Determining Risk Tolerance

crispydoc Uncategorized Leave a Comment

One of the challenges for a new investor is determining your risk tolerance, which is how aggressively to invest your savings.  There are several considerations to factor into determining how much volatility you can handle – in this case volatility means what percent of stocks (vs. bonds) you feel comfortable owning in your asset allocation.

80/20 would be considered aggressive or high risk, while 20/80 would be considered conservative or very low risk.  Like running a disaster preparedness drill at your hospital, determining your risk tolerance is at best an approximation of what you think you can handle in a crisis.

During a bear market, broad equity indexes (such as the S&P 500) lose at least 20% of their value for at least 2 months.  If the decrease lasts less than 2 months, it’s termed a correction.  Bear markets occur, on average, every 3.5 years and last an average of 15 months.

Understanding the Life Cycle of the Market

My investing history happens to encompass the two most recent bear markets: a 58% percent drop from 2000-2002 and a 57% drop from 2007-2009.  These were the times when the finance media was screaming the loudest and receiving the greatest exposure.

Family members well into their retirement who had been heavily invested in stocks during the latter bear market pulled out of the market completely – locking in their losses and missing out on the tremendous upside from the ensuing bull market. Why did they pull out?  They held too many volatile investments – they couldn’t sleep knowing the losses their portfolio had taken on, and they had overestimated their risk tolerance.

How did I stay invested in a largely equity portfolio?  Good old-fashioned ignorance.  I’d love to say I was brave, but mostly, I just ignored my financial statements and continued to maximally contribute to my retirement accounts.  At the time we used a financial advisor, and I basically continued to save and invest as high a proportion of my income as possible.  How might I have handled it today?  Hopefully in exactly the same way, minus the advisor fees.

Bear markets are a natural part of the market cycle, and knowing history (they come, they go, the market has only ever gone up over time) while maintaining perspective (a bear market means stocks are on fire sale – time to load up, woohoo!) means I framed the situation differently.

My existing equity investments were not lost money, but money bound to recover.  My new equities purchased were not sudden stinkers – nothing had fundamentally changed about the thousands of viable businesses with excellent products that I collectively owned in my total stock market index fund – but amazing bargains I was able to purchase at pennies on the dollar.  In fact, for a young investor, one of most ideal situations you can hope for is having the good fortune of loading up on stocks during a bear market early in your investing life.

The Sleep Test

A well-regarded rule of thumb is to determine how much of a loss in your portfolio would cause you to stress out and lose sleep.  If you determine a 30% drop would meet your ulcer-development threshold, then double that number and plan to hold no more than 60% equities.  Many wise investors suggest taking it one step further for brand new investors: double the number and subtract 10, for 50% stocks, because behavioral finance studies have demonstrated that until you face an actual disaster, you are likely overestimating your risk tolerance.

Time is on your side

Early in your career, you will be relying more on your intellectual capital and less on your financial capital, so it is common to emphasize growth with greater stock allocation.  A younger doctor whose investments tank can make up any financial shortcomings by working longer and harder.

Younger investors can assume greater volatility (more stocks = greater risk and commensurately greater reward) because they have a longer time horizon to allow their investments to recover – all those peaks and valleys that can seem frightening when looking at market performance graphed out over 5 years tend to smooth out in a reassuringly gradual upward trajectory over a 20 or 30 year period.  Front loading your retirement investments also allows the magic of compound interest to work in your favor earlier.

Build in a Glide Path

As you near retirement and you realize that you “can’t take much more of this shift,” you will likely not have much more work life left in you.  Consequently, you will be depending on your cumulative investments to support you financially, so you’ll want to be more risk averse and focus on capital preservation.  A glide path, which transitions your investments from higher volatility (stocks) to lower volatility (bonds) as you approach retirement factors in your lower risk tolerance over time.

In Conclusion

Subject yourself to the theoretical sleep test to determine your level of risk tolerance and allocate your assets accordingly.  Understand the life cycle of the market, accepting that corrections and bear markets are inevitable stops on the road to wealth.  Build a glide path into your plans, so that you take on the greatest risk early in your career, when you are best able to weather high volatility, and reduce your risk exposure as you approach retirement.

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