The Elusive 7%-10% long term average...

Does an investor need to measure the risk, or know the risk is there and try to quantify it's significance?

For example, I have 18-38 years to retirement. I have inflation risk and need to counter that risk. I don't need to know how much inflation risk I have, I just need to know it's there, and invest in assets which typically return higher than inflation to counter act that risk.

Do I need to measure that risk to truly know it's significance to my situation?

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No, depending on the risk. But to optimize your situation, you do need a measure.

-Will

william dot trice at ngc dot com

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How exact a measure? To argue risk (with regard to asset allocation) can be quantified precisely is arguing a fallacy. This is because churning out a number based on xyz is mostly an exercise in garbage in, garbage out, given that xyz can be darned arbitrary and besides, xyz's margins of error are highly dependent on many assumptions.

The goal is to get a person in the perceived ballpark. I happen to think jIM's definition of "optimum" is fine and appropriate, given how crude the measures of risk for each asset class can be and given how financial planning cannot be an exact science.

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Sometimes. For instance, you don't know what inflation is going to run. But, you have some idea on how long you might live.

Just invest in corporations. If inflation occurs, the corporate plants will increase in replacement costs, allowing for less competition and allowing for a higher price for the products produced.

In the short run, knowing the inflation rate can help you decide if bond investments are viable.

-- Ron

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All you've done is traded inflationary risk for market risk (both systematic and non-systematic, depending on the level of diversification). The point was that knowing what risks you are exposed to is primary; being able to quantify those risks MAY make planning a little easier but is not essential to long-term planning.

Believe it or not, financial planners worth their salt know that all of planning hinges on "risk management". Proper investment allocations, insurance coverages, yada yada all fall into place during the process of hedging the client's risk exposures.

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jiM has a long time frame (18-38 yrs.) and there should be little market risk over that time frame.

It's not much of a science if planners can't quantify risk or know where to go to get those risks.

A relative took early retirement a few years ago when family medical insurance was $10,000 a year, but know it's running $20,000 a year. She didn't have anyway of predicting those insurance costs.

I don't think that financial planners can be expected to know the best way for an individual to invest. A financial planner has to educate the client as to the risks and alternatives and help the client exercise those alternatives.

My point is that real estate and corporations are the major components of the tangible wealth of a country and those seeking to only invest in bonds, CDs, and immediate annuities may find themselves in trouble.

-- Ron

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Agreed (I didn't recall jIM's timeframe), time is a mitigator of market risk. I was just citing a general example and I now think you were giving a specific response. Hence the confusion. Had jIM's timeframe been shorter, his risk exposure would have been greater.

Sure it is. Anyone who thinks financial planning eliminates risk is going to be sorely disappointed. Financial planning attempts to MITIGATE risk. You proved it yourself with your opening statement. We don't need to exactly know the volatility of jIM's investment portfolio to mitigate against market risk nor do we need to know exactly what inflation will be to counter inflationary risk. We just need rough estimates. Of course, the better the estimate, the better the output (in theory).

I can't tell if you're agreeing with me or if I just did a terrible job of conveying my thoughts earlier. All the same, this is what I was also saying.

When most of my clients approach me for the first time, they have a specific and obvious problem in mind. For a VERY loose example, suppose a 35 year old inherits a large amount of money (enough that he wants to retire now, but not enough that he's buying a Ferrari). He comes to me for help. Well on the surface, his biggest risk seems apparent; longevity risk (the risk he'll outlive his money). One counter to that is an immediate annuity. Of course, that then gives rise to inflationary risk (the risk that he'll lose his purchasing power over time). So maybe only some in an immediate annuity and the rest in equities intended to beat inflation. But now he also has market risk. This goes on and on. Hopefully, I've eventually addressed most of the risks out there and the client ends up with a nice we'll rounded financial plan that doesn't eliminate all his risks, but minimizes and balances them against each other. Looking back after the plan is done, it seems pretty obvious that the plan came to fruition primarily by simply knowing and managing the risks my client was exposed to. The asset allocation percentages, annuities, insurance, etc... all took care of themselves throughout the process.

Now specific product selection is another matter.

Again, agreed. I didn't intend to counter that point. I was more or less trying to tie the need to quatify risk vs the need to know risk into your other post.

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Then we disagree (not unusual unfortunately) on the definition of 'optimum', although I agree that the measures are crude.

By the way, I am not advocating trying to optimize risk.

-Will

william dot trice at ngc dot com

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Maybe I'm just feeling cantankerous today, but few of us have any idea how long we might live, and most of us have some idea regarding future inflation.

I expect to live to 100 or beyond because I'm mitigating my risk of heart disease by exercising and eating a healthy diet, wearing my seat belt, and keeping my mind active. But there are people in my situation who have dropped dead 100 yards from the finish line of a marathon. I'll make my plan based on the 100 year number rather than the 100 yard number and will likely die somewhere in between, when my heirs will have something to argue over.

At the same time, I suspect we all have some idea what inflation will be, at least close enough to include a reasonable number in our financial plans. Without that expectation, none of us would ever be able to retire.

Elizabeth Richardson

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