Measuring and Controlling Shortfall Risk in Retirement.pdf

Measuring and Controlling Shortfall Risk in Retirement Gary Smith Department of Economics Pomona College 425 North College Avenue Claremont CA 91711 gsmith@ Donald P. Gould Gould Asset Management LLC 114 N Indian Hill Boulevard, Suite S Claremont, CA 91711 dgould@ correspondence: Gary Smith, gsmith@: 909-607-3135; fax: 909-621-8576 * We are very grateful to the Journal’s referees and editors for their careful reading and very helpful suggestions. Our thanks also to Greg Handler, Adam Perlaky, and Michael Reed for their research assistance. Measuring and Controlling Shortfall Risk in Retirement Abstract A key challenge for retired investors is determining the stock-bond asset allocation that, for a given spending rate, provides an acceptable probability of shortfall—having real wealth drop below a specified floor during the investor’s lifetime. Standard portfolio analysis yields the well- known tradeoff between risk and return described by the Markowitz frontier. For retirement planning, we reconceptualize this as a tradeoff between shortfall probability (risk) and the median value of terminal wealth (return). For specified assumptions, there is a stock-bond asset allocation that minimizes shortfall risk. Portfolios with more stocks increase the median values of terminal wealth, but at the expense of higher shortfall risk. Portfolios with less stocks are inferior in that they decrease the median value of terminal wealth and increas