Should the return an investor ‘needs’ to meet their set of goals be a consideration when deciding how much risk to take with a portfolio?

It’s a tempting thought.

It’s easy enough to calculate. It certainly sounds plausible. Unfortunately, it’s dead wrong.

If the risk that you’re willing and able to take is not enough to get you to your goals, then any use of ‘risk required’ implies taking more risk than you’re either able or willing to do. And if you’re not willing to take it, nor able to take it, how can taking it be a good idea?

Should goals ever out-rank emotional comfort?

This is not to say that an investor’s goals don’t have a role to play in the construction of a risk profile. They do.

But they do so because the amount and time horizon of each goal should form part of a comprehensive assessment of risk capacity, and consequently of a risk profile. That is, an investor’s goals should already be accounted for in any good assessment of the risk the investor is able to take.

What about using risk required as a short-term guide to the attainment of a specific goal?

Increasing risk in pursuance of an especially important goal may look like a good idea, but only if you excessively narrow your focus. Zoom out a fraction and any risk increase to attain a goal will also increase the possible wider downside consequences. In the downside scenarios, the increased risk could mean failing to achieve not only the goal in focus but everything else as well. No single goal is ever worth risking penury.

Risk required is often a dangerous temptation because it prioritises unreasonable aspirations over suitable investment choices. It can often be simply brushed aside: a nervous investor with few resources should never be encouraged to put those resources on the line, no matter how bold their dreams. To quote Warren Buffett: “It is madness to risk losing what you need in pursuing what you simply desire.”

However, it can get more complicated. For example, what should an investor do when they expect they won’t be able to meet their expenditure needs in retirement unless they increase the risk on their investments, potentially many years in advance?

In all instances:

  • Investors should certainly take as much risk as they’re willing and able to, as early as possible, but…
  • Increasing risk beyond that indicated by a risk profile arrived at through a sound combination of risk tolerance and risk capacity is never justified. Increasing risk beyond an investor’s willingness and ability may well increase the probability of meeting some future spending goals… but it always also increases the chance of catastrophically failing to do so.
  • The answer is always a combination of reducing expectations, increasing net savings, or delaying goals (including retirement date).

The irony is that a high risk required, i.e. a high reliance on growth in one’s investments to meet one’s goals, is actually a sign of low risk capacity, and should logically lead to a reduction in risk.

So far we’ve looked only at the ‘more risk’ side. However, investors looking to fund future goals (including uncertain and as-yet-unplanned future spending) should also be wary of taking much less risk than indicated by their risk profile. Even on the downside, it is better (though less vital) to actually take the risk you’re willing and able to take.

In particular, distant spending needs shouldn’t be protected by setting aside cash outside of investments. A low risk required may indicate that you don’t need to take as much risk, but equally, it could mean you haven’t fully accounted for how your spending needs and aspirations may change. A new high-maintenance relationship or an inspiring thought that rocks your world could change your needs and make you wish you’d grown your wealth when you had the chance.

Unregulated, unannounced, unnecessary

If there’s no value in changing a risk level because of risk required, how did it even become a consideration for anyone in the first place? Where did it come from?

Despite the word ‘required’, ‘risk required’ is not required by the regulations. It does not appear in the FCA Handbook. It is referenced in an example of good practice in DP07/2, though then only as part of a more sensible example of a firm looking at risk need as part of the planning process – not as an input into the calculation of a risk profile.

The proponents of using risk required in a risk profile may argue that considering it helps to plan when to reduce spending to essentials, or to know at what point lower-priority goals would be sacrificed, or to stress-test resilience to income shocks and the resulting effect on sustainability.

This is all true. But these are all about planning to be more adaptable in the future in response to events as they occur; they are not reasons to change risk levels now. They are outputs from a suitability calculation, not inputs into it. There is no need to bolt on an additional measure – especially when doing so could be monetarily or emotionally catastrophic.

If you ‘need’ to earn a higher rate of investment return than the portfolio with which you are likely to be comfortable is expected to earn, you need better needs, never riskier investments.

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