One of the few things that all investment experts agree on is that risk in a portfolio should be determined on an individual basis. Only you can determine how much risk your portfolio should contain. You will be motivated in this decision by two dissonant drives. The first is greed; we all want lots of money, and you need it to a certain degree. You cannot retire on social security alone. From the point that you retire, your investments will generate all of your income. You had better be sure that there is enough money to last until you die, and that is an unknown factor. The other driving force behind your risk profile will be fear. Recall from our discussion of prospect theory that fear is generally more powerful than greed, and we may make irrational decisions if we focus on loss.
When it comes to assessing your risk profile, you will want to consider three overarching themes and somewhat interrelated themes:
- How much ability do you have to take risks?
- How much will do you have to take risks?
- How much need do you have to take risks?
Your ability to take risks depends largely on how badly and how soon you will need the money you have invested. Even if you are a risk junkie and thrive on market volatility, you must curb your risk appetites the closer you get to retirement.
Your willingness to take on risks has to do with your personal psychology than anything else. This is where the sleep test we discussed earlier comes into play. This is perhaps the most difficult aspect of portfolio design and management to pin down. You have to translate a general aspect of your personality into a number of standard deviation units. Investment advisors use questionnaires to help clients determine this factor, but the results aren’t spectacular.
Saying what you will do in a given situation is very different from what you would actually do in a real-world situation where losses are measured in your hard-earned dollars. The converse of just how conservative one can be (those that think of loss foremost) is the question of just how much money can be made (for those who think of returns foremost). Whichever extreme you find yourself at, you will need to temper your willingness to take on risk with rational considerations of your ability to take on risk and how much risk you need to take.
Most people do not need to take on extraordinary risks to achieve extraordinary gains. Both can be accomplished when you invest early and consistently. If you are risk-averse in general, or you are very close to retirement and haven’t saved adequate, it may be necessary to get a goal and then reverse engineer how much risk you must take to reach your goal.
Since the nature of risk tolerance is so personal, I must leave it to you to determine your own. I can suggest some rational ideas for establishing a floor and ceiling.
As to the floor, you need to figure out what the minimum compounded return you need to reach your minimum goals is. You can do this with a compound interest calculator on many free websites. Let’s say, for example, you are 42 and want to retire at age 62, and have computed that you will need $1 Million in savings to keep your standard of living where it is. If you are very conservative and only plan to earn an average of 5% per year on your portfolio, you will come out with a result like this (generated using the investor.gov Savings Goal Calculator): “If you contribute $2,520.22 every month over the next 20 years towards your goal, you will have $1,000,000.00 in savings.” For most folks, that is not reasonable. You will need to up the time that you will invest, or up the risk that you are willing to take.
If, for example, you started investing when you were 22, you could reach your goals with this ultra-conservative portfolio as follows: “If you contribute $689.85 every month over the next 40 years towards your goal, you will have $1,000,000.00 in savings.” If we invest more aggressively, assume the risk of buying the market, and achieve the average return of around 10%: “If you contribute $188.28 every month over the next 40 years towards your goal, you will have $1,000,000.00 in savings.” If you are in the late saver category, you will need to really ramp up both risk and constant dollar contributions: “If you contribute $5,228.78 every month over the next 10 years towards your goal, you will have $1,000,000.00 in savings.”
The ceiling of risk is highly personal and will have a lot to do with your risk tolerance. Risk tolerance is the amount of decline that you can see in your portfolio and not break discipline and make trades. This number is likely much lower than you think. We tend to be more rational when there is no bad news that would cause a spike in fear. When markets are humming along nicely, and our portfolios are doing well, we tend to be optimistic. When there is a downturn, we quickly turn pessimistic, and our risk tolerance questionnaire answers change dramatically.
If I must grasp for a rule of thumb, I would say that you should never accept more portfolio risk than you would have if your entire portfolio were invested in an S&P 500 index. Given sufficient diversification, you can achieve this market return with a lower level of risk, and even with the addition of return boosting factors, there is no sense taking on more risk than absolute beta. Depending on the dataset you choose and the lookback period, you will find that market standard deviation is somewhere around 15% with spikes up to nearly 20% if you include the great depression. If we accept the 15% standard deviation figures correct and use the normal distribution to approximate the probability curve of that volatility, we can make some statements about how often you can expect big moves. About 16% of the time you will be above the mean by more than 15%, and about 16% of the time you will be below it by more than 15%.
For a commonly used hypothetical $10,000 portfolio, that means you will have a net asset value of between $8,500 and $11,500. (The properties of the normal curve dictate that the probability of all observations falling within one standard deviation below or above the mean is 68%). About 13.5% of the time, you may be down to as little as $6,000 in portfolio value. The same 13.5% applies to the upside, and in those instances, you will be up to a portfolio value of $13,000. About 2.5% of the time, you will be down to a low of $6,000. In the most exceptional year, you could expect to be up to as much as $14,500. A little less than 1.0% of the time, you will be outside of the third standard deviation, and your gains and losses are unknowable.
If you are like most people, you thought about those gains and losses as dollars rather than as percentages. You may see the $4,500 loss a shudder a little bit, and still say, “I can take it.” Let’s look at those percentages using your $1 Million portfolio that you will have when you are close to retirement. The 45% decline at the third standard deviation down from the mean is very near what happened to market values in 1931, and the pain didn’t end that year.
Many economic thinkers (e.g., Peter Lynch) believe that we now have the appropriate safety nets to keep the Great Depression from happening again, but that doesn’t mean that we can’t see shorter-term losses of equal magnitude. If you log into your brokerage account and see that you are down $450,000 what will your response be? I hope that it will be to shoot your computer and not look at your balance again for at least a year. Many people would capitulate and sell, and that would doom you to a retirement of poverty and deprivation.
There are two primary lessons here. The first is that you can accept the most risk when you are young, and your overall balance is low relative to your ultimate retirement goals. Any funds you lose in a 50% downturn still represent shares that history indicates will appreciate back to the old valuations and beyond. This is also a great time for constant dollar investing since there is a half off sale that will help you accumulate many shares at an excellent cost basis.
The other side of that coin is that the older we get, the more pragmatic and risk-averse we should become. If we look at the all-time great collapses, it may take 20 years or more for markets to recover. If you don’t have that time to wait, you need to protect your portfolio by diversifying away a large percentage of that risk, which in turn diversifies away the huge $450,000 profit in one year that is also possible when odd things happen in the right direction.
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Last Updated: 6/25/2018