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Know your own risk tolerance

Know your own risk tolerance

One of the side effects of using the word risk in investment is the connotations of bravery, cowardice, and going for glory.

Loading your investing decisions with such emotional baggage is about as healthy as loading your potato skins with cheese, bacon, and sour cream.

It’s not as if risk even has a precise meaning in everyday use. Risk is very different if we’re talking about taking a shortcut down a dark alley to the supermarket, a paratrooper going out on patrol in Afghanistan, or Warren Buffett spending $20 billion to buy a company.

I’m notoriously risk-averse in real-life. I emailed friends in vindication when the horsemeat scandal broke, since they’d all suffered from my pickiness about food.1 I’m not exactly the first one through the doors of a dodgy pub in a foreign city, and I avoid winter sports for the same reason Dustin Hoffman avoids flying in Rainman.

Yet when investing, my risk tolerance is as high as anyone I know.

True, everyone takes risks when they invest. I’ve one friend who shuns shares except for periodic punts on tech companies, and others who keep all their money in cash.

My first friend risks losing his entire investment – though not everything as most of his money is elsewhere in a business.

The second group risks losing the lot to inflation.

I believe my diversified, equity-denominated portfolio is far less risky and potentially more rewarding. Yet my co-blogger The Accumulator quails if I tell him I’ve put a five-figure sum into a small cap property company.

For him it’s the risks of lagging the return from the market and losing out in trading costs that loom largest.

You call that a reward?

Even the flipside of risk – reward – means different things to different people.

My share-punting friend says he wouldn’t get out of bed for 6% real returns a year. He’d rather re-invest in his business. A reward for him, rightly or wrongly, is something that moves the dial now, not in 20 years time.

In contrast, I see him putting too many eggs in one basket.

My risk-averse mother isn’t fussed her portfolio of investment trusts increased its dividend payout last year. But she was excited when I told her the portfolio value had risen by so many thousands of pounds – even though the shares were bought for income, she many never sell them, and I’ve warned her they could as easily go down as up.

At the far end of the spectrum, the soldier in a warzone may be rewarded for putting his body armour on. He might only lose a leg, not his life.

Because you’re worth it

Risk, then, is a personal thing. You say to-may-to, I say tomato, you say banana, I see a banana skin.

This may seem obvious, but in my experience it’s not.

I was recently challenged in the comments on Monevator because I said pound-cost averaging a lump sum into the market was a sensible strategy for some people, if it reduced the chances of them losing a great deal of their new money in a sudden crash and they couldn’t emotionally take it.

The counter-argument was that over most periods, investing a lump sum immediately has delivered a higher return. Pound cost averaging was therefore “irrational”, and I should try to get people to see that.

But I don’t think it is always irrational.

Many people would happily take 5% returns over 20 years instead of 6%, if it meant a much smaller chance of losing 30% in any one year.

Certainly people should know the risks and rewards of their choices. However the decisions they make are not irrational just because they have an emotional component – and certainly not just because they reduce the potential return.

To say otherwise is to look at only one side of the equation – like speeding without considering the chances of a crash (or a divorce and a spell in jail!)

Even financial advisors have my sympathy when it comes to advising clients about risk.

What a terrible job!

Most people are more risk-averse than they think, and hate losing money. Whereas gains they shrug off as the natural order of things.

Yet few people go to a financial advisor to hear how to make a fairly secure 3% real return a year.

The crying game

Unfortunately, even if you agree that risk taking is a matter of personal choice, it’s difficult to judge your own tolerance ahead of a market crash, a recession, losing your job, or whatever else life throws at you.

(We’ll ignore the ‘upside’ problem of your returns being much higher than you expected. That’s only a drawback in the world of academics!)

You might vow to regard risk as just as important as reward, and choose an appropriate portfolio. But that’s a rational decision, not an emotion, and we’re emotional creatures.

The danger is that when the shares hit the fan, your emotions will take over, with damaging results.

Education can help. You might know you’re very afraid of losing money, say, but you’re convinced by the historical return from shares. So you could read all about previous stock market cycles to prepare mentally, and maybe begin trickling a small amount of money into shares over the next few years to get started.

The snag is we only live once. Take too long getting comfortable with risk and you might not have enough time to get a reward.

Worse, even a decade of experimenting might not tell you much. Plenty of investors in the 1990s felt very confident about shares. Only the thought of missing out on the biggest gainers bothered them! Then two bear markets in a decade slammed them for six.

Equally, some people seem wired for silly risk taking. Las Vegas exists because such people will always shrug off losses to try to make back their money.

My share-punting friend will probably never change. The best I can do is encourage him to lock some regular savings away in a pension fund, and hope he doesn’t learn about self-managed SIPPS!

How to explore your own risk tolerance

Here are some ways to better understand your own attitude towards risk.

Discover what others do

Read up on rules of thumb about risk, returns, and asset allocation. They’re not perfect but they are time-tested. Generations of investors have seen their fortunes ebb and flow, and these rules are the collective folk wisdom that’s been left when the tide’s gone out.

Stress test your portfolio

Instead of exclaiming, “What are the chances of that!” when someone says your portfolio is too risky, use a Monte Carlo simulator to find out. Is it worth a 10% chance of having no money at 75 for a 2% chance of having a maximum gain of £3 million, instead of £2 million? I’d suggest not.

Visualise the consequences

Look at photos of your parents when they were young, and again when they’re old. We have trouble imagining ourselves in our old age – but in most cases that’s who you’re taking risks for.

Try our risk tool

Experiment with the new risk tool here on Monevator, developed by the boffins at Which? It asks how much you’re prepared to lose in a year, and suggests different portfolios as a result. (I wouldn’t fuss over the exact asset allocations it suggests – thinking about the potential payoffs is the idea here).

Image of a portfolio adjusted for risk

Click this image to go try the risk and portfolio tool!

Now none of these methods can really tell you how it feels to lose half your pension the year before you retired because you stayed 100% in equities too long.

But working through them puts risk and reward into the spotlight where it belongs.

Tip: Consider all the risks when making investing decisions. The first reason to invest is inflation, which erodes the real value of your money even as its nominal value stays secure. Over the long-term, inflation could be a bigger risk than temporarily losing 20-30% of your money in a crash.

Search for the hero inside yourself

Outside of the City and Wall Street, investing is not about beating the rest. It is not a macho sport.

I’d guess my own risk tolerance is higher than perhaps 90% of Monevator readers, although I’m not sure all of the newer arrivals to the market know it. I’ve seen my net worth plunge faster than the Liberal Democrat vote at a local election and I know I can endure it. In contrast the last few years have been a nirvana for shares, and complacency is building.

But despite my own attitude to risk, you won’t find me berating you for keeping 50% of your funds in cash, let alone for paying down your mortgage instead of gearing up to invest in shares.

Risk comes down to your own circumstances, goals, and your own gut feeling. Don’t take the risk of anybody convincing you otherwise.

  1. I don’t think eating horse is bad for you – I think not knowing what you’re eating is. []

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{ 25 comments… add one }
  • 1 PC March 15, 2013, 12:33 pm

    Yes but is there any alternative? (to taking a bit too much risk)

    I have a higher proportion of my portfolio in equities than I should, but can’t bring myself to invest in bonds because they look too high and don’t want to leave money in cash to lose money slowly to inflation.

    There isn’t an easy answer …

  • 2 The Investor March 15, 2013, 12:55 pm

    @PC — I sympathize. 🙂 I don’t really want to rehash the bond debate yet again, but hope this post might make people think of other ways to reduce risk if they need to after thinking about their risk tolerance.

    E.g. As private investors we can get 3% on cash if we lock it away for a few years.

    I’m still very long equities but am increasingly looking for odd or uncorrelated assets, too. But that’s (rightly!) beyond most people’s interest.

    Finally — and what prompted this post and last week’s — too many people think either/or. Even 20% cash paying 3% rebalanced after any big corrections in the stock market likely won’t hurt your returns too much and many will appreciate the cushion in a crash.

  • 3 Paul Claireaux March 15, 2013, 1:06 pm

    Interesting article.
    But what curious portfolios. Heavily slanted towards USA equities when most informed observers would say that market is one of the more overvalued.
    Was this designed for USA residents or the UK?

  • 4 The Investor March 15, 2013, 1:17 pm

    @Paul — It’s for UK residents.

    People are very poor at predicting when markets are overvalued, and have been calling the US overvalued for at least two years. I think the tool is not so bothered by that sort of judgement call, and is more based on size of underlying markets and historical returns and correlations.

    e.g. Our own Slow and Steady Portfolio has by far its biggest ex-UK equity allocation in the US:

    http://monevator.com/passive-investing-model-portfolio/

  • 5 Paul Claireaux March 15, 2013, 1:27 pm

    Aha – i see.
    So following that logic you would have held a very large proportion of Japanese equities at the top of their market in 1989 when that market accounted for a very large proportion of the world equity capitalisation.
    24 years later the Nikkei 225 index is still less than 30% of it’s 1989 price.
    When markets bubble (like that one did) the % you invest goes up with that system.
    you might want to rethink that strategy and let Which / Barrie and Hibbert know too !
    There is a warning on all investment products that goes something like “past performance is no guide. . . . !

  • 6 The Investor March 15, 2013, 1:59 pm

    @Paul — Yes, the logic would lead you to having been exposed to Japan before the crash. In mitigation you’d also enjoy the growth and rebalance when it’s too high, but clearly you’d have taken a long and painful hit to that proportion of your portfolio.

    I’d counter though that Japan is an outlier / worst case scenario (to date!). Also the US is at nothing like the same level of potential over-valuation. To me it looks slightly optimistically priced for strong growth, but I don’t think the growth is out of the question.

    I’m sure Barrie and Hibert might want to see your track record of deftly outperforming global markets for the past 30 years before abandoning a passive approach. 😉 It’s very easy to say this or that is over or undervalued — I do it myself — but the overwhelming fact is most active investors get these sorts of decision wrong, at least after costs. You may be an exception for all I know, but by definition most won’t be.

    To be clear, I don’t invest in the pure passive way either. But I do it with my eyes wide open, and I think most will do better passive.

  • 7 OldPro March 15, 2013, 2:07 pm

    I propose “OldPro’s Monevator Comment’s Law”… which says that any article whatever the topic will be discussed in the comments as either… is there a bond bubble… is emerging markets / the US / Katmandu market overvalued… is Hargreaves Lansdown the cheapest place to hold fund X…

    Not a complaint… I keep coming back! But I stand by my Law!

  • 8 diy investor (uk) March 15, 2013, 2:28 pm

    I think many mistakenly associate low risk with cash and bonds. But as John Kay points out (the long and the short of it), they are not low-risk investments for those who wish to protect their future real living standards. Don’t confuse the search for minimisation of risk with the search for certainty.

  • 9 BeatTheSeasons March 15, 2013, 2:32 pm

    I feel PC is right in that there isn’t much alternative to taking on more risk at the moment, particularly after the recent equities rally.

    In which case perhaps this article should be called ‘Change’ instead of ‘Know’ your own risk tolerance. I’ve already massively reduced my spending habits and increased my savings rate, so I don’t see why I can’t also adjust my investing expectations.

    @OldPro – can we add gold and farmland to your comments law?

  • 10 Paul Claireaux March 15, 2013, 2:43 pm

    Ha, well I’ve survived with my funny methods for the past 30 years, thanks but I’m afraid i don’t have data to demonstrate personal fund performance. Like most people I’ve held a number of products and funds over that time and made use of more than just market performance – canny use of legitimate tax breaks works too.
    Of course we need to be careful with past performance even where it’s available—because equivalent rates of returns are heavily skewed away from the price returns when (like most people) we’re adding in money along the way.
    Someone really ought to explain this to those chaps at Dalbar. It’s quite easy to demonstrate that a 7% pa fund return can be turned into say a 2% pa or 12% pa IRR on savings when regularly investing. It all depends upon the track that prices tack to their final destination.
    Your blog’s guidance seems aimed towards regular savers (rather than those with wealth seeking to protect it) in which case these risk issues that I raise may be less of an issue. But it might be helpful to indicate which element your aiming at on each post. (regular savings over long period or lump sum)
    Of course I cannot predict market movements on a daily basis (though there are plenty confused souls spread betting out there who think they can- sadly) but I do think there’s a difference between 1) blindly tracking a market up and down (whether it’s the UK All share or the MSCI World Cap) and 2) adjusting your position to reduce some fairly clear bubble risks.
    I agree that there are not many obvious bubble points but the run up to 1989 was certainly not an outlier. What about other world markets in 2000, and 2007-8?
    The outlier idea is the common excuse on every crash for the normal distribution follower and when it reaches the scale of blowing up the whole world’s economy then this issue becomes serious – albeit amusing at the same time– see here http://www.nottingham.ac.uk/business/cris/papers/2008-3.pdf
    And yes, the passive investor can usually look back over 50+ years from the top of a bull run and say there – it all worked out fine in the end.
    The trouble is that by the time you’ve actually accumulated some serious amounts of money – enough to fund a decent pension—then the challenge becomes one of wealth preservation (and some inflation hedging) rather than all out growth and to hell with 70% downside risks.
    Now, i suspect that Barrie and Hibbert have kept much better records than me – so why not invite them to provide actual performance data on the portfolios that their system recommended in say early 1989 and late 1999.
    Would be interesting !

  • 11 Paul Claireaux March 15, 2013, 2:58 pm

    To beat the seasons.
    Your view that there is no alternative to cranking up risk is unfortunately shared by large numbers of investors. Driven by these crazy (and temporarily distorting) central bank activities we’re now cranking up the risk in markets.
    Beware and read recent articles Gavyn Davies in the FT.
    A quietly spoken master of economics – he’s trying to warn people.
    Indeed – even some folk over at the Fed are starting to worry that their activities are creating bubbles.

  • 12 The Investor March 15, 2013, 2:59 pm

    @Paul — I don’t disagree at all one should be aware of risks. That’s my point. Where we disagree is how most people should approach this. I think most people trying to look for bubbles and bargains are likely to just churn away some of their gains, and according to the studies we’ve both seen potentially do far worse as they move their money around.

    In contrast, I think by following some broad asset allocation rules and being fairly mechanical about rebalancing — plus taking into account factors such as age — they will likely do better than most who try to be clever. An informed passive investor doing so would not be blindly following the market up just before they reached their pension, as you imply — they would likely be 50-60% in fixed interest.

    The evidence is overwhelmingly on my side that most people don’t/can’t do what you present as “obvious”.

    There is an entire media / active fund management business based on making the sort of claims you do. Investors who want to read about this being overvalued or that being undervalued are well-served by the media/active management industry. And a fat lot of good it does them.

    Here are a bunch of famous investors, economists, and pundits who weren’t as smart as investors would need to be to follow your approach:

    http://www.businessinsider.com/dow-jones-idiot-maker-rally-2013-3?op=1

    I say again, I suspect you and I manage our money fairly similarly. 🙂 For instance, I do personally try to take a view on whether markets are expensive and so on.

    But I am very humble and circumspect about how successful these attempts are likely to prove long-term, and I have an eye to the evidence.

  • 13 rjack (Mr. Asset Allocation) March 15, 2013, 3:04 pm

    “Unfortunately, even if you agree that risk taking is a matter of personal choice, it’s difficult to judge your own tolerance ahead of a market crash, a recession, losing your job, or whatever else life throws at you.”

    This is true. I think it is important to distinguish between your risk tolerance and how accurately you can perceive the actual risk. I think many investors thought there portfolio was “low risk” until the latest crash occurred. I’ve been around long enough to experience several market crashes and investors seem to get a collective amnesia about crashes about 5 to 10 years after the last crash.

  • 14 Paul Claireaux March 15, 2013, 3:24 pm

    You make your points well and i absolutely agree that most people cannot time markets – nor am i suggesting we take an “all in” or “all out” approach on a regular basis. The frictional charges, as you say, are too high. And we cannot call markets daily.
    I’m simply looking out for big bubble build ups (in stocks and house prices as it happens) in the same way as an aircraft pilot keeps a look out for cumulonimbus clouds – the big ones have vertical winds of several hundred MPH and hailstones the size of cricket balls. I’m not joking – flying is my hobby. Now I guess you’re glad that the pilot doesn’t take a normal distribution of risk approach and just plough on through these things because “on average” it’s ok to do it and only 5% of aircraft crash when they do? !
    If I spot what looks like a bit bubble I’ll take some risk off the table – it’s worked so far.
    1997-2000 onwards was obvious on any kind of PE or dividend yield basis for both UK and USA markets. People were throwing themselves into the market which was pumped full of dot.com stocks and got hurt badly.
    Since that time we’ve had an extraordinarily easy money policy which has first pumped up the housing markets both here and the USA and, now that this has imploded, is pumping up both fixed interest and equities.
    This party will come to an end (again) soon. I’m very concerned that following the biggest experiment with the monetary systems in history things could get very messy.
    Your list of bad punditry is excellent – thanks. Yes these guys were calling for a second leg down in 2009 but to be honest the market was reasonable value by that time. It was yielding well over 5.25% and I was back in.
    Now, do i get it right the whole time – of course not but i do take out enough risk at the tops of bubbles to sleep at night and that’s my first aim.
    As I’ve said – if your guidance is primarily for younger regular savers then these issues are less important but as your wealth matures they become very important.
    As for a plan of having 60% in fixed interest nearing retirement . . . please ! not now for goodness sake.
    I think we’ve debated that issue before so enough on that one

  • 15 The Investor March 15, 2013, 4:29 pm

    @Paul — I like your hailstones and airplanes analogy, I may steal it for myself. 🙂 As for bonds, I am sure it will incorrectly go down in the annals of people’s memory that I thought bonds were sensible priced at these levels. For the record: a reminder I absolutely do not.

    However as I fear I am boring you with you saying, I think the average passive investor would have enjoyed (and done better to obliviously enjoy) this huge run up in bonds to-date (perhaps more than us clever folk who bailed out at 10-year yields of 3%, say) and also rebalanced into equities. So when the inevitable declines come (which aren’t likely to be anything like as painful as a stock market crash) we need to keep that in mind.

    We’ll have to agree to disagree on the US market. I’d guess it’s about 10% overvalued. The US economy is hauling itself out of the dumpster, and the recovering housing market is going to fuel growth for years. But this isn’t the post / comments for that, as OldPro rightly reminds us. 🙂

    @OldPro — We don’t have too much on gold and farmland here, thankfully! But yes, we do like to debate those bonds.

    @rjack — Agree, people constantly delude themselves with things like hindsight bias. Related: Every time I talk to someone about investing in active funds, they say “well that’s very well but my Ultra Bingo 2000 fund has gone up 52% in the past two years” or similar. Unless they’re in the financial service business, they NEVER compare that performance with the index. Usually they don’t even think to, or care. People have a very myopic view of their own and the market’s performance.

    @BeatTheSeasons — Agree, for someone who takes an active view, ‘risk’ as academically defined has to be a moving target. i.e. You probably ‘have’ to take on more risk assets currently. Where me and Paul might find some common ground though is I don’t think that’s where the definition of risk should end for us private investors running our own money, as I discussed in last week’s post. 🙂

  • 16 Paul Claireaux March 15, 2013, 4:44 pm

    It’s been fun today. Must get back to writing my book – which contains the hailstone analogy so if you’re going to steal it – at least provide proper attribution. My book will be called IrateInvestment. Out later this year.

  • 17 The Investor March 15, 2013, 4:51 pm

    @Paul — Hah, okay, I’ll leave my hands off that one then. Please do drop me a line when the book is on Amazon or similar.

  • 18 Paul Claireaux March 15, 2013, 4:52 pm

    Will do. Cheers for now

  • 19 Mochimac March 16, 2013, 4:37 pm

    I am just as picky about food and it bothers a lot of people, I know. I just try not to be militant about it, but it’s hard when other people are not as picky, and it comes off as such. Now I just try to eat before I go anywhere.

    As for risk — I read that link you posted about Andy Zaky and it gave me heart palpitations (am going to repost it later on in my March Budget roundup).

    I can understand investors getting caught up in the big sexy returns of some Apple guru but … even so, that would make me very hesitant to put more than 1% on what he’s saying.

    I’d rather win on 1% than lose 100%. This is very true even with what I do now — my rule is no more than 10% in stocks that I am playing around with for capital gains, and no more than 50% in a small pool of dividend-paying stocks (not too many, I can’t keep up with all of them to make sure I’m not losing my capital).

    The rest goes into index funds.

    I figure that’s pretty risky as is.

  • 20 PC March 17, 2013, 1:42 pm

    How much should age influence the amount of risk to take? Is there really a point which you can set as a target for example state retirement age? Unless you are about to buy an annuity, isn’t it something more fuzzy? For example, and fingers crossed, I might be able to gradually work less, extending the date I’m completely reliant on investment income by up to 10 years ..

  • 21 S. B. March 19, 2013, 4:48 am

    The first rule of investing is not to violate your risk tolerance. It is the first rule because when people break it, they generally become irrational and don’t follow any of the other investing rules.

  • 22 PC March 19, 2013, 10:10 am

    The first rule is to write down your rules before committing any money.

  • 23 Paul Claireaux March 19, 2013, 2:51 pm

    I think capacity for risk is far more relevant than one’s tolerance of it at a given point in time. And that’s the bit the FSA are concerned about.

  • 24 Thisisnot Living March 19, 2013, 2:55 pm

    Coming back to the article itself (controversial, I know!) Here’s a question relating to the which? model and it’s evolution.

    I realise there are probably a million factors affecting how the returns and worst loss might change, but it would be really good to understand just how stable (or not) those numbers are over time…

    Put differently, if I chose to keep a 20% risk portfolio, what happens to the seven year return (and worst loss) if inflation now is 10%,  and real growth in us, UK, Europe indices is high say 7%. Now flip those two numbers round… How do the results change. I’m not so interested in thr numbers themselves, just how much I can expect them to change over different scenarios.

  • 25 Paul Claireaux March 19, 2013, 3:12 pm

    I think we already agreed that the model determines asset allocation based upon current market capitalisations.
    So markets that have done well (swollen in value) are given a high weighting.
    That’s irrational IMO. And would have blown you up had you followed it in 1989 – because you’d have been loaded up with Japanese stocks and they’ve been in a bear market ever since!
    At a local level – the same risk applies to all passive investing. E.g. If you just wanted a FTSE All share Tracker then in 1999 you would have been holding a belly full of tech stocks.
    Unwise !
    Trackers can be useful and certainly low cost (and i use em) but using them does not excuse us from thinking about value and where to hold our money. Not in my book anyway.

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