I understand that as you age you want to slowly lower the risk profile of your retirement account, but how should I determine how much risk I should take on currently and how do I measure how much risk I am currently taking on? For example, I would think people that make more money can take on more risk because the minimum acceptable outcome would be a lower percent of their income than someone that makes less money.

Most commonly a single equity vs bond percent by age recommendation used generically for everyone, but wouldn't Large Cap vs Small Cap vs Emerging markets play into things? Along with how much money the person makes?

  • Do you know and understand how risk is often computed into a single value with investments? – JB King Aug 5 '14 at 21:04
  • Have you considered risk management? – Victor Aug 5 '14 at 21:27
  • @JBKing I understand the theory that a series of random normal variables when summed is another random normal variable, and how to do that on paper, but not really sure how to apply that to my portfolio and then how to establish a target. Also not sure how close to reality that theory is where stock isn't really normally distributed and with rebalancing or other real world complicationsn. – Dan Aug 5 '14 at 21:42
  • @Victor I'm not sure what you mean, my goal is to properly manage my risk, which is why I'm posting. Do you mean considered talking to a professional risk manager? – Dan Aug 5 '14 at 21:42
  • No I don't mean talking to a professional risk manager. Take a stock as an example. Say you have $100k in capital. You may wish to limit the loss on each individual stock to 1% or $1000. Then you need to determine where you want to set your stop loss - this will then determine how many shares you buy to limit your loss to $1000 for that position. If the stock goes up you make profit, if it goes down you get out at your stop loss price and limit your losses. – Victor Aug 5 '14 at 23:01

The "right" amount of risk is subjective. You are correct that a person's income, assets, and liabilities contribute to the capacity to take risk. Some people are also more comfortable taking risk than others.

Time horizon is also important. Some investments cannot be sold quickly, but might have higher expected returns to compensate. Some university endowments invested heavily in illiquid assets based on this belief. It worked well for awhile, but later struggled. See this article for more on this.

You may also want to consider an asset/liability framework. In this view, the present value of future expenses increases when interest rates decline.

You are correct that different types of equities and bonds have different amounts of risk. High yield bonds have a much different risk profile than treasury bonds. There are a number of ways to measure risk. You could look at the portfolio historical standard deviation or maximum draw-down as potential measures.

The "correct" allocation also depends on your comfort with complexity. For example, are you comfortable having a different allocation in your taxable account and retirement account? Are you willing to take the time to understand why the best portfolio might involve different assets in different accounts?

Health is also important. Some people feel like can work into their 80's while others lose the ability to work much younger. If you have the option to work, you have a higher capacity for risk.

As you can see, the inputs for the "right" answer can be both unique to the individual and subjective. The output isn't fully objective either.

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