Like beauty, risk is based on the perception of the beholden investor. However, the most espoused measure of risk is the degree of dispersion in units over varying time periods – aka volatility. Since the advent of self-directed investing over the last 40 years it has been adopted as the default measure of investment risk. Nowhere is this unquestioning acceptance more prevalent than in robo-advice. As a pre-retirement potential user of these tools though, is that what I care about? Isn’t my risk that I won’t be able to enjoy my dream retirement in comfort with peace of mind? This concept of “risk” requires a lot more work than simply picking a period of history then running some strategy back tests and extrapolating that into the future.
The first stage of identifying retirement risk, is to understand the type and longevity that a person or couple’s retirement lifestyle will encompass. Can we estimate how much this will cost and for how long? Do we think about it in today’s dollars and then attempt to adjust that into future dollars using inflation assumptions? What should they be?
The second stage of assessing risk is to attempt to quantify this liability profile that the retirement characteristics describe.
The third stage is to attempt to build an asset profile that matches this liability stream – through a combination of accrued wealth, regular savings and investment returns.
The retirement risk is that this asset value will fall short of the liability stream. Needless to say, longevity risk also complicates this situation because the liability stream may be longer than anticipated.
Ultimately it is lifestyle shortfall risk that the user cares about – not whether their model portfolio back tested well over the past 10 years with respect to volatility. Caveat Emptor!