The Benefits of Proper Risk Budgeting

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By: Roger Nusbaum, AdvisorShares ETF Strategists

William J. Bernstein had an interesting op-ed in the Wall Street Journal titled How To Tell If Your Retirement Nest Egg Is Big Enough. Anytime the term nest egg pops up in a post I feel compelled to make the Lost in America reference when Julie Hagerty loses the nest egg at the tables in Las Vegas almost immediately after they hit the road and Albert Brooks tells her to never use the words nest and egg in the same sentence ever again.

He suggests figuring out where you stand right now in relation to where you need to be with a measure called residual living expenses or RLE. RLE is simply the difference between your lifestyle needs minus whatever fixed sources of income you might have or will have like Social Security or pension income.

In Bernstein’s example he assumes a $70,000 annual lifestyle with $30,000 coming from fixed sources of income so a portfolio need of $40,000. The next step is to understand how much your nest egg can generate. He seems to suggest applying a more numbers oriented version of the simple 4% rule but of course there are several theories out there about how much you need your nest egg to be. The big thing is to go with what you believe to be right and measure where you stand right now.

If your RLE is $40,000 and you have $1.8 million accumulated then Bernstein would suggest you declare victory and manage your risk budget to have less exposure to risk assets. From the article;

When you’ve won the game, stop playing.So, retirement nest-egg-wise, what constitutes “winning”? Simple: You’ve won when you’ve acquired enough assets to provide your basic living expenses for the rest of your life.

A sense of game over, which is of course what he is talking about, is a discussion of proper asset allocation which starts with understanding what you really need your RLE to be. If you can reduce the RLE a little then you place less of a burden on the portfolio which is something we have discussed before or you can get by with a smaller portfolio if somehow you don’t quite accumulate as much as you hope for.

Having no equity exposure won’t be right for too many people but someone who is ahead of the game probably should not invest like they are behind the game.

It is important that someone lucky enough to be in this position not eliminate risk assets for several reasons mostly having to do with an unknown future that could include some sort of personal financial shock, loss of purchasing power due to unexpected inflation or any other expected outcome.

And because it is relevant I’ll throw in the idea of monetizing a hobby as part of the solution for reducing the burden on the portfolio in covering your RLE. I believe this list of benefits to this is long beyond needing to draw less from your portfolio including continuing to have a very specific purpose, enjoying what you do and staying more mentally engaged.

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