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

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

(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 if you can hang on.

Calculated risk

Risk 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 (or pain now for pleasure later) that makes equities worth investing in.

Their S&M qualities have brought historic rewards 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:

Pretty, but what does it tell us?

• Based on previous experience, in one year you might see your equities go down nearly 60% in real terms1 compared to less than 40% in bonds and a 20% decline with cash.

• On the positive side of the line, the scope for a bigger win from equities is the reason why we’re prepared to accept that chance of the loss.

Passive investing thought leader Larry Swedroe has previously published this table as a rough rule of thumb 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.

• How much risk do you need to take?

• How much risk can you afford to take?

The need for risk

How much risk you need to take depends on your chances of achieving your investment goals 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 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 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 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, 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 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.

Take it steady,

The Accumulator

1. That is, adjusted for inflation [↩]

Good reads from around the Web.

A slightly shorter list from me this weekend, as I’m preparing this edition of Weekend Reading on Friday ahead of an early start.

In particular, there’s no links from the Saturday papers. Gasp!

So if you spot anything worth sharing, please do share it with the rest of the monevated in the comments below.

Fans of Warren Buffett should also look out for his annual shareholder letter, which should be published this weekend.

Again, please do pop a link in the comments if you see it. 🙂

[continue reading…]

Many everyday investors buy their first share on a tip from a friend – or from the Government, via privatisations like we saw with the Royal Mail.

Some go on to make stock picking their hobby or even their passion, while others begin to invest in active funds.

Increasingly, index trackers and passive investing mark the final stage of this evolution, as people learn more about the high costs of managed funds and how hard it is to beat the market.

Ever contrary, I’ve done the opposite.

When I began putting my cash savings into equities more than a decade ago, I mostly used tracker funds.

Despite having been fascinated by both business and shares for years before that, I’d done my research and I knew that index tracking was the surest route to growing my wealth through the stock market.

However as the investing years rolled by, I strayed – or succumbed to the Dark Side, as my co-blogger The Accumulator put it when we debated our different approaches a few years ago.

And I entirely agreed.

After all, I knew what I was getting into. That was one reason I was so pleased when The Accumulator signed up to share his burgeoning passive investing knowledge with Monevator readers.

I wanted Monevator to continue to make the case that passive investing was the best route for most people, because I absolutely believe that’s true.

However I no longer considered myself the best person to make that case. I’d wandered off the map to a place marked Here Be Dragons.

As tears go by

For most of my nearly 15 years of investing I have traded very rarely and could easily ignore my portfolio for weeks or months at a time – even after I’d begun investing in individual companies and small caps.

Now, after the past three years (the point of this post, which honestly I’m getting to) even I find that hard to believe, but I only need to look back in my investment log to see that it’s true.

Below is a typically sparkling entry I made one day alongside the numbers I copied across from my various broker accounts, which I only ever did on particularly rainy days:

Uh oh, haven’t checked this for ages – thought I had!

This is going to be ugly.

FTSE is at 3,500.

Bottom has fallen out of HSBC, and so on.

Such deep insights: George Soros and his Alchemy of Finance has nothing on me.

The date of that entry was 9 March 2009 – virtually the bottom of the financial crisis in the UK, a rout that had cost me many years of savings – and yet my previous entry had been back in October 2008.

What on earth was I doing that was so much more exciting in-between? Partying with models and rock stars? (Hey, I can’t remember, so it must have been a great party.)

More likely I was reading The Snowball.

I was certainly following the bear market – I have dozens of blog posts to prove it – but I just didn’t seem to be that fussed about the short-term movement of my own portfolio in those days.

Fast-forward a few years though, and it’s quite possible that I knew the value of my portfolio on an hourly basis for some days in March 2015 – and certainly on any violent days like we’ve seen in the first couple of months of 2016.

So what changed?

Fallen angel

Well, on a practical level I unitized my portfolio in 2012, and that weaponized the portfolio check-up process.

I’d hitherto made a deliberate point of not tracking my returns too closely because I felt doing so was likely detrimental to my returns (I still suspect it is) and to my mental health (I’m now doubly sure of that).

But back in 2012 I decided I needed to find out once and for all how much value – if any – my trying to be clever with shares was delivering.

I had hunches, ballpark guesses, and I’d done some back of a napkin maths. But I didn’t know for sure, and that no longer seemed like good enough.

I mean, I’d been blogging about investing for five or six years by that point, and while Monevator has always had a passive focus, especially in the earlier days I’d often shared my active opinions too.

So I felt like I needed to know more about the investor who was giving all those opinions (i.e. me!)

Moreover investing had begun to seep into my professional life.

So from the end of 2012 I started to track my returns via a largely automatically updated and unitized spreadsheet1 in order to see exactly how my investments were performing, without any distortion from savings or withdrawals.

The initial idea was just to continue to copy the most relevant figures over to that racy investment log I mentioned whenever I felt like it.

But two things happened:

1. Now I could see my portfolio live at any time – and pretty much see my net wealth at the same time, given I invariably have between 75-95% of all my worldly assets in the market – I couldn’t resist following it more closely. My data was now just a click away, whereas before I’d had to log into several broker accounts to tot up various numbers to see where I stood.

2. I got to know a couple of people in the finance industry who suggested that as I was so clearly obsessed with investing, why wasn’t I interested in running a fund and earning mega-bucks? (Especially as some of the people they knew who did so hated it…)

The answer to that question is long and even more self-indulgent than this post, so let’s leave it for another day. (Here’s a taster).

However I did decide to follow some of their advice and to dutifully archive my returns on a daily basis, as well as recording all costs and so forth (which I was already doing via my unitised spreadsheet).

My blueberry nights

The idea was to create a three-year performance record, which is the minimum period for these types to get interested.

There was some talk too of recording and/or calculating daily volatility, Sharpe ratios, maximum drawdowns2 and all the rest of it, and even of trying to hedge out market exposure via a spreadbet or similar to create a sort of DIY long/short fund that might help highlight any alpha-generation capabilities I had – or “edge” as the hedge fund guys put it.

Well I’ll save you the suspense. Within 12 months I was bored or forgetful of recording daily snapshots, and worse I believed it was starting to affect my peace of mind (more on this anon).

So I never bothered calculating all that gubbins the typical fund manager’s platform automatically spits out for him or her alongside their profit or loss line at the end of every day.

However I did continue to track everything else, and I downloaded the returns of my portfolio and my various positions every week.

I also continued to record all money in and out through my unitised spreadsheet as part of this, and documented my buys, sells, costs, and so on.

Ashes of time

I kick-started my uber-record keeping from January 2013, and it continues in a slightly toned down format today. (Everything is still unitised and I record monthly snapshots, but starting this year I’ve stopped recording weekly snapshots.)

So what have I got for my pains?

Well, for one thing I now have an industry standard three-year performance record that I can compare with any commercial fund’s returns to see how I measure up over that time frame, rather than guessing and potentially deluding myself.

I’m probably going to share this with you next week – not to try to persuade anyone that it’s a good or a bad idea to invest actively, but rather because I think I’d find it interesting if I was a Monevator reader.

Also, I’d like to put all this data I’ve hoarded away to some practical use!

In addition I’ve learned some interesting things about the difference between being an investor and a trader, and also how hard it is to unpick where edge does (or doesn’t) come from.

Most importantly I’ve discovered how much more stressful investing is when you really care about the short-term – when you know someone other than yourself might see your results – and as a consequence you can find yourself living with the market’s volatility from minute-to-minute.

If I’m honest it has probably affected my mental well-being and my lifestyle, and I don’t think for the better. More on that in a future post, too.

The grandmaster

I’ll end this first part with a quote from Winston Churchill that I think is very relevant to this experiment I’ve been running, and to the changes that came with it:

“We shape our buildings and afterwards our buildings shape us.”

Being able to easily see exactly where all my positions are at any time has changed how I think about those positions.

And knowing that someone might um and ah over the monthly (or even daily) ups and downs has reduced my tolerance for that volatility.

Whereas once I would go months without getting up-to-date return figures from my investments, I rarely go 24 hours these days.

Perhaps there were different responses I could have made to all these new stress points, but the one I found myself employing was to greatly increase my trading activity to try to dampen down the extremes.

Costs exploded. And I slept less well at night.

In the next part I’ll share my returns over the past three years, and in the final post I’ll reflect on what I’ve learned the hard way as I’ve increasingly explored trading versus investing. Subscribe to get these future posts via email.

1. Note: I still hold around 10% in tracker funds, which only update daily, with a lag, so the portfolio is never really 100% marked-to-market in that sense. [↩]
2. i.e. How much did my portfolio decline from peak to trough? [↩]