Building the perfect portfolio doesn’t matter one bit if it doesn’t align with your willingness and ability to take risks. Evaluating your own risk tolerance is difficult for individuals because of the emotions that are intertwined with investing.
Listen now and learn:
- The difference between ability and willingness to take risk
- Factors that drive an investor’s risk tolerance
- How to choose the right asset allocation based on your risk tolerance
Listen Now
Show Notes
Building the perfect portfolio doesn’t matter one bit if it doesn’t align with your 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.
In this episode, I’m going to explain the difference between an investor’s ability to take risk and willingness to take risk as well as the how to measure the components of each.
Here are the considerations I use for assessing risk tolerance.
Ability To Take Risk
Measuring an investor’s ability to take risks is an objective process. The goal is to determine how much volatility a portfolio can withstand and still meet the investor’s goals.
The ability to take risks is driven by time horizon, liquidity needs, size of human capital, and goal/lifestyle flexibility.
Time Horizon
All else equal, as the time horizon increases, the investor’s ability to take risks increases.
Investors with a shorter time horizon have less ability to take risks because they have less time to recover from poor short-term performance. Longer time horizons, however, allow a portfolio’s value to fluctuate more because the investor doesn’t need to withdraw money in a down market.
Liquidity Needs
Liquidity needs are measured relative to the size of the portfolio.
For example, consider two investors who 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.
Investor A, who requires an annual withdrawal rate of 5%, is able to take more risk than Investor B who requires an annual withdrawal rate of 2%.
All else equal, having high liquidity needs relative to the size of the portfolio reduces the amount of losses a portfolio can sustain and still continue to meet expenditures.
Human Capital
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 risks.
An investor with high human capital can offset 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.
Goal and Lifestyle Flexibility
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 lifestyle than it really is.
There are two ways to define and potentially increase 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 comfort in a down market.
Secondly, investors could rank the importance of their goals or even specific expenses, effectively drawing a line between things deemed to be critical and those that are considered a luxury.
Willingness To Take Risk
Gauging willingness to take risks 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 risks is a subjective process, there are fewer hard and fast rules available.
Existing Holdings
There are two groups of new clients whose holdings I have the opportunity to review.
The first is a group of investors who are changing advisors. The other is a group of investors who have largely been managing their own portfolios.
In the first group, a view of existing holdings is a glance into what another professional felt was the appropriate mix of assets for that individual or household. In these situations, I find it useful to take note of the percent invested in stocks, bonds, cash, and alternative assets. I also find it useful to ask the investor about their feelings about the existing portfolio.
For the second group, existing holdings are a window into choices they deemed themselves to be a good fit. Sometimes investors managing their own portfolios will receive outside feedback from time to time that influences their holdings. The questions I ask this group differ a bit from the questions I will ask of someone that is coming from another advisor. The primary difference in the nature of the questions is to gauge a person’s true understanding of their holdings as well as their underlying investment philosophy and general worldview of markets.
For both sets of investors, their existing holdings and their responses to my questions are generally the most telling component of their willingness to tolerate risk.
Investor Statements and Definition of Risk
This second item is closely related to existing holdings, but it can stand alone in some instances. Most notably, in my experience, the more someone talks about risk, the more risk-averse they tend to be, regardless of their self-assessed risk tolerance.
But any statement regarding risk holds little value without context. One person might consider the ability to withstand a 10% 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.
Risk means different things to different people. So I often ask people who proactively make comments about risk to define what risk means to them. If someone’s expectations around market volatility are far removed from historical data, I will take their responses and gauge their reaction to some basic historical information regarding market volatility.
Historical Behavior
Reviewing past investment statements can provide some clues about an investor’s willingness to take risks. Was the investor buying or selling in early 2009? How about March 2020? Does the investor trade heavily? What has the typical stock/bond allocation been over time?
Obviously, human memory is flawed, but still, any recollections or true evidence of past behavior is informative.
I also believe that a person’s profession can sometimes 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 risks than someone who started a business that required regular management of 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 risks.
Risk Tolerance Questionnaires
There are lots of versions of risk tolerance questionnaires, but these can provide flawed results as investors can be biased by the wording of the question, the order of answers, and even what has happened in markets recently.
That said, they aren’t completely without merit, but shouldn’t be the sole way of measuring willingness to take risks. Frequently, the more important questions are asked when going through the financial planning process anyway.
Choosing the Right Asset Allocation for You
The reason assessing risk tolerance is important is that it helps inform the single most important decision long-term investors make: Asset Allocation.
A famous paper published in 1986 determined that asset allocation explains 93.6% of the variation in portfolio returns.
Your portfolio will always rise and fall with the overall market. But the mix of stocks, bonds, and cash in your portfolio will dictate the range of possible outcomes and your long-term investing experience. The more stocks you own, the wider the range of potential outcomes and the higher the potential long-term returns. Bonds, on the other hand, sacrifice return in exchange for lesser volatility.
If the portfolio lacks sufficient exposure to riskier assets like stocks, then you may not generate returns sufficient to meet your goals over the long term. Alternatively, portfolios that don’t take enough risk can require an unrealistic savings rate relative to your cash flow.
Building an investment plan to meet your goals boils down to growing your savings faster than inflation without taking undue risks. But as I said at the start of the episode: Building the perfect portfolio doesn’t matter one bit if it doesn’t align with your willingness and ability to take risks.
By properly assessing your risk tolerance, you can determine the right asset allocation that allows you to meet your goals while sleeping soundly at night.
Resources:
- Asset Allocation: The Most Important Decision A Long-Term Investor Makes.
- The Determinants of Portfolio Performance, published in 1986, by Brinson, Hood, and Beebower.
Submit Your Question For the Podcast
Do you have a financial or investing question you want answered? Submit your question through the “Ask Me Anything” form at the bottom of my podcast page.
If you enjoy the show, you can subscribe wherever you listen to podcasts, and please leave me a review. I read every single one and appreciate you taking the time to let me know what you think.
About the Podcast
Long-term investing made simple. Most people enter the markets without understanding how to grow their wealth over the long term or clearly hit their financial goals. The Long Term Investor shows you how to proactively minimize taxes, hedge against rising inflation, and ride the waves of volatility with confidence.
Hosted by the advisor, Chief Investment Officer of Plancorp, and author of “Making Money Simple,” Peter Lazaroff shares practical advice on how to make smart investment decisions your future self with thank you for. A go-to source for top media outlets like CNBC, the Wall Street Journal, and CNN Money, Peter unpacks the clear, strategic, and calculated approach he uses to decisively manage over 5.5 billion in investments for clients at Plancorp.
Support the Show
Thank you for being a listener to The Long Term Investor Podcast. If you’d like to help spread the word and help other listeners find the show, please click here to leave a review.
Free Financial Assessment
Do you want to make smart decisions with your money? Discover your biggest opportunities in just a few questions with my Financial Wellness Assessment.
