YFP 274: Risk Tolerance vs Risk Capacity (Retirement Planning)

Risk Tolerance vs Risk Capacity (Retirement Planning)

In part three of the four-part series on retirement planning, Tim Ulbrich, PharmD, and Tim Baker, CFP®, RLP®, explain why it’s critical to evaluate how much risk you are able to stomach versus how much risk you should take to achieve your long-term savings goal and considerations for setting asset allocation in alignment with your risk capacity. 

Episode Summary

YFP Co-founders Tim Ulbrich, PharmD, and Tim Baker, CFP®, RLP®,  explain the difference between risk tolerance and risk capacity in this episode, the third part of the four-part series on retirement planning. Tim and Tim explain why it’s critical to evaluate how much risk you can stomach versus how much risk you should take to achieve your long-term savings goal, and considerations for setting asset allocation in alignment with your risk capacity. Tim and Tim break down some strategies to employ when your risk tolerance and capacity are not in alignment. They connect the topic of the retirement nest egg to asset allocation. What we determine we need for the nest egg, combined with risk tolerance or risk capacity, will guide asset allocation. Tim Baker shares the value of a financial planner as an objective third-party in making retirement planning decisions, explains how preconceived notions about money impact the financial plan, and mentions early and ongoing financial literacy to increase risk tolerance. The five to ten years leading up to retirement can be a period of uncertainty, and Tim and Tim explain the sequence of returns risk during that time frame. They close with a reminder to revisit asset allocation percentages over time to maintain the amount of risk initially planned.

Links Mentioned in Today’s Episode

• YFP Planning: Financial Planning for Pharmacists
• Schedule a free Discovery Call with YFP Planning
• YFP 272: How Much Is Enough? (Retirement Planning)
• YFP 273: Alphabet Soup of Retirement Accounts (Retirement Planning)
• Your Financial Pharmacist Disclaimer and Disclosures

Episode Transcript

[INTRODUCTION]

[00:00:00] TU: Hey everybody, Tim Ulbrich here and thank you for listening to The YFP Podcast, where each week, we strive to inspire and encourage you on your path towards achieving financial freedom. 

On this week’s episode, Tim Baker and I continue our four-part retirement planning series by discussing the difference between risk tolerance and risk capacity, and how this impacts your asset allocation plan. Highlights from the show include why it’s critical to evaluate how much risk you’re able to stomach, versus how much risk you should take to achieve your long-term goals. discussing strategies to employ when your risk tolerance and your risk capacity don’t jive and some considerations when setting your asset allocation plan to be in alignment with your risk capacity.

Before we jump into the show, I recognize that many listeners may not be aware of what the team at YFP Planning does in working one on one with more than 270 households in 40 plus states. YFP planning offers fee only, high-touch financial planning that is customized to the pharmacy professional.

If you’re interested in learning more about how working one on one with a certified financial planner, may help you achieve your financial goals, you can book a free discovery call by visiting yfpplanning.com. Whether or not YFP Planning’s financial planning services are a good fit for you, know that we appreciate your support of this podcast and our mission on how pharmacists achieve financial freedom.

Okay, let’s jump into my conversation with certified financial planner, Tim Baker.

[INTEVIEW]

[00:01:25] TU: Welcome everyone to this week’s episode of the YFP, podcast excited to have Tim Baker alongside me again as we continue our four-part series on retirement planning. On Episode 272, just two weeks ago, we talked about determining how much is enough when you’re saving for retirement. Last week, episode 273, we talked about the alphabet soup of retirement accounts with a focus on those tax advantaged accounts. In this episode, we’re going to focus and dive into further on how to differentiate risk tolerance versus risk capacity, which ultimately leads to how the funds are going to be allocated within your various accounts as you’re putting together your savings strategy, also known as asset allocation.

So, Tim Baker, let’s start with why this topic matters and the connection to the nest egg ultimately, that folks may need to take just about the risks they think two or perhaps even more or less.

[00:02:18] TB: Yeah, I think this is one of the probably the most important concepts to understand. Because I think once you understand it, it’s kind of the easiest thing to adapt to better improve your financial situation, especially for like long term investment for the sake of retirement. So, I think a lot of people leave a lot of meat on the bone with regard to opportunity to improve their financial planning, because they either lack the experience or they don’t understand it, or it’s scary. But I think understanding this concept between what your risk tolerance is and what your risk capacity is, and then adapting that to your portfolio is huge. Again, we’ll kind of talk about conservative Jane versus aggressive Jane and really, all of the factors that are involved in that. One of the easiest ones to kind of change your dial up has to do with risk and ultimately, your asset allocation, which we’ll get into today.

[00:03:08] TU: Yeah, and I think this is a topic, Tim, where like, just being honest with yourself and having some self-awareness on how do I feel about the risk that I’m taking. Obviously, we’re going to talk about the importance of putting that alongside of your goals, do those jive, do they not jive. And I think this is really where the value of a third party can come in as well, when you’re looking at whether it’s one individuals, two individuals doing the financial plan, but often we might need to be both pushed and or held accountable. Obviously, an objective third party can play a really valuable role there.

So, I think we’ve all been told before, at some point or another that, hey, we’ve got to take some risk, if we’re willing to achieve, those big lofty, long term goals that we have. We talked about in episode 272, we need this big number 2, 3, 4 or $5 million, that seems way off into the distance, or perhaps for folks that are a little bit closer to that, not so far off in the distance. But regardless, it can feel overwhelming. And so, we’ve got to take some risk to get to that goal. But I don’t think we often differentiate this concept of risk tolerance versus risk capacity. So, Tim, let’s start there, break these two down in terms of definition of tolerance versus capacity.

[00:04:16] TB: Yeah, the tolerance is what we’ll start with, and this is typically the one that most people understand and know about. When I think of risk tolerance, I think of like the questionnaire. So, probably a buyer’s perspective, one of the things that we need to do to make sure that we’re doing our due diligence with a client is to ask them some questions about their experience, their outlook on the market, their understanding of how stocks and bonds work. If x loss, how they would feel about x loss or x gain and what their actions would be.

So, it’s really based on a questionnaire. From the advisor perspective, it’s really based on what we think the client can handle in a down-market. So, we’re trying to build out the best, and again, what we’re trying to do here, ultimately, is to get the best possible return for the least amount of risk, and that’s what asset allocation is. So, from the investor’s perspective, or in our case, the advisor or the client’s perspective, it’s the amount of risk that you want to take. It’s more of an emotional thing.

To me, that is basically the starting point for the conversation at least. And there are a lot of ways to get about, like what your risk tolerance are. So, one of them is kind of the rule of thumb, and I think I misspoke on a couple episodes back when we talked about this, because I think they’ve actually adapted it, the general rule of thumb. So, the general rule of thumb is that, to get your risk tolerance, you take 110, and then you subtract out your age, and then that gives you the amount of stocks or equities that should be in your portfolio.

So, if you’re 30 years old, 110 minus 30, you should have an 80% of your portfolio in stocks, or equities, and then the remaining 20% in fixed income or bonds. I think that that is a terrible rule of thumb myself. I think that’s a rule of thumb that doesn’t like necessarily hold up. But it’s what a lot of people use to kind of get started. The other way is to kind of go actually go through like a risk questionnaire, and I know Vanguard is one that – you can do that for free, go to their website and basically answer a few questions and it says, “Voila, you are 60/40, or you’re 70/30”, whatever that is. And I would actually start there before using any rule of thumb.

So again, the risk tolerance team is basically what we think you can handle on a down-market, or what you think as a client, you want to take. It’s more of an emotional thing.

If we shift over to risk capacity, this, from an advisor perspective is based on what you can actually handle on a down-market. So, this is actually using some numbers and looking at time horizon, and things like that. So, from your perspective or the investor’s perspective, it’s how much risk you should take. It’s more objective, and factors, and savings rate, goals, time horizons, think things like that. Again, it goes back to that amount of the risk that you can handle.

To give you an example of a risk capacity, versus risk tolerance, say we’re both 40-year-old pharmacists, and me close closer to you, and I’m not a pharmacist. Say, we’re just –

[00:07:23] TU: Coming up. It’s coming up.

[00:07:24] TB: So, if we both take a questionnaire, you could take that questionnaire and be a very savvy investor, have read up on the topic, and you can come back with a very, say, aggressive allocation for where you need to be. And I could do the same thing and come back very, very conservative. So, I could be a 50/50, you could be a 90/10. That’s risk tolerance, is basically based on our inputs in a questionnaire. For risk capacity, it does have to do with the individual itself, but it’s really about, I think, kind of where you’re at in life as well. So, in the same breath, if we’re both 40 years old, and we have 25 years left in the workforce, and we both kind of have the similar amount saved or earning potential, our risk capacity is so much higher than, say, my risk tolerance because I’m scared of the market, because I just have a longer time horizon.

So, where risk capacity is typically the lowest is right at the point of retirement. Because that is typically your longest time horizon, where you have a fixed dollar amount, i.e. your nest egg to work with. So, you just don’t have a lot of room capacity to take a lot of risk. You have to be somewhat conservative. Whereas if you have a longer time horizon, you have good earnings, a good savings, your capacity is a lot, a lot more. Maybe a convoluted way to say it, but to recap, tolerance is kind of like what you feel or like what you want to take. Risk capacity is what you can or what you should take. One of the things that often happens in this, is that those two things are not often equal. So, what we do as a third party is kind of have a conversation about this, and educate a client and sometimes that is over years, because sometimes they’ll say like, “Hey, Tim, I understand what you’re saying, but I just want to be safer.” I’ll say, “Okay, I’m going to bug you about this again.” The next time it’s like, “All right, well, my head didn’t fall off when the market went down 20%. It’s doing what it’s doing. Maybe I’ll be a little bit more aggressive.” And I think that is all the difference when it comes to long-term investing, is making sure that you are – again, you keep expenses low. We’ve talked about that numerous times with regard to your investment portfolio, but your asset allocation, which is based on your risk tolerance, and your risk capacity is set where it needs to be and then the big proponent of that.

[00:10:00] TU: Yeah, this is Tim, where I think the rubber meets the road of what we started this series on, with the nest egg calculation and looking at how much is enough, right? Because you and I could punch numbers in a calculator, or like, “Great, we need 4.2 million 3.7”, whatever the number is, but then we start to get a layer deeper. We talked about the tax advantaged accounts of how we might get there. But the next layer of which we’re getting into today is really that how are we going to invest within these types of accounts, which is the asset allocation. Which, as you just mentioned, comes down to, ultimately our risk capacity and the potential friction that may or may not be there with the risk tolerance.

So, I think that my question here, let’s lean into that situation where there’s a disconnect, where there’s a rub, where I understand what you’re saying, risk tolerance is what I’m able to stomach, risk capacity is maybe what I need to be able to do to get to that nest egg number. So, let’s say I punch in my numbers in the nest egg, they come out at $4.2 million, but then I realized, like, based on the rate of return and the level of aggressiveness that, those numbers are determined upon. I’m not comfortable with that. So, play that out. Is that a scenario where, as you just mentioned, we’re kind of working towards this and getting more comfortable in the long run? Is it adjusting down that nest egg goal? How do you begin to work through this with a client?

[00:11:20] TB: Yeah. The nest egg is a multivariate problem. So, the two defaults that I would always go to is like, if you’re not comfortable with taking more risk, and again, I would say, investing is definitely risky. Of course, it is. But what I would say over a 20 plus year time horizon is actually fairly predictable. We have enough data points that says that the US market, and again, there’s not necessarily any – it’s not past performances are indicative of future performance. But I think we’re not gambling here, we’re not speculating.

So, we’re not taking a bet all on like one stock. But I think if you’re uncomfortable with that, I think, the second thing I would say, is you have to save more though, you have to invest more. When we talked about conservative Jane versus aggressive Jane, and we kind of said, “Hey, conservative Jane, she makes $120,000. She gets 3% cost of Living raises, she saves 10%. She has a 30-year career. And then this is her nest egg.” What’s your income? What’s your cost to live? What do you actually save? And then the time horizon, 30 years. So, the other thing that you could say is like, “Okay, well, maybe we’re not retiring at 65 in 30 years. Maybe we’re retiring at 70.” So, it’s a 35-year career. And that’s the thing is like, you can always work longer. 

One of these things have to give, and that’s why I say like, the easiest thing for me, is to say like, “Look, if you’re 30, 35, 40, even 45, and you have 20 years, left until retirement, who gives a crap if the market goes down in 2022?” But, we as humans, we feel that loss, we’re like, “Man, my portfolio was $200,000 or $20,000, and now it’s $140,000 or $14,000.” You feel those losses. But again, this goes back to like what I was saying, it’s hard for us to conceptualize time, and when the market went down during the pandemic, I don’t even think about that and a lot of people freak out about that. But we know that the market is going to do this, and this is like on a podcast, I’m just waving my hand up and down like a roller coaster. But typically, it’s going in a positive trajectory. You’re just going to have some of those ups and downs.

What I would say is that, if you can stomach those ups and downs and lean more towards equities, you’re going to be better off. I think what people do is they put more bonds or fixed income in their portfolio, to smooth out those rides, even those rides are still the same. But what they do is they make themselves feel better in the near term, at the behest of like long-term performance.

So, on the other side of this, Tim, is like, if we’re talking to the pre-retiree, the person that’s going to retire in the next five years, sometimes you look at that portfolio, and it’s looking at him like, “Whoa, we’re taking way too much risk.” Because if the market does go down 40%, then we don’t have enough time to recover from that. So, it’s really indicative to like, say, “Hey, I’m glad you took risks throughout your working career. But now we got to start protecting the principal.” And this is where you probably want to be the most conservative with your portfolios is kind of that right in the eye of the storm, which is 5 to 10 years plus or minus, your retirement date. And people get that wrong, too. That’s where you almost – you’re at risk for like sequence of return risk, which means that if the market is down, say 20%, 30%, 40%, and then you’re taking 40 or 50 grand out of your portfolio to live on, the failure rate, meaning you’re going to run out of money is so much higher than anything that you could be doing leading up to that.

So, it’s really, really important to know where you are in space and time, and ensure that your portfolio is positioned in a way that’s going to, one, get the best returns, but also protect you. For a lot of us, it’s kind of not knowing. And I would say it’s one of the major missteps that I see, looking at people’s portfolios is a misalignment of that.

[00:15:31] TU: Yeah. Tim, one of the things I’m sensing, at least anecdotally, and talking with pharmacists, about this in various settings, is that the mid-career pharmacist, so I’m thinking about the group that is maybe 10 to 25 years into their career, they’re not yet feeling the retirement date right around the corner, but they’re certainly past kind of the early part of their career. I think there’s a real risk here, as you highlighted. Some of the limitations of the rule of thumb, to get too conservative too early. And I think, in this moment, we’re in a period of volatility right now in the markets. And depending on when people graduated and started investing, this might be the real first significant downturn that they’re feeling in the market, right? You look at even some of the start of the pandemic. That was very short lived. It was significant, to drop. But it was pretty abrupt and recovered quickly.

So, I think this is really – I graduated in 2008. I’ve talked about this on the show before. This is the real first test for me in my portfolio to say, “All right, am I really adhering to my asset allocation plan and what I need to be doing, and the rub potentially the tolerance capacity.” And I think it’s different than a new practitioner, because you have worked hard for 10 or 15 years, you have built up several $100,000 or more of savings, and you’re looking at this saying, “Man, this hurts in the moment.” But if we’re looking 20, 30 years into the future, as you said, over and over again on the show, the worst thing we can do is buy high and sell low. So, the third party here, I think, it’d be really helpful making sure we have a plan to kind of weather the storms. But I specifically am thinking about that mid-career group right now, in this period we’re in of volatility, and they’ve done hard work, they’ve built up some savings, and this might be the first test, of that happening.

[00:17:12] TB: Yeah, I mean, and when those numbers get bigger, you feel that even more, right? I’m human. When I do catch a glance at my portfolio, I’m like, “Oh, is this really?” But I had to step back and look at the long term. I almost have to like detach myself emotionally from it. Because what happens, and I say this all the time is like, when the market just does this, and it’s just a downward plunge, your first reaction is you want to take your investment ball and go home. You don’t want to play anymore. Oftentimes I say, is like, you want to do the exact opposite of how you feel. So, that’s when I reassure myself and I say, “Hey, Tim, you know what, you are putting in x amount of dollars into your 401(k) at every pay period. And now, what you’re buying with those dollars is going. It sets the dollar cost averaging.” So, when it’s up, I’m not buying as many shares, but I’m still like, patting myself on the back, because I’m like, “Yeah, my portfolio is up.” But when it’s down, I have to basically say, “Look, if I’m putting money into my portfolio systematically, on a recurrent basis, which is typically what people do in their 401(k), your dollars are just going farther.” So, then when it does rebound, you’re going to see that impact even more.

So, it is one of those things where it’s, again, it’s not getting caught up in the moment, and it is really looking at the long term. But when you hear the news, or you hear other people talking and there are things that – it gives you pause, and you start to doubt yourself. But I think at the end of the day, what I always say to myself is like I trust the market. I trust what the data has showed. Again, maybe it’s not always going to be 10% when you just sit down for inflation, it’s 6.87%. But always not be that. And sometimes people go to the catastrophic thing. I’m like, “Then we have other problems to worry about, if that’s the case.”

I really believe that, if you look at all this all the things, whether it’s you can make more money, and then potentially save more or you can work longer. To me, the easiest thing to do is to kind of like surrender yourself to the market and say, “Look” – to your point, Tim, like the rule of thumb, it’s this gradual, and I have – I’ll share the camera here, which I’ll be on the video, but this is like a really terrible sketch. Because I was trying to like sketch this out conceptually, because I’ve never showed this. I’m a visual learner. In the rule of thumb, it has you go in and say like, “Okay, if you’re 30, then how do you start in 80% equities?” And then when you go to 40, you’re at 70%. In my mind, I’m like, “No.” Hell to the no. Because it’s just so much lost opportunity.

Whereas mine is more like, my belief and this is more of a capacity thing, is more of a cliff. So, you should be very much mostly equities, and there’s a lot of criticism against an equity portfolio. And again, this is not investment advice. This is not investment advice. But it should be typically closer to the equity or equity portfolio. And then when you get close to that eye of the storm, that’s when you start to basically divest out of equities, and go more to the fixed income, the bonds, and then you go through that eye of the storm where you’re here, and then you start to gradually, as you get to 75, 80, and you’re really looking for combating its longevity risk, which is the fear of the money running out. You need that to last into your 90s, 100, that type of thing. So, you’re going to take more risks on the back end, but typically, you have a more of a handle on spending, and things like that, post eye of the storm time.

So yeah, I mean, no matter where you’re at in life, this is an important conversation to have. And there is no right answer. But I would say that there are wrong answers in my estimation. But I also think it’s important to say that, at the end of the day, we say this about student loans, but at the end of the day, if you’re like waking up and you’re like sweating bullets, because you’re worried about how your investments are faring, especially in a volatile market, then we talk about this with the emergency fund, it’s just not worth that.

[00:21:20] TU: But, something’s got to give.

[00:21:21] TB: Something’s got to give. That means you either have to save more or work longer, and there’s a lot of –

[00:21:27] TU: Spend less.

[00:21:28] TB: Spend less, yeah, which, which is really hard. That’s the one I didn’t mention, because that’s really, really hard to do, for most people. And I think I said on a previous episode, some people look at a 60% to 80% of their income, and that’s basically what they need is. Some advisors just look at what the tax return says, and if you’ve earned $180,000, leading up to retirement, that’s what they plan for, because that’s basically the money that’s flowing through. So, there’s lots of different ways to kind of look at that as well.

[00:21:59] TU: Tim, I think one of the interesting things here is for folks, again, I mentioned the self-awareness thing. I think they really dig deeper about like, where might these beliefs come from. Wherever you are, on kind of the risk tolerance, what you’re able to stomach scale. You mentioned earlier in the show, some folks might be like, “Hey, I’m scared of market. I’ve heard that multiple times. I have no interest kind of investing in the market. Don’t trust it. Not comfortable with the risk, whatever the case may be.” And then there’s obviously the other end of the spectrum, which is like, I’m all in on whatever investment strategy could be equities, could be cryptocurrency, could be real estate, could be a combination of things. I don’t even feel the risk. It’s like, “Man, you could have two people at the same point in their journey, and are just dichotomously in very, very different directions.”

I’m just curious from your life experiences working with clients, is that coming from some of the money scripts and things that were growing up in? Is that coming from experiences like, “Hey, I lived through the 2008 recession. I saw my parents lose a significant amount of their nest egg or grandparent”, whatever be the case. Obviously, the pandemic could have an impact. Where does that come from?

[00:23:13] TB: I think it’s a combination of all those things. I mean, you even look at it, the Great Depression, that generation didn’t put money in banks, because they just didn’t trust banks, and then that can kind of filter through later generations. I think it’s a combination of, kind of your – I think your upbringing, like I would – I talked to my parents, and they’re older now, but even when younger, I think, my mom opened up a Roth IRA for me when I was really, really young, but I think it was like, mainly in cash, or like, very, very conservative bonds, or something like that, that we actually invested in which , again, doesn’t really make any sense if it’s going to be used for 14-year-old in retirement, 50 years later or 60 years later.

So, I think it is a lack of understanding and kind of, I think, a lack of education, or financial literacy around investments is part of it. That’s not anyone’s fault. I just think it should be more part of the curriculum and the things that we talk about as students in grade school, in high school. And again, we kind of talked about you can take out hundreds of thousands of loans, but not really not understand like the financial implications of that. So, I think we need to do a better job of that. I think, again, to go back to my own experience, Tim, we didn’t talk about money growing up. It was very much a taboo thing. So, it was kind of just something that was hands off, which I think kind of does lead to stunted growth in that regard. I think that a more openness to kind of talk through some of these things, and some of like the head trash, I think, a lot of it goes – it does come from your experience. I think there is a curiosity for a lot of people and we see it, where we kind of talked about maybe some missed prioritization of like, you’re invested in penny stocks or individual stocks, but you’re not necessarily taking your match for 401(k) or you have zero emergency fund.

I don’t hate on that too much, because I think it’s someone’s willingness to kind of learn and understand, like how markets work, right? I’ve been in that boat. But I think over time is like, the market is very, very humbling, where you – it’s almost like going to the casino. No one ever says, like, “Oh, man, I lost all this money.” It was like, “I had a great” – those things get lost in the fold. I think that over time, I think people’s experience with the market is, even professional. I just read a headline somewhere that Warren Buffett says, like a monkey could pick stocks better than most financial advisors, which I would agree with. Because there is a lot of randomness with that. So, it’s, again, buy the market, don’t try to beat the market.

I think it’s a little bit of that. It’s experience, it’s education. So, people that are nerds about this, that read up, I think kind of understand what to do. But I think a lot of it is the fingerprints of what our families put on us, and sometimes those things are overcomeable, and we are aware of those things, and sometimes they’re not. Sometimes it takes someone to say, “Maybe we need to look at this a different way.” Because if you want to get to where you need to go, and for a lot of pharmacists, especially if they’re a lot of pharmacists out there, they might be the first person in their family to have graduated from college. They might be the first person that make a six-figure income.

So, with that, comes, I think, a different set of issues and things to think about as you’re – because, again, typically, the higher you are on the income scale, we look at like Social Security, less of your retirement paycheck is coming for security. The lower you are on the income, the majority of your paycheck is going to come from security. So, you just have a different set of issues and things to think about, as you make more money and have that paycheck. So, I think it’s all of those things that can shape your money script, the things that you’re saying to yourself, but I think it also is even deeper than that. It’s kind of the caveman, cavewoman approaches like you don’t want losses, right? So, you want to protect yourself in any way that you can to shield yourself from those losses. So, we do sometimes irrational things just to protect that pain. I think that’s just in our DNA. We’re here today because our ancestors have survived, some didn’t. But as the evolution of sorts is that you are programmed to do things that maybe don’t necessarily make sense in here now.

[00:27:45] TU: Tim, that’s so true. I think it’s human behaviors, you mentioned. But as you’re talking, I can and always will, I think vividly remember the significant losses in my portfolio. You feel more in the moment, but I don’t remember the significant gains in my portfolio. The long-term trend is up in a positive direction, and the significant ups have been bigger than or equal to some of the significant downs. But I don’t remember those. Like I do the losses.

Let’s wrap up this third part of our retirement planning series by connecting all of this to the asset allocation plan. So, what we determined we need is the nest egg. We talked about that in the first episode. What our risk tolerance or capacity is, those two things combined is going to then help us inform what our asset allocation plan is. So, how we actually are going to distribute these dollars within the accounts, the various alphabet soup of accounts we talked about in the last episode. So, what is asset allocation, Tim? Just to find that a little bit further, and then what are the main variables. We’ve obviously talked about one in terms of the risk, but other variables that can impact our asset allocation plan?

[00:28:51] TB: Yeah, so the asset allocation is basically the art, or you can say, even the science of construction of portfolio with a mix of stocks and bonds to achieve the most amount of return for the least amount of risk. That’s what you’re really trying to do. So, at a very strategic level, there’s basically two buckets or two asset classes. There are stocks, which are basically where you own an equity share and a company, and you’re afforded things like dividends and capital appreciation. These are the things that we need to outpace things like the inflation monster, the tax man, et cetera. And then the second part of the portfolio are bonds or fixed incomes, and these are typically IOUs or notes that say, “Hey, government, I’m going to lend you the money.” Or, “Hey, corporation, I’m going to lend you my money. Give it back to me sometime in the future, but give me an interest payment as we go.”

Between the two, typically, bonds are more like a linear growth. Stocks are more exponential growth, but there’s typically more risk with stocks and less versus with bonds. That’s asset allocation in a nutshell. And then what you could do is, you can kind of go more granular in terms of like, “Okay, well, if I have this” – if 80% of my portfolio is going to equities or stocks, you can divide that up between things like large cap, mid cap, small cap, international, emerging market, real estate, that type of thing. And then same thing with bonds, if 20% of your portfolio is going to bonds, you can divide that up between junk bonds or international bonds or short duration bonds, long duration bonds, government bonds, that type of thing.

So, it is more granular. But at a very high level, to tie risk to asset allocation is, either using the rule of thumb, or using some type of risk tolerance, gauge or questionnaire, you can say, “Okay, I’m going to answer these questions. It’s going to say I’m an 80/20 portfolio, maybe a more balanced 60/40 portfolio.” And with that, if you have kind of an unexamined, approach, meaning like, most of the time, I think a lot of people will take that, and that’s how they invest. And I think, what we, as an advisor would do is say, let’s say, “I’m you’re 35, I know what saying you’re at an 80/20. But here are some numbers to show you that you should probably should be more aggressive.” We’re not going to spend this portfolio for another 30 years. Who cares what it does for the next 20, for the next 10, whatever that is. But let’s take a little bit more aggressive. 

So, that’s where you kind of get that talk about risk capacity. And then what you do is say you say, “Okay, we’ll compromise. We’re going to like a 90/10.” Then essentially, if you have $100,000, we’ll just say you’re a government employee with a TSP, if you have 100,000, know that 90,000 is going to go into some type of equity portfolio. So, the big one in TSP would be the C fund, which mimics the S&P 500. And then 10%, would go into the bond fund. That’s basically it. That’s where you connect the risk of where you’re at which again, is partly derived from the things that we just talked about, your upbringing, the head trash that you have, your experience. If you’ve experienced any pain, et cetera. And then, it should be then examined from where you’re at in terms of your time horizon, what you have saved. You’re working with an advisor, obviously. If you don’t have experience, you have a little bit more cred there to come up with, you know, what your final number is for your asset allocation. And then you put that into practice.

And then the idea is that over the course of a year, five years, 10 years, that portfolio is going to drift. So, say you are at 90/10, it could drift to a 95/5. It could drift down to an 80/20 or an 85/15, and you really want to make sure that you rebalance that over time. Because if you don’t, then if you’re an 80/20 portfolio, and you drift to something like a 90/10, if the market was then to go into a spiral, you’re taking more risk than what you signed up initially. So, sometimes when I say to rebalance, it just means to basically lock your percentages back to what you originally had agreed upon with your advisor or with yourself. That’s the big thing. So, you are kind of just resetting the percentages.

[00:33:12] TU: Again, this is a really important connection, as we bring this all together and talk about the value of a third party and the value of a planner that can really help your –it’s not – the value is not coming from picking stocks or picking investments that are going to beat the market. We’ve established that, what you’re describing is more passive investing strategy and here, we’re just talking about investing, which again, is just one part of the financial plan. The value really comes from okay, what is the game plan? What is the life plan? What is a wealthy life look like now? What is retirement life look like? What’s the number for us to get there? What does that mean today? How much do we need to be saving today to get there? We talked about that, in the first part of the series. What accounts are we going to leverage? How do we optimize this tax strategy? And within there, how do we begin to pick the investments, rebalance those portfolios over time.

Again, just such an important reminder, there are a lot of nuances in there alone, but investing is one part of the financial plan. So, we need to take that step back out of this silo that we’re in retirement planning and say, “Okay, what else is going on? What are all the other aspects of the financial plan that are happening? And does that impact or does that change potentially how we’re going to approach our investing plan?” I think, sometimes, we can hear this and hear the passive investing strategy. We can hear the nest egg calculators and think like, I can do that, I’ll just rebalance every once in a while. And you certainly can do it yourself. But let’s not lose sight of what can happen when you bring a third party into the equation, and we also have some value in zooming out and making sure this is fitting in correctly with the rest of the financial plan and the other puzzle pieces that are involved.

[00:34:56] TB: Yeah, the act of investment is a necessary, I don’t want to say evil, but it’s a necessary thing that we need to do to, again, get in front of things like inflation and taxes. A lot of advisors make that the central part of their practice and it is important. I don’t want to say it’s not important. But it typically takes a backseat to a lot of the other things that are going on in life, whether that is, “Hey, I need to pull money out of this investment, because we have to put an additional on our house, because I’m taking care of an aging parent.” Or, “Hey, we have a kid that’s going to college. So, we need to, again, change some things around.” Or, “Hey, I lost my job, so I’m not going to be able to invest like I was.”

The thing with a financial plan is that, the value is more in planning, not the plan. And the investment piece is very important, and it can be as complicated as you want to make it. But even in the simplest version, it can be complicated, because again, if we’re talking about an asset allocation, the example that I gave is in a TSP, but if you’re trying to do that across a brokerage account, an IRA, a Roth IRA, some of the task, it can very quickly, when you add layers, get more and more complicated. But I think that the – yeah, the value, I think, with working and this is at any part of the financial plan, not just the investments. It’s almost like an am I crazy type of – am I crazy to be doing this? Should I give myself permission to do this? And sometimes, because of the environment or the way that we live today with social media, like there’s so much gaslighting. You can almost start to doubt your own judgment. So, it’s sometimes good to have a rock or a steady influence, and this is at, really, any part of your life, but I think finance is what we’re talking about here to just say like, “Hey, am I crazy? Or what do we do here? Or this is a variable or this is a bump in the road? Or this is an opportunity, like what’s the best way to proceed?” Again, super biased. But I think that’s really the value. It’s not necessarily saying like, “Hey, we’re going to beat the market and all that nonsense. It’s like, life has happening, and are we living a wealthy life or not?

[00:37:20] TU: Yeah. And so, to that point, whether you are a new practitioner listening, early on in this journey of saving for the future, mid-career pharmacists wondering, “Hey, am I on track? Are there other things I should be thinking about? How does this fit in with other goals that I’m working towards? Or, pre-retiree, retiree thinking about more the distribution stage and building that retirement paycheck, which we’re going to talk about on our fourth and final part of the series. Regardless of where you’re at in the financial journey, our fee only financial planning team of five certified financial planners, in-house tax team that includes a CPA and an IRS enrolled agent. They’re ready to work with you to build your retirement plan, among work with you on your other financial goals.

So, you can book a free discovery call, learn more about our one on one financial planning services that is customized for the pharmacy professional. You can book that call at yfpplanning.com. Again, that’s yfpplanning.com. Thanks for listening and have a great rest of the week.

[OUTRO]

[00:38:09] TU: As we conclude this week’s podcast, an important reminder that the content on this show is provided to you for informational purposes only and it is not intended to provide and should not be relied on for investment or any other advice. Information in the podcast and corresponding materials should not be construed as a solicitation or offer to buy or sell any investment or related financial products. We urge listeners to consult with a financial advisor with respect to any investment. 

Furthermore, the information contained in our archived newsletters, blog post and podcast is not updated and may not be accurate at the time you listen to it on the podcast. Opinions and analysis expressed herein are solely those of your financial pharmacist unless otherwise noted and constitute judgments as of the dates published. Such information may contain forward looking statements, which are not intended to be guarantees of future events. Actual results could differ materially from those anticipated in the forward-looking statements. For more information, please visit yourfinancialpharmacist.com/disclaimer.

Thank you again for your support of the Your Financial Pharmacist Podcast. Have a great rest of your week.

[END]

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