Can you take the pressure when your portfolio is sinking faster than a sub with a leak? At what sorry depths does your brain implode and your stomach dissolve in an acid bath of its own stress?
That’s what risk tolerance hopes to tell you.
By staying on the right side of it, you’ll hopefully resist the urge to panic sell in a crisis as if you’re throwing small children in the way of an escaped lion that caught you pulling faces when you thought his cage was locked.
Knowing your risk tolerance helps guide your asset allocation so that you’re not over-committed to equities when the market drops.
But nobody’s born with an innate knowledge of their risk tolerance. You can take a test, but it doesn’t come with a reliability guarantee.
Also, ticking boxes on a questionnaire is an entirely different experience to coping with the emotional shock of confronting your first bear.1
Bear market survivors
The surest test of your risk tolerance is how you reacted last time 20% or more was wiped off your wealth. (If that’s never happened to you then we have some helpful ideas in the next section).
Your first bear market raking represents hard won experience that you can put to good use:
- If you panicked and sold up then your asset allocation is too aggressive. You need to dial down your equities and dial up your bonds. Your risk tolerance is likely low or very low.
- If you felt worried but held your nerve without losing sleep then your risk tolerance is moderate and probably about right for that level of loss. You just need to consider a worse-case scenario (see the next section).
- If you rubbed your hands at the sight of securities on sale and rebalanced into the battered asset class then your risk tolerance is high. Consider a more aggressive position.
- Your risk tolerance is very high if, instead of praying for deliverance, you prayed for further falls so you could grab even better bargains.
Passive investing champion William Bernstein matches these reactions to the table below published in his brilliant book The Investor’s Manifesto.
|Risk tolerance||Equity allocation adjustment|
- Your bond allocation equals your age.
- Your equity allocation is then adjusted higher or lower by your bear market reaction as described above.
- A low-risk 30-year-old would be 60% in equities and 40% in bonds.
- A high-risk 60-year-old would go for a 50:50 portfolio.
Whatever you do, do nothing in the heat of the moment. You may feel like you’re being water-boarded while Donald Trump screams “LOSER!” in your ear but hang on. Sales during a storm can only crystallise losses.
Aim to gradually increase your bond holdings a few percent per year in line with the table above.
If your behaviour under fire suggests you can handle more adventure, then you can think about upping your equity position.
But again, only gradually.
Remain alive to the possibility that you may not feel so calm in the future if a bigger loss rips a chunk out of your bigger portfolio.
Bear market virgins
It’s better to be opt for an asset allocation that’s too conservative rather than too aggressive.
That’s because one of the worst things that can happen in investing is that you panic-sell, lock in losses, and swear off equities for good – missing strong returns in the future.
If you don’t have a real-life reference point to work from then assume your first big losses will feel much worse than you can predict.
A cautious approach enables you to build up your capabilities rather than having your confidence destroyed by an early trauma.
We’re generally advised to assume that equities can lose 50% of their value at any time.
The UK market’s biggest real2 return loss was -71% from 1973 to 1974.
And it lost over 33% in 2008.
If you missed that debacle, try this:
- Write down the equity value of your portfolio.
- Halve it.
- How would you feel if that’s the amount you had in six month’s time?
- How would you feel if it took 10 years before your equity portion recovered its original value? Would you hate yourself? Would you feel stupid? Sick?
- If so, repeat again only this time you lost 25%. Then 20% and 10%.
- Can you cope if your portfolio doesn’t recover for 10 years?
- Dampen your portfolio with bonds or cash until you reach a position you can live with.
Prolific passive investing thinker Larry Swedroe has published the following handy table as another way to find that position by allocating more of your portfolio to government bonds.
|Max loss you’ll tolerate||Max equity allocation|
All this said, as a professional party-pooper, it’s my sad duty to mention that there’s no guarantee that bonds will actually save you in a market crisis.
A 50:50 portfolio of UK equities and bonds still went down -58% in 1973 to 1974.
Like flood defences or an asteroid-proof umbrella there is no way to defend against the very worst that can happen.
But all the same, you are much less likely to suffer unbearable losses with a large slug in UK government bonds.
Risk tolerance fine-tuning
Don’t assume that your risk tolerance is a fixed characteristic.
- How you feel when you’ve got £300,000 on the line may be different to when it was only £3,000.
- How you feel when you’re 60 may be different to when you’re 30.
- How you feel when you’re close to your goal may be different to when you’re 20 years away.
- How you feel under strain may be different to when the market is buoyant and everyone feels invincible.
Err on the side of caution and be honest with yourself about how you felt during dark times versus how you would liked to have felt.
Don’t take unnecessary risk even if you can handle the consequences. Once your goals are in reach there’s no point letting Mr Market knock them out of your grasp again.
Pare back your equity allocation to take risk off the table.
If you need all your capital back within the next five years then you shouldn’t be in equities. Do the 50% loss exercise and see how that looks.
Self-education can improve your risk tolerance to some degree. Many Monevator readers report taking comfort from their knowledge that major losses are commonplace.
History also tells us that we’re likely to recover our losses within a few years.
You just need to view investing as a long game.
Try horror-binging on a gory book of past stock market manias and crashes to understand the polar extremes that we’re likely to weather in the future.
It’s a lot easier to deal with a crisis once you realise it’s normal.
Take it steady,