Risk Tolerance And The Marginal Utility Of Wealth
The intersection of needs, desires, and risk.
In his excellent book, Your Complete Guide to a Successful and Secure Retirement, Larry Swedroe discusses something that economists call the marginal utility of wealth.
As a recent retiree, his discussion of this topic presented me with a perspective which has influenced my own decisions over the past year or so. As a little weekend reading, let me now share it with you.
Needs, Desires, Lifestyle, and Risk
A basic principle of financial planning is that investors must be willing to take on extra risk in order to achieve a greater expected return.
Particularly as one approaches, or enters, retirement age, this discussion becomes very real and meaningful. Further, before continuing, allow me to stipulate that there is no one right answer, or decision, with respect to what I will present here. An individual who has consistently saved and invested from a young age may be blessed to be able to evaluate this matter differently from one who may be playing catch-up late in their working career. Still, I believe the discussion will be useful to all.
Certainly, having a little more in a financial way is preferable to having less. I would be lying if I said that I would not like to have just a little more of the finer things in life.
At the same time, most of us achieve a lifestyle with which we are comfortable. And the converse of having more must always be considered; namely that by taking on too much risk we could place what we have already achieved in jeopardy.
In his book, Swedroe gives a great example of this. In 2003, in the course of his work, he met a 71-year-old couple with financial assets of $3 million. For most of us, that sounds like a lot. However, just 3 years earlier, in 2000, this particular couple had financial assets of $13 million! Unfortunately, In short, a large portion of that $13 million had been heavily concentrated in U.S. technology stocks. You may recall that the Nasdaq average plunged from from 5,048.60 in March 2000 to 1,114.11 by October, 2002, a decline of 77.9%. Ironically, the couple told Mr. Swedroe that they had been working with a financial advisor during this period.
Larry asked them an interesting question. Essentially; “If your portfolio had doubled, to $26 million, would it have led to any meaningful change in the quality of your lives?” Sadly, the couple said “no.” The end result? A painful outcome, when the potential benefits of all that risk would not have changed their lives in a meaningful way.
When I read this account, I couldn't help but think back to a book by Andrew Tobias I read in my mid-20s. Tobias made the basic point that it is much harder to have achieved a certain lifestyle, and then to lose it, than to have never had it in the first place.
In summary, the concept of marginal utility of wealth argues that there is little reason to take additional risk in expectation of a superior return, when one’s life would not change in a meaningful way even if the goal was achieved.
In general, I might suggest that the lifestyle you are living by time you are approaching retirement age is the one you have become used to; are comfortable with. As Swedroe suggested to the couple, even if you could double your financial assets, would your life really change all that much?
Let’s say you have $1 million in retirement assets and could turn it into $2 million by taking an outsized risk. But the potential cost of that risk would be to quickly cut that amount in half, leaving you with $500,000.
Based on the concepts mentioned above, you might conclude that the drawbacks of the negative outcome far outweigh the incremental benefits of the positive outcome.
In general, one gets rich by some combination of inheriting money, working hard, and taking risks. One stays rich by controlling spending, and adopting a defensive mindset when it comes to one’s assets.
Before we leave this discussion, let’s acknowledge the circumstance where an investor may make the decision that greater risk is warranted. At the outset, I referenced the individual that, whether due to a late start or other challenging circumstances, is now playing catch-up when it comes to meeting their needs during retirement.
In this case, the marginal utility of wealth may, in fact, be greater for this individual. It may represent the hope of a better retirement, and the downsides for falling short may not be much different than the status quo.
Whatever your particular circumstance, I hope this has at least given you a basis for making a sound decision in your personal case.
Thanks for honoring me with your time by reading my work.