Today we continue a discussion that began with defining risk and then focused on measuring the risk/return tradeoff. To briefly summarize those articles, we learned:
- Given the choice of two portfolios with identical returns, we should prefer the one with the lowest amount of risk.
- The word “risk” is used to describe the volatility of returns, which we quantify using standard deviation.
- The higher the standard deviation, the more volatile (risky) the investment is expected to be. We could also say that a higher standard deviation means there is more uncertainty in our expected return.
- Our goal is to generate the best risk-adjusted return. Volatility is the cost of higher returns and the Sharpe Ratio helps us ensure we get the most bang for our buck.
The next piece of the puzzle is understanding your personal risk tolerance. Even if a high-risk investment earns a sufficient amount of return to justify the volatility, some investors are unable or unwilling to take such risk. Our objective at Plancorp is to create a portfolio with an amount of risk that generates sufficient returns, but still allows you to sleep at night.
An investor’s risk tolerance is primarily determined by their willingness and ability to take risk. Evaluating your own risk tolerance is difficult for individuals because of the emotions that are intertwined with investing. Even the most self-aware individuals could benefit from having an outside source assess their risk profile.
Measuring an investor’s ability to take risk is an objective process. The goal is to determine how much volatility a portfolio can withstand and still meet the investor’s goals. Ability to take risk is driven by time horizon, liquidity needs, size of human capital, and goal/lifestyle flexibility.
Investors with a short time horizon have less ability to take risk because they have less time to recover from poor short-term performance. Longer time horizons allow a portfolio value to fluctuate more because the investor doesn’t need to withdraw money in a down market. All else equal, as time horizon increases, the investor’s ability to take risk increases.
Liquidity needs are measured by the size of expenditures relative to the size of the portfolio. For example consider two investors that both are beginning retirement at age 65 with a $5 million portfolio. Investor A requires $300,000 per year from the portfolio to meet annual living expenses while Investor B requires only $150,000.
An investor requiring an annual withdrawal rate of 2% is able to take more risk than someone requiring an annual withdrawal rate of 5%. Having high liquidity needs relative to the size of the portfolio reduces the amount of loss the portfolio can sustain and still continue to meet expenditures.
An investor’s human capital can be viewed as their future earnings potential. An investor that is approaching retirement has relatively low human capital whereas a younger investor with multiple decades of work remaining is said to have high human capital. The greater an investor’s human capital, the greater their ability to take risk. An investor with high human capital can offset the portfolio losses and volatility with their future earnings. In retirement, an investor has zero human capital because he/she does not have earnings outside of the portfolio.
Finally, lifestyle flexibility can modestly increase the ability to tolerate risk. The difficulty with relying on lifestyle flexibility is that most investors believe it will be easier to cut back on their lifestyles than it really is. There are a two steps that can help increase and define lifestyle flexibility. First, financial advisors can model for higher retirement spending levels than the investor currently uses. This allows for some additional cushion to protect the investor’s comforts in a down market. Secondly, investors should rank the importance of their goals and draw a line between those that are critical and those that are considered a luxury.
Gauging willingness to take risk is difficult to accurately assess on your own. An unbiased investment professional can be a big help here. Because measuring an investor’s willingness to take is risk is a subjective process, there are fewer hard and fast rules available.
For a financial advisor, the process starts with listening to an investor’s statements regarding their willingness to take risk. These statements must be taken with a grain of salt since risk means different things to different people. For example, one person might consider the ability to withstand a 5% portfolio loss as a high risk tolerance whereas another person considers the ability to withstand a 40% portfolio loss as high risk tolerance. Other people simply believe that they have a high risk tolerance because they own a small percentage of stocks. In my experience, the more than someone talks about risk, the more risk adverse they tend to be, regardless of their self-assessed risk tolerance.
Reviewing past investment statements can provide some clues about an investor’s willingness to take risk. Was the investor buying or selling in early 2009? Does the investor trade heavily in volatile markets? What has the typical stock/bond allocation been over time?
The investor’s profession can offer a glimpse into their experience with risk taking. For example, a tenured teacher or physician with a steady salary probably has less experience taking risk than a business owner that has to take regular financial risks as part of their daily lives. This isn’t a one-size-fits-all approach, but it can provide some useful hints for determining willingness to take risk.
There are lots of versions of risk tolerance questionnaires (here is one example), but these can provide flawed results as investors can be biased by the wording of the question or order of answers. They aren’t completely without merit, but shouldn’t be the sole way of measuring willingness to take risk. Frequently, the most important questions are asked when going through the financial planning process.
If you’re ready to start making smart decisions with your money and build your wealth, take a brief financial wellness assessment, and learn in just 9 questions your biggest areas of opportunities you should be focusing on in your finances.
This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice. All investing involves risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. You should consult your own tax, legal and accounting advisors.