Question

Describe how someone’s risk tolerance directly impacts their retirement planning. Use an example to illustrate how much difference it would make if someone was a conservative investor who averaged a 7% return over 32 years on their savings versus another more aggressive investor who averages 11% over the same period. Interpret your results: advantages and disadvantages of the two investment strategies

Answer 1

Risk Tolerance is the ability and willingness of an investor to take on the volatility in his investments.

Risk tolerance of a young employee is high since he has a lot of time to retirement, whereas the risk tolerance for an elderly person approaching retirement or has already attained retirement is low.

It is very commonly said in the world of finance: Higher the risk, higher the returns.

For example:

A conservative investor who averaged a 7% return on his savings of $1000 over a period of 32 years, would be worth $8715.

An aggressive investor who averaged 11% return on his savings of $1000 over a period of 32 years, would be worth $28,205.

So the investor who earned average 11% returns would have attained the networth of $8715 (equal to 32 years of 1st person) by the end of approximately 21 years, thus saving 11 years (32 years less 21 years).

Investment Strategy 1: Advantage: Easier to get investment options yielding 7% returns with moderate risks.

Disadvantage: Time horizon is long.

Investment Strategy 2: Advantage: Shorter time horizon, more financial flexibility.

Disadvantage: Risky investment options since the rate of return is high at 11%.