What is risk tolerance? This question seems to have a simple answer: the risk you can tolerate in your investment portfolio. However, that’s where the simplicity ends. To assess and define risk, some advisors offer surveys, others ask a series of questions.
Answer the “Need” Question First
To me, the first question should not be how much risk you can tolerate; rather, it should be how much risk do you need? More specifically: What portfolio asset allocation do you need to make your financial plan work? After all, over the long term, the more risk you can accept, the higher your returns are likely to be. Ideally, I settle on the lowest risk asset allocation that will achieve the objectives of an individual’s financial plan. Once you answer the “need” question, you can work backwards to answer the “tolerate” question.
Suppose you think you can only tolerate a 10% decline in the value of your portfolio. Does that mean you should have a super-conservative portfolio, such as only 30% equity? Perhaps. But is that realistic for what you need to accomplish your objectives? You don’t know until you do the math. Therefore, the first step is to complete a financial plan to estimate the returns you need. What if you develop a financial plan and find that it requires a 60% equity portfolio to meet your objectives? Should you still stick with the overly conservative 30% equity portfolio? Probably not.
It’s possible that you think you can only tolerate a 10% decline, but don’t fully understand the implications involved. Some of my new clients toss out a 10% number for risk tolerance – it’s a nice round number and sounds scary enough. But is a 10% decline really that significant? Usually not, especially viewed with a long-term lens. Keep in mind that 10% declines in the stock market tend to occur once or twice per year, sometimes even more. Trying to manage risk around that frequent of an event is likely to lead you to poor decisions, which can compromise your returns and substantially increase your income taxes.
The Most Important Factor in Determining Your Risk Tolerance
Here’s another surprise: the most important factor in determining your risk tolerance may not be what you think – it’s time. Given enough of a time horizon, risk can become irrelevant.
Let’s look at a couple of examples. What if the investor is 30 years old? In that case, he probably has a 50+ year time horizon. Should a 10% decline over a one-year period really matter to him? With a bit of education, he would see that at his age, a 10% decline over one year is relatively meaningless since he has so much time to recover from the temporary loss.
Surprisingly, the same can be said for an affluent 65-year old retiree in good health. With seniors living so much longer than in the past, it’s possible this healthy retiree could live for 20 or 30 more years. Even if she were taking portfolio withdrawals, which tend to compound the impact of negative returns, a 10% loss in a single year would probably not have a significant impact on her overall portfolio.
Risk is largely about taking the right perspective given your personal situation and time horizon. Blindly selecting an asset allocation based on age (as many do) may lead you to bad decisions. Instead, focus on time horizon and the particulars of your financial plan. If you invest with an asset allocation that truly fits your risk tolerance, you should be comfortable enough with your portfolio to ride out market declines and stick with your long-term plan.
Time Compresses Risk
Time is more than a matter of perspective, it actually compresses risk.
Suppose you have a 60% equity/40% bond portfolio (60/40). Since 1950, the worst one-year calendar return you would have experienced would be roughly a 20% loss. Could you tolerate a one-year loss of 20%? Maybe not.
But maybe that’s not the right perspective. If you’re 50 years old, your time horizon is likely to be 30 or more years. It’s more appropriate to look at the risk impact of longer time periods.
Simply moving out the timeframe to 5 years, the worst compound annual return since 1950 for your 60/40 portfolio is no longer negative – it’s approximately 1%. Change the timeframe to 10 years and the worst performance is about 2% annually. Better yet, take a 20-year perspective and the worst performance is estimated to be more than a 6% annual return. Many of us would be happy with a 6+% annual return, and that’s the worst 20-year period on record since 1950.
The key takeaway is this: As your time perspective increases, downside risk diminishes.
Managing Risk – Less is More
Let’s face it: You need to recognize that the stock market is a psychological nightmare and the statistics prove it.
Dalbar is an independent research group that tracks investor behavior. During the 20-year period ending in 2017, they found that the average balanced-fund investor earned less than 40% of the return they would have made if they simply did nothing – just bought, never sold and just held on. Less than 40%!
Why? Because investors get sucked in by market psychology – they buy high and sell low – exactly the opposite of what they should do. And they do it year after year, decade after decade. The cards are that stacked against trying to beat the market.
Sure, in extraordinary circumstances, such as extreme overvaluation combined with either aggressive rate hikes or a high possibility of an impending recession, I may seek to lower risk in my client accounts. But it’s rare and certainly not casual – managing risk is the focus of my practice and yet I hardly ever reduce it. Ironically, cutting risk is one of the riskiest investment moves you can make. Less is more.
One of the smartest things you can do is not time the market. Once you start trying to sell at what you perceive to be the highs, the more likely you are to become another statistic for the Dalbar reports.
The reality of the stock market is that the large majority of the time it is in a long-term uptrend. Downturns tend to be quick. The 2000-2002 bear market lasted about two and a half years, while the 2007-2009 took less than a year and a half. A bear market is a 20% or more decline, and they’re brutal to be sure; but once they’re over, stocks tend to bounce back quickly. If you sell during the decline, you’re probably going to miss some of the ensuing rebound because it’s going to rise hard and fast.
While stocks incurred two bear markets in the first decade of this century, this past decade has not seen a single one. That’s four years of bear markets over nearly a 20-year period – roughly 25% of the time in bear mode and 75% in bull mode. I like those odds.
Think about it: Even if you bought at exactly the wrong time – at every market peak– you would still have positive returns! Chances are you’re going to be right when you invest for the long term, unless you try to outguess the market. That’s when people run into trouble and get poor returns.
Instead, take these five steps:
- Work with a CERTIFIED FINANCIAL PLANNER ™ professionals to develop a financial plan.
- Determine the asset allocation of stocks and bonds you need to achieve the goals you expressed in your financial plan.
- Make sure the asset allocation fits your risk tolerance, and if not, consider whether you can adjust your risk tolerance by taking a longer-term view of risk.
- Buy low-cost, diversified funds.
- Hang in there during downturns and keep buying.
Sure, you’ll take your lumps now and then, but if your risk tolerance truly fits, you will be more likely to weather the storms, catch the dramatic rebounds and come out on top over the long term.