The first post in this series discussed why an asset allocation strategy is important if you want to grow your wealth. One of the key steps to doing that is determining risk in all its various forms and how it affects you.
Risk Vs Return
No doubt you’ve heard this one before, but it’s important enough that it’s worth repeating.
An investment with lower risk is more stable and will have relatively low returns.
An investment with higher risk is more volatile but with the potential for higher returns.
The smart thing to do is to build your portfolio with a combination of investments with different risk and return characteristics. A diversified portfolio reduces the risk impact of each individual asset and spreads it across all your holdings. So if that hot biotech stock you just bought on your buddy’s recommendation is a smaller % of your portfolio, it’s now not as risky as if you sold everything in your 401(k) to buy that. (Please tell me you didn’t just do exactly that.)
So, if you’ve diversified your portfolio correctly, it should provide a higher expected return with lower risk as a whole, especially when compared to its underlying investments. After that’s the whole point of asset allocation isn’t it?
Notice I used the word ‘expected’ above.
Remember: Risk is guaranteed, returns are not.
Comparing Risk Across Asset Types
We’ve discussed the broad types of asset classes. From the same 30,000 foot view, you already know that:
- Stocks (and stock funds) are the riskiest but offer the best returns. They are also your only hope of growing your wealth.
- Bonds are less risky than stocks with lower returns
- Cash and its equivalents are the least risky, but also have the lowest returns.
Prof. Damodaran at the Stern School of Business provides the annual returns for these three broad asset classes on his site. For the purposes of illustration, we’re using the 3-month treasury bill rate as a cash equivalent.
If you’re more concerned about the last decade, here’s how diversification helped to contain overall losses during the 2008 financial crisis:
As Rick Ferri mentions in his book All About Asset Allocation:
Risk-free investments are a myth. They do not exist. If one were created, it would need to have a government guarantee, stably daily value, and inflation protection, and to be completely tax-free.
Understanding Yourself: Risk and You
This is arguably the most important facet of investing, period. Different people react to risk in different ways at different times in their lives. Understanding who you are and defining your approach to risk is extremely important to determine a plan that works. Keep in mind, that your approach is not set in stone and will change over time – for various reasons.
Your Capacity To Take Risk
Your capacity to take risk depends on a bunch of factors:
- What’s your time horizon?
Are you a young millennial just out of college or a middle-aged employee retiring in the next 5-7 years?
A younger investor with a longer time horizon will have a greater ability to withstand any downturns like the 2008 financial crisis. A longer horizon also means you should consider riskier assets such as stocks vs US treasuries.
- How stable is your income?
Are you a white-collar employee on a stable career path or a full-time entrepreneur? If you’re self-employed like yours truly you need to take your cyclical income into consideration. You shouldn’t have to take drastic measures like selling your investments just to pay your bills.
- How soon do you need the money?
Are you saving for a down payment on your first home? Or are you almost retired and need an income on a monthly basis?
Naturally, the answers will depend on the objective and you should end up with different risk profiles for the different buckets of money you envision. Of all the factors that go into answering the “how much risk“ question, this is probably the easiest to figure out.
Your Willingness To Take Risk: The “Sleep Well At Night” Test
This is also called as risk tolerance. This is the toughest to figure out and requires some introspection.
- Do you get upset when your monthly statement shows a drop over the last month? What about when all you’ve been hearing is that the market is going up, up, up but your statement shows a loss?
- If you were old enough to experience losses during the 2008 financial crisis, how did you react?
- Do you monitor your retirement portfolio daily with its swings or once a month/quarter or even longer?
- Do you get excited when the market goes up and end up buying more of the asset class that’s growing? Or do you stick to your documented investment strategy (more on that in a future post) rebalancing as needed?
Most people think that they’ll be able to weather a storm better than others because they are smarter about their selections. However, when shit meets fan then all bets are off.
During the 2008 financial crisis, I had maybe ~100K in all our investments combined which had dropped by 40%. I didn’t sell anything and was patting myself on my back for not doing so. I remember sitting next to an elderly gentleman on the subway back from Manhattan. We got to talking and the topic of the financial crisis naturally came up, as that’s what was on everyone’s minds. I casually remarked that this was a great opportunity to buy if one had spare cash lying around.
I still remember his answer: When half of your investments, all that you have worked very hard to build for over two decades are suddenly wiped out in a few days, the future looks bleak.
Perspective – always relevant. If I had a million bucks, and lost half I’m sure I would feel differently than when I had 100K, even with the same 40% drop.
Dollar amounts matter.
So when you think about the potential for loss, don’t think about how losing 30% would affect you. Think about losing a million from a three million+ dollar portfolio and how that would derail your (early) retirement plans.
Your Need To Take Risk
I have a friend, let’s call him Ralph. Ralph is in his mid-40s and started working for Netflix about a decade ago. Ralph was naturally part of their ESOP plan and let’s assume that over this period, he held on to some stock and sold the rest to build a diversified portfolio. He did the latter because he was smart and didn’t want to the majority of his net worth in a single stock. Enron, anyone?
Here’s the growth in Netflix’s stock price during the last 10 years:
In case the font is too small, that’s a 6927% increase.
Needless to say, Ralph is a multi-millionaire today – a fact that he couldn’t have seen coming when he joined Netflix over a decade ago. Of course, this is an extreme case and won’t happen to 99% of us but the point is that Ralph is a wealthy man today.
Do you think he needs to take on additional risk, putting aside for a moment his capacity or willingness to do so?
Chances are he has more than enough to meet his financial objectives. Any incremental net worth increase needs to be weighed carefully against the risk that he (or you) must accept and whether it would be worth it.
If you’ve already won the game, why still play?
A more common scenario
Now consider John, also middle-aged living in a nice middle-class suburb in suburban New Jersey. His property taxes are through the roof, his kids go to private school, and they drive newer model cars. Sound familiar? They have a $250,000 portfolio and expect to retire in their late sixties, leaving them about 20+ years to go. Both their parents have lived well into their 80s, and so John and his wife expect to spend about 20+ years in retirement as well. At their current spending levels, their portfolio is going to need to grow by leaps and bounds before it’ll meet their requirements. Any debate around safe withdrawal rates doesn’t even come into the picture.
This scenario is more common than not, and John will need a pretty aggressive portfolio (in addition to reducing his spending) if he plans to retire. If John doesn’t have a high tolerance for risk, he has bigger problems to deal with.
How To Determine Your Risk Tolerance
First, go ahead and try out a few questionnaires that help you determine your risk tolerance, and may even suggest an asset allocation. All the big brokerage houses have one – for instance, here’s one from Vanguard and another from Charles Schwab.
Go ahead, take that quiz – I’ll wait.
You should end up with a recommendation that looks something like this:
As you can tell, this is overly simplistic. Even Vanguard mentions that “you should view them only as broad guidelines on how you might consider investing your savings.”
I would argue that this is just a starting point – not for an asset allocation but purely to get you started to think about the questions you need to ask yourself.
Adopting A Two-Dimensional Risk Tolerance Assessment Process
Michael Kitces from the Nerd’s Eye View has written extensively on this topic. He mentions that risk tolerance questionnaires are too one-dimensional. They are eager to calculate a “risk score” in an effort to categorize your portfolio. The capacity to take risk vs. the willingness to take risk should be measured separately. This should then be scored on a two-dimensional scale in order to get a true picture of an investor’s risk tolerance.
In essence, having a low willingness to take risk, and/or limited capacity to afford risk, should be viewed not just as a component of the risk score, but a constraint to the proper portfolio the investor agrees to in an Investment Policy Statement. Which means investors who have low tolerance or low capacity should remain in conservative portfolios And similarly, investors with “just” moderate tolerance or capacity should stay in moderate portfolios, and not drift up to aggressive just because their other score is high.
So What’s A DIY Investor To Do?
Step 1: Start with the traditional risk tolerance questionnaire.
Step 2: Then think about the questions they ask, but with dollar-amounts in mind instead of just percentages.
Step 3: Recognize your [a] capacity, [b] willingness and [c] need to take risk. Do so separately for each with low/medium/high grades or get more quantitative if that’s what floats your boat.
Step 4: Finally, try and use the results to understand whether you should be conservative, moderate or aggressive. Don’t get bogged down by the details i.e. how much stocks vs bonds – we’ll cover that in the next post.
If you get stuck or don’t trust yourself, an option could be to make a visit to a fee-only financial planner. They will have access to tools that and can hopefully give an unbiased opinion. The obvious caveat here is that [a] it won’t be free and [b] you’ll face some indirect pressure to use their help to make investments.
You’ll realize that real life is more complicated after going through this exercise. You have multiple but conflicting goals. They could be a house down payment, a new (old) car, the desire to travel to exotic locations or raising a family. All have different time horizons, monetary and liquidity requirements and hence, different risk considerations.
In these cases, I prefer to keep separate mental buckets for different goals i.e.:
- Conservative: Emergency fund, Vacation/car fund etc
- Conservative-Moderate: Downpayment for a new home
- Moderate-Aggressive: Retirement and taxable portfolios
- Aggressive: Kids’ 529s, since they’re on the younger side
With each, the capacity, willingness and need to take risk will likely grow more conservative as the date draws near. You’ll also find that the same changes for you as you grow older. Each of us is unique in the combination of factors that need to be considered. Don’t hesitate to re-evaluate as needed and if you find yourself itching to react to market swings in either direction.
- Vanguard Investor Questionnaire
- Risk Capacity Survey