There are three main risk elements when it comes to financial planning and your portfolio, and they are this, number one, your portfolio has a risk score. How risky is it compared to the market? Number two, there’s a risk tolerance. That’s how risky do you feel like you need to take? That’s a psychological internal evaluation that you go through to find out what your risk tolerance is and you need to match your risk tolerance up to the risk of your portfolio. But the least talked about risk factor when it comes to your portfolio is your risk capacity, and that’s a real financial term. Basically, what that says is how much risk can I really afford to take? Today, we’re really going to zone in on risk capacity and what your portfolio can afford to have with the ups and downs of the market.

First, let me dig a little deeper and show you where you might be misaligned. Sometimes there are people, sometimes when they get to retirement and man, they’ve got a risk tolerance that’s off the chart. They’re able to take, they think psychologically they don’t mind taking a lot of risk, but their portfolio is of such size that if they took a big risk with that portfolio and their capacity is very small because they can’t afford to lose much of what they’ve got because they don’t have that much. So their risk tolerance could be super high, but their real risk capacity could be low.

The flip side is I’ve worked with a lot of our clients’ children and their children may be 25, 30, 35 years of age and for whatever reason, their risk tolerance is really low. They don’t want to take any chances with that retirement money. Well, a 29-year-old has 30 years before they’re going to be able to tap into the 401k or the IRA without penalty at 59 and a half. So, they’ve got 30 years of market exposure and generally historically, the market has always been very good to us. It’s always grown. So, they may have a very low risk tolerance, but the capacity they have at 29 years old, 35 years old, 39 years old, should be really, really high because they can afford, they’ve got time on their side for the ups and downs and the swings of the market.

So older people, sometimes they have a high-risk tolerance, but a low-risk capacity, they can’t afford to lose very much, and younger people have a really low risk tolerance, but the capacity to really throw it out there and let it grow because they’ve got 30 years to make it up if they do lose.

So, what should go into determining your risk capacity? First thing is time. How much time do you, if you’ve got two years left and you’re marginal as to how much money you have saved for retirement, you don’t have much risk capacity. You can’t afford for there to be a 50% downturn in the market like we’ve had twice since the year 2000. You might have a high tolerance for risk, but you don’t have the time to recover, so your capacity needs to be very low.

Second thing you need to consider when it comes to capacity, how covered are you for income? Some people are sitting out there and they’ve got a good strong social security. You may be married and have a second really good strong social security. You could have one or more pensions that’s going to bring income into you. You could have rental income that’s coming into you. Some people have an inherited IRA beneficiary IRA that’s bringing in income at least over the next 7, 10, 8 years, whatever. You have to drain them now within 10 years. So you may have a real healthy income flow, which means you don’t have to immediately start drawing down on your lump sum that’s left over.

So that could mean that your capacity could be pretty high for a risk level. Your risk capacity, you say, I can afford to lose some money and it’s still not hurt the income flow that I have. So again, we’re trying to help you determine your risk capacity. How much time do you have? Number two, what kind of income flow do you have? Number three, how big is that portfolio? I mean, if it can take a hit of 20, 30, 30 5%, you say, let’s put that in the numbers. If you’ve got $1 million saved for retirement and you would be okay if you went down to 650,000 in a real serious downturn, if you’ve got that high risk tolerance and you want to throw it into the market and the market doesn’t treat you well, you’ve got to understand real numbers. Are you going to be comfortable if that portfolio goes from 1 million to 650,000?

You say, yeah, I know because I’ve got faith in the market that it’ll still be strong. So, if that portfolio is big enough and you don’t have to draw on it soon enough, some of these other factors we’ve talked about the size of the portfolio might help you have a bigger risk capacity.

And the fourth thing that I would say you need to look at if you’re going to try to determine your risk capacity is what are you spending? Yeah, that’s that four letter word budget, B-U-D-G-E-T. How much in retirement are you going to be spending? We try to coach people every single day that you need to know your budget because that’s your bingo target. That’s how much you’re going to be spending. So you put this thing together and you say, I need to know how much I’m spending. How do I find that out, Tom?

Well, you look at what you’re spending now. Oh, I’m not retired yet. I know, but so many times it’s very close. When in retirement what you’re going to be spending, your budget almost stays the same. Your mortgage stays the same, your car payments stay the same. Your car insurance stays the same, your food stays the same. All those things stay the same. You’re going to need at least 88 to 90% as much in retirement as you needed before you retired. So figure out what your budget is. Don’t just keep putting it off because it’s not a fun task to do. But the fourth thing in determining your risk capacity, you need to know your budget, your expenses. What am I spending now? We’re honing down. Now we’re bringing that cone down from just risk capacity. It’s just letters on a page that I wrote down to a number that says I can afford X, y, Z.

That’s how you determine your risk capacity. So how do we get you a bigger risk capacity? There’s one thing I can do when it comes to the first issue that we brought up, and that is time. Some people choose once they see all of these things on paper and you start developing what we call a retirement blueprint. Some people choose to work another year or to work a second year or third year before you do retire. In other words, they put off real retirement. Another thing that has to do with time is some people get a part-time job even in retirement. What does that do? It puts that time further and further away as to when you’re going to have to start really turning your portfolio into a retirement plan. So, there are some things you can do to give yourself more time.

Second, how can I increase your income sources? Some people see the wisdom of ensuring their income in retirement. In fact, if you’re not on the bandwagon for this, you’ve missed the bandwagon, you can still catch it, but the bandwagon is taking off as people don’t have pensions and don’t have as much confidence in social security. Fixed indexed income annuities are becoming far more popular in the last five years. There is four times as much money going into fixed indexed income annuities as there was just five years ago. It’s amazing how it’s exploding because what that does is it increases your income capacity in retirement. Yes, you’ve got your social security, maybe two. You’ve got your pensions, you’ve got your rentals, maybe you’re working, but that annuity gives you guaranteed income for as long as you live even after you run out of your money. It’s an old age insurance. People still in retirement, they insure their house, they insure their car, they insure their health, they insure their long-term care, they insure their pets, but so many times because they’ve been told to hate annuities, they hate the annuity that will come along and ensure your income for life.

Don’t be pushed into a corner, a cul-de-sac where you can’t get out. At least explore the option of increasing your retirement income by putting some of your portfolio into an income annuity that’s going to give you guaranteed income for the rest of your life, increasing your income, and therefore maybe increasing your risk capacity.

Okay, we’re talking about increasing your risk capacity. The third way that you might be able to increase it, if you’re still working, put as much money as you can in that 401k that IRA. Make sure you take advantage at least of the match. But if you’re close to retirement and you’re probably going to have a great retirement, you’re probably maxing out your 401k. That means that if you’re over 50 years of age, you can put over $30,000 this year into a 401k. Make sure you’ve stayed up with those increasing amounts through the years and in these last 2, 3, 4, 5 years before you do retire, build that portfolio as big as you can.

You say, I’m maxing out my 401k. Start a brokerage account and start putting extra money into that but build that lump sum as big as you can because from that, you’re going to have to turn on a flow of income somewhere somehow in retirement.

The fourth way you can increase your risk capacity is you can get rid of as many expenses and liabilities as you possibly can before you retire. The big one, try to get your house paid off. Don’t give me the math. I’ve done this 30 years. You can’t pull the wool over my eyes. The people who retire and they have their house paid for are the most contented people in retirement. My house is paid for, I don’t have a mortgage. Well, what about the deductions? And the deductions aren’t that big anymore, and if you live in California, your taxes and your insurance are going to take almost every penny of the allowed deduction anyway.  Now, so forget that mortgage game, pay the house off and every month in retirement, instead of running the high hurdles and you’ve got that mortgage payment every month, you’ve got that mortgage payment. Run the low hurdles where you just fly over those hurdles, watch a track meet sometimes you’ll understand what I’m talking about. Get the mortgage paid off. Get the credit cards paid off. For goodness sakes, at least the mortgage is probably gaining in value because of the value of your home. But nobody ever gained in value by having a bunch of money they owe on credit cards. That is just a hole in the bottom of the bag. The student loans, I can’t tell you how many people are retiring and they’re still carrying that parent plus loan for their kid because they went, the kid went back and didn’t get out of the basement, and we don’t even have basements in California and they didn’t get out of the basement. You’re paying for their second and their third master’s degree. They don’t need another degree. They need a job. Okay? You need to take care of the goose for the family that’s laying the golden egg. Increase your risk capacity because you get those things paid off. You don’t want to drag that weight all the way through retirement. You want to increase your risk capacity when you pay those debts off.

So let me give you two things to do. You say, man, I’m motivated to do this. The one thing I would do, if you want to do it yourself, act. Do something, say, I’m going to do something this week or today even to help increase my risk capacity in one of these four major areas that I’ve talked about on this show. Number two, you say, yeah, I want to do something, but you know good and well it’s going to be just like the other 484 times where you’ve decided to do something and then you didn’t act and follow through. That’s where you may need some help from a financial advisor in doing these evaluations. What’s the risk of your portfolio? What’s your risk tolerance? We can give you scores on both of those. We can help narrow down like we’ve done in this podcast. We can help narrow down to really find out what’s your risk capacity and what are you comfortable with, but also what are you able to afford in your portfolio? We can help, your financial advisor can help. Somebody can help, but nobody can help you if you just listen to this and you walk away and you do nothing about it. I think about the scripture in the Bible where it talks about the person looks in the mirror and they see what needs to be done and they walk away and they do nothing. They don’t change it all. This podcast won’t help you unless you take individual action or you call us or somebody and you start taking action to increase your risk capacity. Here’s one thing I know the market throughout your retirement is going to go up and down, so you need to know how much of that up and down, how much capacity your portfolio has to be able to handle, how much of that up and down of the market that you’re going to experience as we live this thing called life. Hey, thanks for listening, but risk, capacity, just a small little bit of an overall financial blueprint. You need one. You need to know where you’re going. You need to have a plan. I’ve said so many times before, so many people spend more time planning a two week trip to Europe than they do a three decade retirement.

You need a plan. You want to know what’s in a plan? You want to know how it all fits? You can check out a show we’ve done already that’ll show you what a retirement blueprint is all about. Hey, if we can help you, particularly about a situation, a question, anything you’ve got, give us a call! We’ll see you next time.