Risk aversion is well understood by economists. There’s a mathematical underpinning to it that may be tricky for the layman to understand. The basic idea is quite easy to understand. In the context of retirement planning there are some unique considerations. But before we look at these we’ll take a look at risk aversion in its simplest form.
Risk aversion in a nutshell
Try this thought experiment. I’m offering you the choice between these two options:
- A single coin toss. If it’s heads I’ll give you £100. If it’s tails you’ll get nothing.
- I’ll give you a guaranteed amount that I’ll tell you in advance.
In option 1 there’s a 50-50 chance of receiving £100. This means the ‘average’ amount is £50. The technical term for this is the ‘expected’ amount, even though receiving exactly £50 is impossible. We can measure your risk aversion by the minimum amount that you’d accept in option 2. The lower the amount you’d accept, the greater your risk aversion. If the minimum amount is exactly £50, then you’re risk neutral. If it’s less than £50, then you’re risk averse; the low the minimum amount, the more risk averse you are.
And if the minimum amount is more than £50, then you’re actually risk seeking. This is the attitude of a gambler on the roulette table. The house always wins in the long run. But people still play roulette for the thrill (or for the irrational hope).
Deal Or No Deal
The thought experiment I just described is a simplified version of the TV gameshow “Deal Or No Deal“. I’m playing the role of the Banker, and and you’re the contestant with a box that contains either nothing or £100. You either open the box or you accept my offer. My job is to make you the lowest offer that you won’t refuse. This is because over the long run, with many contestants, I’ll save money with lower offers being accepted. Otherwise the payout would average out at £50 per contestant.
But for you as the contestant, there’s no long run. You only get to play the game once. Your personal risk aversion determines how low an offer you’d accept. There are a couple of factors that determine this:
- How badly you need the money. In other words, how rich or poor you are.
- Your propensity to gambling.
Risk aversion and investment
In real life investment, the choices we make aren’t as cut and dried as in our thought experiment. We have a wide range of investment choices. At the low risk end of the spectrum, we have bank accounts that pay variable interest, and that cannot lose money. Fixed interest bonds tend to have a slightly higher risk, since prevailing interest rates risk could rise, causing you to lose out. Shares in stockmarket-listed companies are even higher risk, since their trading values can go up or down, and they might even go bust.
Generally speaking, higher potential reward comes with higher risk. A financial adviser will typically try to assess your risk aversion, and recommend an investment portfolio to match. There are three broad categories of investment portfolio:
- Cautious. Low risk, with relatively low long-term expected returns.
- Balanced. Medium risk, with medium long-term expected returns.
- Aggressive. High risk, with higher long-term expected returns.
Investment time horizon
When we talk about low or high risk investments, we’re not just talking about the risk of losing everything. We’re also talking about volatility. High volatility means that the value of our investments can go up and down like a yo-yo. Risk aversion is often equated with volatility-aversion. But for someone planning to invest over many years, we can expect volatility to smooth itself out. In other words, the longer we hold our investments, the lower the risk becomes. But if you’re risk averse you might not have the stomach to ride out the storm of volatility along the way; if your investments take a tumble you might be tempted to cut your losses too early, and sell.
Leaving aside risk aversion, the rational choice is usually to take more risk in a diversified portfolio when investing over a long period of time. But risk aversion can make it necessary to cut down on risk, so as to avoid stress and worry; even if higher risk is theoretically more rational.
Investing for retirement
Saving and investing for retirement is clearly long term if retirement is many years away. Even if your retirement is imminent, you may need to draw down your accumulated investments after retirement; so your investments may still need to be long term. And if you’re already retired and drawing down, then the longer your life expectancy, the longer term your investment horizon is.
When it comes to retirement planning there are actually two types of risk you need to be aware of. The first is investment risk, which we’ve been talking about up till now. This type of risk is common to all types of financial activity, whether for retirement or for the short term.
The second type of risk is specific to retirement planning: it’s the risk of ruin. This is the risk that you’ll run out of money during retirement, or (at best) that you’ll need to reduce your standard of living to avoid doing so. This might happen for a variety of reasons, such as:
- Your investments might crash.
- Your spending might be unsustainably high.
- Inflation might have eaten away at your net worth.
- You might have lived much longer than expected.
Risk aversion takes on a whole new meaning when it comes to risk of ruin. You only get one lifetime in which to get it right.
Combining the two types of risk aversion
As we noted earlier, in order to achieve greater investment growth over the long term, it’s necessary to take greater risk. In retirement planning, the risk of not achieving sufficient long-term growth contributes to the risk of ruin. In other words, the lower the investment risk the greater the risk of ruin, and vice versa. This means that the two types of risk push in opposite directions:
- Investment risk aversion leads you to more cautious investing.
- Risk of ruin is mitigated by more aggressive investing.
How can we reconcile these two competing tendencies? This is just one of the complicating factors in retirement planning, but one that’s important to understand. In order to support a desired lifestyle with an acceptable risk of ruin, it might be necessary to take greater investment risk than your investment risk aversion would allow. Usually the only safe way around this is to reduce discretionary spending, thus requiring less investment risk to achieve the required investment growth.
The two types of risk aversion are just part of the complexity of retirement planning. Our Intelligent Retirement Calculator takes these and many other factors into account when optimising your financial plan.