As human beings, we tend to categorize things to help our brains better sort, retrieve and analyze the millions of informational tidbits that we experience every day. Unfortunately, from a financial perspective, we often think of our portfolio(s) as one monolithic glob of money that will somehow fund our living expenses in retirement with little or no account restructuring.
Most advisers—as well as popular financial magazines—will encourage families to maintain a cash reserve account of risk-free, liquid assets to fund a minimum of six months of living expenses in case of a job loss or other unexpected life events. In essence, this is a type of savings “bucket” for your emergency cash flow needs.
Understand the Trade-Offs
When an investor splits her accounts between low-risk cash holdings for emergencies and higher risk stocks for growth, she is prioritizing her risk management strategy knowingly or unknowingly based on perceived risk factors. On one hand, holding more cash protects you from having to draw down from a stock-heavy portfolio during a prolonged downturn. This is known as the sequence risk of withdrawals, and it has been particularly severe during this most recent decade of poor stock market performance. Holding more cash also provides the investor with flexibility to take advantage of future investment opportunities. However, holding cash has significant opportunity cost given the current low interest rate environment; it also offers zero inflation protection.
On the other hand, the higher risk stock portion of your portfolio provides the potential for both inflation and longevity protection but increases the risk of capital loss given the volatile nature of the stock market. The point here is that there are always trade-offs when an investor allocates her assets along the risk spectrum. How to evaluate the severity of each type of risk factor is a subject for future blog posts. For now it is important to note that the most severe risk outcomes, like a prolonged down market or another bank crisis, will generally occur infrequently but may have the biggest impact on your retirement plans, especially if one occurs near or in retirement. In these situations, there is usually little or no time to recover. Thus, we believe it is important for an investor to identify and insure against these risk types if possible.
Know Your Capacity to Take Risk
Knowing your personal risk capacity is helpful to understanding how big of an emergency cash fund you need to maintain. The Consumption Ratio is a great place to start since this will provide you with a rough idea of your financial strength and your ability to survive a rare, but severe, risk event. While risk tolerance deals with your emotional reaction to stock market volatility (a.k.a. your ability to sleep at night), risk capacity is more critical here, in my opinion, since it addresses your financial capability to put meat and potatoes (or tofu and sprouts) on the dinner table during retirement.
About Jim Koch
Jim Koch is the Founder and Principal of Koch Capital Management, an independent Registered Investment Advisor (RIA) in the San Francisco Bay Area. He specializes in providing customized financial solutions to individuals, families, trusts and business entities so they are better able to achieve their goals. Jim sees himself as an "implementer" of financial innovation, using state-of-the-art technology to provide practical investment management and retirement planning solutions for clients.
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