When it comes to risk planning in investments, especially in retirement, take care not to go about it the wrong way. Don’t make the mistake of establishing unrealistic return goals and forcing yourself into an asset allocation and risk profile that is inappropriate for your situation. Your assets are finite and can only provide a certain amount of money on a sustainable basis. Reaching too far for return in retirement can be a cataclysmic experience if you get your timing wrong and are unprepared for the financial consequences. As such, your risk profile is of the foremost consideration in your retirement planning. Because no advice is appropriate for all investors, this process requires both objective and subjective analysis of your own situation. We’ll show you how to you determine how much risk your retirement portfolio can tolerate. (For background reading, see Determining Risk And The Risk Pyramid and Personalizing Risk Tolerance .)

Take a Look at Expenses

The first step in this process is to determine your spending rate on an annual basis. The calculation is a simple division of your annual spending needs into your total portfolio value. For example, if you have a $1 million portfolio and plan on spending $50,000 per year, you have a 5% rate of spending ($50,000/$1 million). So what does your spending rate tell you?

One way to view your spending rate is as a gauge for the lifespan of your portfolio. More specifically, the higher the spending rate is, the shorter the lifespan of your assets, and vice versa. Assuming proper portfolio diversification. a 4-5% spending rate is generally considered sustainable over the long term while still protecting, if not enhancing, your real spending power. To illustrate, consider the fact that the average college/university endowment has a 4.6% spending rate (according to the 2006 National Association of College and University Business Officers survey) and keep in mind that endowments are operated to be infinite pools of money. So, if you can live on a 4-5% spending rate, then you’re in pretty good shape and can sustain a moderate to high risk tolerance in your portfolio.

The problem is that most people probably haven’t saved enough money to live on a 4-5% rate of spending by retirement. Still, this knowledge is a very valuable general rule in your investment planning because it allows you to use your spending rate as an easily understood guidepost for risk tolerance. For example, if you have a spending rate of 10%, you know for sure that your portfolio’s lifespan could be relatively short if you hit a protracted bear market. Therefore, you would need to invest in a very conservative manner to minimize fluctuations in portfolio volatility, lest your spending rate force you to sell large positions in a down market. Conversely, if you only have a 1% spending rate, your risk tolerance would be virtually limitless, as would your potential for portfolio growth.

As such, the key point here is to understand the potential effects of normal spending on your risk tolerance, which carries over into asset allocation and diversification considerations. The best way to illustrate this concept is by looking at the performance of a portfolio invested entirely in the S&P 500. with and without spending. Figure 1, below, illustrates the cumulative market value of a $1 million investment in the S&P 500 during the period of March 2000 and May 2007, with and without a $50,000 (or 5%) rate of spending.