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What you need to know about risk tolerance

Ladies and gentlemen, for your edification (maybe) and entertainment (that’s pushing it) there now follows a readable piece about risk tolerance [1]

You know, that oh-so-elusive trait we’re all supposed to account for when determining our asset allocation [2]?

(Yeah, ‘course we do.)

How much pain can you take? How much BS? Risk tolerance is a similar deal. It’s your ability to bite down on a metaphorical plank of wood and endure when your portfolio is shedding pounds like a slimming club champ with the runs.

At some point on the voyage to the bottom of the market, people can snap. They sell out of their sinking assets to staunch the losses. It’s like pushing passengers off an overloaded life raft. In a state of panic, you’ll try anything to stabilise the situation.

When you’ll snap – at 20% down, 50% or 90% – that’s the breaking point that risk tolerance attempts to predict.

Because, like your offed life raft buddies, those losses can come back to haunt you. Losses equal permanent damage if you sell, but are usually only temporary setbacks [3] if you can hang on.

Calculated risk

Risk [4] is the key word here. By holding on, you’re taking the risk that your assets may never bounce back – or may even suffer greater losses – for the chance to reap the rewards that should come if and when the economy recovers.

It’s this trade off between risk and reward [5] (or pain now for pleasure later) that makes equities worth investing in.

Their S&M qualities have brought historic rewards [6] of 5% a year to investors in UK shares, versus just 1.6% for the playful spank of bonds and 0.9% for the soft tickle of cash.

This graph shows the sort of stomach lurching dips you might have to endure in one year of holding equities compared to bonds and cash:

Volatility of UK equities, bonds and cash [7]

Pretty, but what does it tell us?

Passive investing thought leader Larry Swedroe has previously published this table as a rough rule of thumb [9] to help you keep your equity allocation in line with your pain threshold.

Max loss you’ll tolerate Max equity allocation
5% 20%
10% 30%
15% 40%
20% 50%
25% 60%
30% 70%
35% 80%
40% 90%
50% 100%

The non-equity part of the portfolio goes into intermediate or short domestic government bonds.

There are a couple of modifiers to the above idea.

The need for risk

How much risk you need to take depends on your chances of achieving your investment goals [10] with the money you can invest and in the time you have left.

If you need to average 5% real return per year to hit your magic number [11] over the next 20 years then you’re only going to hope to get that from equities.

But if you can tick along at a slower growth rate [12] of say 2% then you can put more of your money into steadier government bonds. Even if you feel like you could take more risk, there’s no actual need.

The lifestyling [9] technique is an example of this, whereby you ease off the equity pedal and press on the bond brake as you near your goal. You do it for the same reason you ease your car into the garage slowly rather than at 60mph to get parked that bit quicker. The opportunity is not worth the risk.

Similarly, if you’ve hit your target then there’s no need to take any risk at all. The difference a few extra grand makes is nothing in comparison to the devastation most would feel if their wealth halved when they’d achieved their goal already.

Even if you can watch your portfolio plummet 50% and feel nothing (What are you? A psycho?), you only need to ensure your portfolio keeps up with the cost of living once it covers your outgoings.

The ability to take risk

How much risk you can afford is a function of how vital your portfolio is to your future well-being.

If your portfolio will be the mainspring of your income during retirement then you can’t take as many chances as someone who is also expecting plentiful support from direct benefit pensions, inheritances, passive income and so on.

Equally, if you’ve amassed a pool of wealth to make Smaug jealous then you can afford to throw caution to the wind a bit. Like Warren Buffet’s passive portfolio [13], the chances are that you could still shower in champagne even if a huge chunk of your assets went walkies – simply because you’ve got more than you can ever spend anyway. Dream, dream.

Once your essential needs [14] are covered then, theoretically you can stick the rest on the horses and it won’t really matter. In reality, you’re probably investing for future generations and hope to leave a larger legacy by investing in equities.

The other dimension to your ability to take risk is income stability.

If you lost your job and would be forced to liquidate a portion of your portfolio to cover your expenses then you should take less risk than someone who’s backed up by a large emergency fund, a hefty redundancy payout or income insurance.

Remember you’re most likely to lose your job in a recession at the very moment that equities are being pounded, too.

If your job is very stable (perhaps you’re the Queen) then you can take more risk than someone who’s liable to be P-45ed at the first sign of a slowdown.

Risk management

Your chosen asset allocation will likely be a muddy compromise between your estimated risk tolerance and your need and ability to take risk.

The truth is that many of us are in a precarious situation. We need to take risk if we’re ever to retire but Plan B looks pretty sketchy if Plan A proves a train wreck.

In this instance give your risk tolerance the casting vote. You have an August snowball’s chance of reaching your goals if you flip out and sell during a downturn, so staying within your risk tolerance is cardinal.

But how can you work out your personal risk tolerance? Here’s some handy pointers [15].

Take it steady,

The Accumulator

  1. That is, adjusted for inflation [ [18]]