Good reads from around the Web.

I haven’t agreed with everything written by Cullen Roche of Pragmatic Capitalism over the years – for me he doth protest too much when it comes to dissing passive investors who dare to call themselves that – but I have linked to him plenty of times.

The man undoubtedly knows his investing onions. And even when he sees onions and I see – um – fennel, I usually find his writing a tasty broth worth consuming.

(Mental note: Don’t blog on an empty stomach.)

Cullen has now written a research paper, and it’s basically an investing mini book that you can download for free as a PDF from the SSRN website.

It’s got a serious title – Understanding Modern Portfolio Construction – and it’s a serious read. But not a difficult one.

You say potato, I say passive investor

I think Cullen’s hostility towards the concept of passive investing (as opposed to using index funds and ETFs, which he fully endorses) is made more articulate within the context of this greater work.

He writes:

I’m still not entirely on the same page, but as (some) active fund fees come down and cheaper dealing fees and robo advisers bring down the cost of owning stocks, too, I guess the argument is moving in his direction.

Anyway, download the PDF, have a read and see what you think. (It’s U.S. but relevant – just remember the tax comments don’t tally exactly with the UK).

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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
Very high	+20%
High	+10%
Moderate	0%
Low	-10%
Very low	-20%

The non-equity part of the portfolio is in intermediate or short duration domestic government bonds.

• 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 real ² 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
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 is in intermediate or short duration domestic government bonds.

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,

The Accumulator

1. A bear market is commonly considered to be a 20% fall from previous market highs.[↩]
2. That is, inflation-adjusted[↩]

Good reads from around the Web.

I liked Mr Money Mustache’s take this week on the right way to think about falling share prices:

Suppose you’re just starting out as an egg farmer, and your goal is to build up a nice, profitable business.

You want to build up a flock of hens so big that they are eventually producing thousands of eggs per month.

Enough to live off for life and retire.

You buy your first 100 hens, and they get right to work.

You allow those eggs to hatch so more hens can be born, and you also continue to buy hens from the farm supply store.

Suddenly your phone rings and it’s Farmer Joe down the road.

“The price of hens has just dropped by 50%! You’ve just lost five grand on those hundred hens you bought last summer!”

Is this a sensible way to think about it?

No, of course not. You’re happy that hens are cheaper, because now you can build your egg business even faster.

Stocks are just like hens. They lay eggs called “dividends”, which are real money that can either flow automatically into your checking account, or automatically reinvest itself to buy still more stocks.

Read the rest of the article for his typically no-nonsense take on passive investing.

Sadly, the markets seem to have stopped falling and some have risen rather notably. The FTSE 100 is all but back to where it began the year.

Let’s hope someone comes up with a few new scare stories for the economy!

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