Tuesday, April 27, 2010

Risk Tolerance

Before I get into details of the portfolios presented in the previous post, it will be useful to discuss risk tolerance, since it's so fundamental to making investment decisions.

In his book, The Only Guide to a Winning Investment Strategy You'll Ever Need, Larry Swedroe breaks down risk tolerance into three components:

  1. The willingness to take risk
  2. The ability to take risk
  3. The need to take risk

The Stomach Acid Test: Willingness to take risk.

You must assess your emotional and psychological ability to handle the inevitable downturns in the stock market. Most people think their willingness to take risk is higher when markets are doing well, and lower when doing poorly. This leads to buying high and selling low types of behavior. So, you really need to consider this seriously. If you have $300,000 in stocks (by stocks I really mean mutual funds that own stocks), a 20% downturn (which is not that uncommon) will result in a loss of $60,000, and a 30% downturn will result in a loss of $90,000. Historically, the US stock market has always recovered from such losses, but it might take a long time, so you must be prepared to be patient, and wait out these bad times.

Swedroe uses the chart below to help people think about how much equity (i.e., stock) exposure is appropriate for them, depending on how well they can tolerate a temporary (although potentially long lasting) reduction in the value of their portolio. He calls this the "sleep well or eat well" decision. If you take higher risk than that which enables you to sleep well, chances are that you'll abandon your strategy when the market tanks (buy high, sell low).

Maximum Tolerable Loss (%) Max Equity Exposure (%)

5 20
10 30
15 40
20 50
25 60
30 70
35 80
40 90
50 100

Rather than using the above chart, I just keep in mind the rule of thumb that one should be mentally prepared to accept a loss of 50% in the stock portion of their portfolio. Keep in mind that in the great depression, stocks lost 90% of their value, so maybe the 50% rule of thumb is too conservative.

Ability to Take Risk

According to Swedroe, the ability to take risk is determined by 3 things: investment horizon, stability of earned income, need for liquidity.

Investment horizon is the length of time a sum of money is expected to be invested. If you're saving for a specific purchase in the near future, the investment horizon for the funds needed for the purchase is the length of time until the purchase. For your retirement savings, this may be your expected lifetime, the longer of your expected lifetime and your partner's, or even longer (e.g., if you want to pass some assets on to your heirs). Swedroe uses the chart below as a guideline for using investment horizon to determine the maximum percentage of assets that should be allocated to equities. Using these guidelines, you should have no money in the stock market that you expect to need within 3 years, only 10% of what you expect to need in 4 years, etc.

Investment Horizon (Yrs) Max Equity Allocation (%)
0-3 0
4 10
5 20
6 30
7 40
8 50
9 60
10 70
11-14 80
15-19 90
20+ 100

I'm a bit more conservative. I wouldn't recommend investing any money in the stock market that you expect to need in less than 10-20 years.

If you have high confidence in the stability of your earned income (Swedroe uses the example of a tenured professor, or a government employee), then this gives you greater ability to take risk, since you aren't as likely to be dependent on your savings and investments to pay your bills.

Next is the Liquidity Test. This is determined by near term cash requirements and potential for unanticipated cash needs; e.g., medical bills, car repairs, home repairs, loss of job, etc. Cash reserves of 6 months of ordinary expenses are generally recommended for unanticipated needs, and I recommend that these be invested in FDIC insured savings accounts, CDs or treasury bills (money market funds probably are OK, but remember that they are not guaranteed not to lose money). For known future expenses, equity allocation should not exceed the above table (according to Swedroe), and fixed income duration should not exceed time horizon.

You can use the table above to help think about expected, major future expenses like college costs, buying a car, putting a down payment on a house, expensive vacations, etc.

For example, if you're saving for something you plan to buy within 3 years, none of that money should be in equities; it should all be in short term, fixed income investments. As another example, for a known expense in 5 years, according to Swedroe, no more tan 20% of that expense should be held in equities (and 80% in fixed income with a maturity of 5 years or less). Again, I would tend to be even more conservative than this, and invest in a high quality bond fund with a duration of 5 years or less for known expenses within 5 years.

If you're uncomfortable seeing your principle go up and down, then you can use high yield savings or checking accounts, money markets, or FDIC insured CDs for all of your fixed income investments. For individual investors, high yield accounts and CDs may pay higher interest rates than short term government obligations (e.g., treasury bills), so for the smaller investor (who doesn't have enough to exceed the FDIC insurance limits), they make more sense. Currently, I would recommend using high yield checking, savings or money market accounts for shorter term needs, because you can get as much (or maybe even more) than you can get on a 3 month CD. You could then use a ladder of CDs (CDs maturing at different times in the future) for intermediate term needs.

If you're comfortable with some fluctuation of principle value, then you can allocate some of your fixed income assets to bond funds. Short term bond funds fluctuate less in value than intermediate term, which in turn fluctuate less than long term bond funds. In general, the value of bonds (and bond funds) goes up when interest rates go down, and vice versa. Currently, government bond rates are quite low, due to the fear and uncertainty in the market (I first wrote this in October 2008). Conversely, non-government bonds are paying higher rates than usual relative to government bonds. If you believe things will work out, then something like the Vanguard Short Term Investment Grade Bond Fund might be a good choice for your shorter term fixed income allocation (this has turned out quite well from October 2008 to April 2010). As fear in the market subsides, the spread between government and corporate bond rates will be reduced (rates of corporate bonds will come down and/or rates of government bonds will go up), and the prices will move in the opposite direction. Of course, if the fear gets worse in the meantime, the value of investment grade bonds will go down even further.

Your allocation to equities should be the lower of the willingness and ability tests. For example, if you have a secure job and a long investment horizon (high ability to take risk), but you are unsure that you could stick to a higher stock allocation during a long, severe bear market (low willingness to take risk), you should reduce your stock allocation to suit your low willingness to take risk.

The Need to Take Risk

Swedroe points out that considering the need to take risk is often overlooked by financial advisors, as well as investors. According to Swedroe, your need to take risk depends on the rate of return required to meet financial goal. In his book, Swedroe provides the following table as a guideline for determining need to take risk (at the time this was written, the yield on 2 year treasury notes was about 2%):

Goal: rate of required return (%) Equity Allocation (%)
2 0
3 20
4.5 40
6 60
7.5 80
9 100

Without worrying too much about the specific numbers, the main point is that if the need to take risk is lower, a lower allocation to stocks is prudent.


  1. This may seem unrelated, but this got me thinking... Do you have any insight on the housing market these days? You mentioned a housing bubble in a previous post...and obviously things like this should be kept in mind when assessing risk tolerance as well. For example, let's just say I am toying with the idea of buying a house some day, yet I'd like to determine how long I'd wait to buy a house based on information regarding housing prices, which would in turn affect my risk tolerance....any advice or insight?

  2. Interesting question. Buying a house involves some unique considerations which are beyond the scope of a quick comment, but let's briefly consider it in terms of the risk tolerance framework in the post.

    Willingness to take risk: Although you don't get a monthly statement showing the value of your home (like you do with the types of investments I discuss in this blog), you certainly must realize that the value of a house can decline, and you may need to live with a significant decline in value for many years (as many people are experiencing now). You should be mentally prepared for that.

    Ability to take risk: A secure income is even more important than with other investments, since you must make mortgage, tax and insurance payments, and you will have maintenance costs. You should plan on an investment horizon of many years, since the transaction costs (buying/selling) are significant, and you don't want to be forced to sell if the value is much lower than what you paid. Since a house is not nearly as easy to sell as stocks or bonds (or mutual funds that invest in them), any money invested in a house should not be money you might need anytime soon.

    Need to take risk: I wouldn't consider this much of a factor to consider, since a house is such a different beast than other investments.

    With respect to the specific question at the end of your comment, I don't think the information on housing prices affects your risk tolerance, other than a big downturn like we've had helping you to understand the risks better; e.g., to realize that housing prices can indeed go down significantly, so you should consider this in assessing your willingness to take risk.