to bottom, you can see the s&p 500 would have been down 53%, they’re down 23, down almost 780,000. Again, they have to be able to internalize that. So from a strategy of how we determine the risk that you should take, it’s using all of these tools, and then every quarter, the clients get these numbers from riskalyze get an email that kind of breaks down the risk that they’re taking their portfolio, because risk, you know, tolerance changes over a period of time.
So it’s it’s not a super simple thing. I mean, a lot of people don’t have a very sophisticated methodology for figuring out exactly what risk they have. And that’s what you got to be careful with because you could be taking more risk than you think or not taking enough and it’s really nice to kind of know what you need to do. And maybe if your plan says I have to take more risk, what you maybe need to do is go in there and look and see what you’re spending and say okay, maybe we’d spend a little bit less because we don’t want to take that much risk. So you know, there’s adjustments that you can make on either side but but that’s how that’s how so