Allan Roth has decades of experience constructing retirement investment portfolios for clients, but he never predicts the direction of the stock market.
He does, however, predict human behavior. "People will buy after the market goes up," said Roth, founder of a financial planning firm in Colorado Springs, "and they will sell when it goes down."
Roth is describing what the behavioral finance experts call recency bias — the tendency to use our recent experiences to make assumptions about what will happen next. The stock market's recent volatility — punctuating a nine-year bull market that was preternaturally smooth over the past year — points to the possibility that recency bias could do a lot of damage to retirement portfolios this year.
Just to be clear: No one knows where the market will head this year. But volatility, and the possibility of a major bear market, point to a missing part of the equation in most retirement saving plans: a careful assessment of risk.
Employers sponsoring 401(k) plans have a fiduciary duty to select plan fund choices that are varied enough in time horizon and risk levels that participants can create a diversified portfolio. To do this they must consider the range of participant time horizons.
Many plan sponsors do not have the investment expertise required to select the plan's fund choices or provide individual participant advice, so they hire a fiduciary to help with plan fund selection. Some of the fiduciaries that help select a plan's fund choices will also provide education (not fiduciary) or individual participant advice (fiduciary). In the case of individual participant advice on their 401(k) portfolio, an appropriate needs-based analysis would be factored in to the investor's time horizon and goals.
Outside of a 401(k) plan, assessing risk tolerance is standard procedure for all financial advisers — broker-dealers are required by the Financial Industry Regulatory Authority to assess risk tolerance as part of the agency's suitability standard for evaluating investments, and registered investment advisers must assess risk tolerance as part of the "duty of care" obligations they have as fiduciaries.
But there is no broad agreement on the best way to assess investor attitudes about risk.
A wide array of tools is available that can measure risk tolerance, but the smart approach is to consider risk as part of a broader goals-based approach to retirement saving.
If you really just want to test your risk tolerance, here is a simple approach: ask yourself whether you understand how much you could lose if the market really crashes, and whether you could withstand the losses while it recovers.
In the last big market crash, the S&P 500 Index fell 55 percent (including dividends) from its peak on Oct. 9, 2007, to its trough on March 9, 2009. Bonds, as measured by the iShares Core U.S. Aggregate Bond ETF, returned 7.39 percent, including interest and other income.
Kendrick Wakeman, chief executive of the analytics firm FinMason, recommends a simple stress test: apply those figures to your current portfolio. Taking the test not only helps determine your breaking point, but also helps prepare you emotionally so that you will be less likely to panic and sell at a market bottom.
But few financial advisers administer that test. A survey by FinMason last year of nearly 500 investors with personal financial advisers found that only one in four had been informed by their adviser how much they could lose in a crash.
And the long nine-year bull market has encouraged more risky investor behavior. "Many of the new clients coming to me over the last few years have been taking far more risk than they were in 2007," Roth said. "The duration of the bull market is one reason, but interest rates were higher back then, so there were more opportunities to earn something decent on bonds."
Conventional wisdom encourages young people, in particular, to take more risk, said Michael Kitces, founder of the XY Planning Network, a network of fee-only advisers specializing in serving Gen X and Gen Y clients. "The idea is that you can 'afford to take a lot of risk' because you've got a long time horizon," he said. "But times like this are a good reminder that no matter your time horizon, you should never take more risk than you are comfortable and willing to take."
Indeed, research has shown that for young savers, the key ingredients for a financially comfortable retirement are getting an early start and saving at a healthy level. Compound returns will take care of the rest.
Even for younger investors, a well-balanced, diverse portfolio is important, Kitces said. "Remember, if a portfolio is well diversified, not everything should go down together. But that also means not everything should go up together, either. If everything in your portfolio has all been doing well in the bull market for the past several years, that means you may be overly concentrated."
Mark Miller writes for Reuters.