Assessing Risk Tolerance & Asset Allocation

It is important to understand the role that the different holdings in your portfolio play. The Robocorp Canadian portfolio building tool is simply an aid for you as a DIY investor. You need to make sure that your investment plan is suitable. So, it is vital to know what different assets are intended to do and how they best fit together.

One of the most important aspects of managing your own portfolio is managing risk.

Choosing the right asset allocation is key to managing risk. Asset allocation is deciding how much of each type of asset to hold. Risk, reward, and taxes are also intermingled. That makes where you hold investments (TFSA, RRSP, Corporate Investments, personal accounts) also important as a secondary consideration (asset location). Asset location is also more complex and we will discuss it further in coming weeks.

The process of assessing risk tolerance and deciding upon asset allocation are discussed in this post. To do that, I will also show some of the historical returns and volatility from different Canadian model portfolio asset mixes.

I am also excited to introduce two new online tools that I have built to help. And play with.

There are desktop/tablet and smartphone versions of the Canadian Portfolio Historical Return & Volatility Visualizer that you can access by clicking the icons below. Later in the post is a second tool for the more adventurous: The Investin’ Intestinal Fortitude Tester.

The Function of Different Levels of Asset Allocation

The Stock:Bonds Allocation Maximizes Returns & Contains Behavioral Risk

The highest level view of asset allocation in a financial market portfolio is the stocks:bonds ratio. The purpose of getting that stock:bond allocation right is to maximize your potential investment return without exceeding your risk tolerance.

Exceeding your risk tolerance increases the behavioral risk that you will sabotage your returns by buying or selling at the wrong time. This behavioral performance gap is driven by greed and fear. It can historically lead to an average 0-2%/yr drag on returns (highest for investment areas “in the news”). Worse individual performance is possible.

Bonds help to decrease the portfolio volatility that provokes bad behavior. Stocks have the most risk and the highest potential return. The right asset allocation is the best balance of the two for you – personally.

Further Asset Diversification Mitigates Investment Risk

More granular asset allocation also includes holding different types of assets to achieve the level of diversification that you want. Diversification helps to minimize investment risk by spreading your money out.

That can be across different business sectors and geographic regions.

We can also diversify even further by investing in multiple companies within a sector or region.

Adequate diversification is most readily done using index-tracking ETFs that hold thousands of stocks or bonds across different sectors and regions. They are liquid, low fee, convenient and diverse. This is why Robocorp uses them.

The other reason that Robocorp uses broad index-tracking ETFs is that it minimizes the risk of choosing the wrong active manager. Passive index investing usually beats active management. At last check, 90% of actively managed Canadian funds underperformed their comparable passive indexes. I wouldn’t bet on picking the right one. Plus, the winners usually change every year. An easy risk to avoid by learning to passively DIY invest, or using an investment advisor who does if you accepting the potentially high costs of outsourcing your portfolio managment.

Risk Tolerance & Investing

With investing, risk and potential reward are closely related. Optimal returns require taking as much investment risk as you can tolerate, maximizing long-term returns, while also not gambling. Money required for usage in the near-term should not be risked. It should be saved. Not invested.

Actually achieving those theoretical higher portfolio returns for taking risk, over the long run, requires not exceeding your risk tolerance. To do that without learning the hard way, we should attempt to estimate our risk tolerance in advance. Our risk tolerance capacity can also evolve as our situation changes. So, we should revisit our risk tolerance assessement intermittently.

Estimating Risk Tolerance

There are various questionnaires that attempt to do this. Robocorp has an embedded link to three different risk assessment aids. No risk assessment tool has been shown to predict how investors will really behave in their future investing. However, our best bet is to take a multi-modality approach.

Questionnaires

These are the most common tools used. In searching the literature, all I could find in terms of validation of these tools was against other questionnaires or advisor opinion. No prospective studies. Physician on FIRE has links to multiple questionnaires on his site.

Robocorp links to the Vanguard risk tolerance questionnaire. This tool will suggest an appropriate stock (equity) to bonds (fixed income) ratio for your questionnaire result. Using a robo-advisor will also have its own version of a risk-profiling survey.

If you have a good human financial advisor, they may use some of these tools in conjunction with a more subjective discussion of your risk tolerance to arrive at a number. We must decide on actual numbers to build a portfolio. However, risk tolerance is subjective, personal, dynamic, and difficult to truly predict.

In addition to a questionnaire assessment, it is also a good idea to look at historical returns for different asset allocations over time.

The chart below shows historical returns for different stocks:bonds allocations over the past thirty years. These portfolio return estimates were made using the indices tracking the total return of the TSX (Canadian Equity), S&P 500 (US Equity), MSCI EAFE (Non-North American Developed Markets), MSCI Emerging Markets, and Canadian bonds. The portfolio mix was generated using the automatic equity allocation option in the Robocorp Portfolio Building Tool.

You can also historically simulate different custom allocations using my newly-minted Model Portfolio Historical Return & Volatility Visualizer. It has pretty cool interactive charts.

These are historical numbers and don’t predict the future.

However, they are useful to give you a sense of what the return and volatility of different bond:equity mixes have looked like in the past.

Notice how the returns plateau out at 70:30 while volatility continues to rise more rapidly as the bonds allocation decreases below 30%.

These historical model returns are also better than you would have gotten if you bought and sold emotionally – deviating from your asset mix plan.

That can happen from being too cautious and buying at the top of a market because you feel left behind with the low returns of fixed income. It can also result from being too risky and selling low because you can’t stomach the paper losses of your equity holdings during a downturn. 

This is why the most important part of risk assessment is being honest with yourself.

You need to consider how much gut-wrenching volatility that you can and are willing to endure for an increase in long-term returns. No one really knows their investing intestinal fortitude until they face a significant “bear market”.

Another exercise that I have created to help you get some idea of your risk tolerance is The Investing Intestinal Fortitude Tester. This is meant to be complementary to a questionnaire. Questionnaires focus on sterile number questions.

Risk tolerance is about emotion and the feeling in your guts.

This simulator can show you how much your portfolio would have dropped, highlight some of the external life pressures, give the perspective of how long it would have taken to drop/recover in a historical draw-down, and put that into the big picture. You can also see how that changes with different asset allocations. Put in a quarter and click one of the icons below for a ride.

Consider at what allocation you would develop gastrointestinal upset. You may want to take a few minutes to try it out. Then, clean off your screen and read the rest of this post.

For the fainter of heart, here are some examples of what the loss on a $1M portfolio for different asset allocations during their biggest U.S. equity draw-down over the past couple of decades could look like.

If you can’t stomach seeing that loss on paper or need the money during a draw-down, then you might sell and transform it from a “paper loss” into a real one.

Maybe, you’ve lived through a big bear market or two.

Recall what it felt like, what you actually did, and whether you would be able to see that happen again in your current life circumstances. Pain does fade with time (otherwise the human species would go extinct as we wouldn’t reproduce more than once). However, it is protective to remember discomfort sometimes. A bear market occurs on average every 3.5 years, and a big one about once per decade.

You may think that you are immune. Don’t kid yourself.

You may be more resistant to volatility if you:

• Don’t check your portfolio frequently
• Have a secure job
• Are well off enough that there is no threat of starvation or eviction
• Think about investing for the abstract “long-term”
• Have a layer between you and acting on impulses. Like a written investment plan taped over the buy/sell button on your screen. Or a good financial advisor that advocates for regular passive investing.

You can improve your investment risk tolerance, but no one can become invulnerable.

A downturn is not just about the depth of portfolio losses. It is also about pervasiveness and duration.

A bad “bear market” often unfolds over one or two years. You cannot ignore your portfolio that long.

While you may have better financial security than most people, even physician fees drop when the government (which skims revenue from the economy) is broke.

The financial woes of a recession will also permeate the media, the doctor’s lounge discussions, and the lives of the people around you. Seeing your neighbor lose their job or your friends and family struggling are not abstract.

Even if you are amongst the “working wealthy” – you are not immune.

Assess your risk tolerance. Use equities to take investment risk and bonds to dampen behavioral risk. Diversify. Invest.

Hopefully, this post and the associated risk assessment and asset allocation tools will help you get started. No tool is perfect, and you do not need to perfectly estimate your risk tolerance. As shown in the earlier graph, the differences between different +/-10% stocks:bonds allocation is small.

The most concerning error is of risk-tolerance-over-estimation if you don’t have experience. You don’t want to over-estimate yourself and make “the big mistake” when you can’t handle the depths of a bear market and sell.

Of course, the only way to get experience is to invest. One risk that cannot be otherwise mitigated is losing time for your investments to grow slowly and comfortably over a long-term investment window.