People always talk about "risk" in investing articles, but rarely explain what they mean by it. What sorts of risks should I be concerned about when investing and planning for retirement and what can I do about them? -- Ernie G., Newark, Ohio
You're right. People often toss around the word "risk" as if there's only one risk we face. In reality, there are a variety of risks that you should be taking into account when it comes to investing and planning for retirement.
Here's a rundown on what I consider the three biggest, plus advice on how to manage each one.
1. Investment risk.
Traditionally, investors have equated risk with the extent to which an investment's price or returns bounce up and down. The greater the volatility, the riskier the investment. And to quantify that volatility in a mutual fund, ETF or portfolio of investments, investors typically turn to standard deviation, a measure that calculates how much an investment's annual return fluctuates around its long-term average annual return.
The bigger the standard deviation, the more volatile the investment. You can find the standard deviation for any fund or ETF by clicking on the Ratings & Risk tab on its Morningstar page.
But many individual investors have trouble relating to this technical measure. Besides, while it's easy to find the standard deviation for a single fund or ETF -- for reasons too technical and boring to go into here -- it's harder to calculate it for your entire portfolio.
I think a more accessible gauge for most people is how an investment or group of investments fares during a big market downturn. In the financial crisis year of 2008, for example, U.S. stocks lost 37%, international stocks slumped 46% and U.S. bonds gained 5%. If you're considering a portfolio of, say, 50% U.S. stocks, 20% foreign and 30% bonds, you can fairly easily calculate that such a portfolio would have lost about 26% in 2008 financial.
There's no guarantee you'd see the same results in the next crash, but you'll have a decent idea of how different assets have fared and how they, and your overall portfolio, might do in future downturns. If you think you might panic facing such a loss, then you probably want to scale back your stocks holdings to a level where the loss would be tolerable.
To get a sense of your tolerance for risk -- and to see how different combinations of stocks and bonds have fared in the past -- check out this Investor Questionnaire.
2. Shortfall risk.
This risk measures the probability that you'll fall short of a goal, such as being able to maintain your current standard of living during retirement. You can assess this risk by going to a retirement income calculator that employs Monte Carlo simulations, or hundreds of different scenarios to estimate how often you end up with the result you want.
After plugging into the calculator such information as your age, how much you already have saved, how your savings are invested, how much you expect to save between now and retirement and when you plan to retire, the calculator will estimate the probability that you'll be able to sustain a given level of income in retirement.
Quiz: What's your risk tolerance?
If you find you have only a 60% chance that your savings plus Social Security will generate the retirement income you'll need, you'll probably want to save more, retire later or make other adjustments to improve your chances of achieving a secure retirement.
I like this gauge of risk because it looks at the big picture. If you're a nervous Nellie investor and you consider just investment risk, you might decide to huddle in a portfolio of mostly cash and bonds. But the returns from such a conservative investing strategy might be too low to build a nest egg large enough to sustain you in retirement.
By looking at shortfall risk, you'll be able to tell whether you need to make adjustments to your saving, investing strategy and anticipated retirement date.
3. Emotional risk.
Even when we know intellectually the investing risk or shortfall risk we face, we sometimes make emotional or impulsive decisions and, in effect, become our own worst enemy.
Many people, for example, invest more aggressively and take on more risk after the market's been on a big run. Is that because their ability to withstand a setback has changed and they can now tolerate a bigger loss? No, it's because the giddiness of a bull market lulls them into a sense of false security, leading them to underestimate the risk they're actually taking.
It's only after the bull market comes to a crashing end and they're sitting on an unacceptable loss that they realize they let their emotions get ahead of them. This process works in reverse as well. We become overly pessimistic after a market downturn, and invest far too cautiously.
This is a tough risk to manage. All the signals we get from other investors and the financial press during bull and bear markets reinforce feelings of irrational exuberance or undue pessimism. So it's easy to go along with the crowd and invest too aggressively during good times and too conservatively in bad time.
My advice: After you complete the Investor Questionnaire I mention above, print out a copy and refer back to it before you make any change in your investing strategy. A simple reminder may be enough to stop you before you do something you'll later regret.
There are other potential risks to be sure. One example: inflation, which has been relatively tame the past 20 years, could awake from its slumber. But if you focus on the Big Three risks I've outlined above and get a handle on them, you'll have gone a long way toward increasing your chances of having a secure and comfortable retirement.
Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at walter@realdealretirement.com.
More From RealDealRetirement.com:
More Sex -- and 3 Other Tips For a Happier Retirement
