To feel confident that your savings will be sufficient to support your retirement, there are a number of risks to be managed. Part 1 of this blog published last month addressed managing longevity and lifestyle inflation. Part 2 focuses on investing and taking appropriate risk.

To successfully fund your lifestyle in retirement you will need to balance your capacity and tolerance for risk.

No risk, no return

Investment returns are related to the risk taken. A former colleague of mine loved to say, “If you try to shoot the lights out, be prepared to live in the dark.” Different types of risk will command different levels of return depending on how easily the risk can be diversified away. For example, broad stock market exposure will have a higher risk-adjusted return than an equivalent exposure to a single company’s stock. Despite all the academic research confirming the relationship between return and risk, investors still fall prey to offers of high returns with low risk. Those offers are simply better at hiding the risks. You may get lucky and avoid the risk, but relying on luck to earn a return is not investing.

Many use the terms “risk” and “price volatility” interchangeably, which is incorrect. An investment may have a variety of risks (default, changing profitability, sensitivity to interest rates or commodity prices…) which lead to price volatility as market perceptions change. Volatility poses a risk if you are forced to sell when values are low, due to a miscalculation of your capacity or tolerance for risk. Since market downturns can last a long time, risk capacity is measured by how long one can avoid selling at an inopportune time. Risk tolerance, on the other hand, is largely based on emotions and may mean that one acts, or overreacts, to market movements, both up and down. A good investment strategy establishes a level of expected volatility for your portfolio consistent with both your risk capacity and tolerance.

Volatility from well-established sources

Your portfolio’s volatility is driven primarily by its exposure to the stock and bond markets. Public stock and bond markets have been in existence for centuries and their range of likely returns is well known. Stocks represent a share of all future profits and are significantly more volatile than bonds, which are essentially loans to companies, governments and municipalities. Most of our clients have a level of risk capacity and tolerance which requires a blend of stock and bond markets. For example, an investor holding an equal mix of each for a ten year period has earned an annualized return between 2 and 16% (source: JPMorgan Guide to the Markets, 1950 – 2016).

Are you seeking returns better than the market?

While many investors are satisfied to earn market returns, some, including our firm, strive to find sources of additional returns. Any strategy aimed at outperforming a market will introduce some form of additional risk: the more the projected return above the market, the greater the risk. The strategy must more than cover the cost in fees and taxes since the added return is uncertain while the costs are not.

One source of potential additional return is to emphasize small company and value stocks. There is extensive research which has found that small company stocks tend to outperform large companies and that value stocks outperform growth stocks over time. A portfolio with exposures to these two factors (called “dimensions” by Dimensional Fund Advisors, an early adopter) is likely to generate returns greater than the market.

Protect your retirement from rare but extreme events

Not all sources of volatility are predictable. Don’t disregard the risk of a rare event simply because it is too hard to quantify. It is important to avoid having concentrations in your portfolio that may make your portfolio more vulnerable to rare events. Some families I have worked with over-invested in what they know well. Texans like oil exposure. West Coast investors love tech. Over time, their portfolios end up having an industry or commodity exposure even though they may seem diversified. An extreme event may have surprising impact on a concentrated portfolio.

Global diversification across asset classes, countries and industries may sound boring, but it is the single best strategy to protect against the rare event.

A sensible approach is to start with your goals and then craft an investment strategy which balances your capacity and tolerance for volatility with sufficient growth to meet your retirement needs.