In all of investing, potential risk and reward are strongly related. Most people need to take some investment risk to grow their money fast enough to meet their goals. However, they must also avoid taking on risk that exceeds either their risk capacity or their risk tolerance. One way we do that is by choosing our asset allocation of stocks:bonds.
On the previous page, we assessed risk capacity to avoid a forced sale of investments at a bad time to meet a cashflow need. That means determining how much money we can invest (rather than save) and a stock:bond allocation that matches the timeframe in which we will need the money.
On this page, we will try to find a stocks:bonds asset allocation that matches our risk tolerance. Risk tolerance is very much about emotion and predicting how we will respond to future events. So, it is hard to quantify or be precise. Fortunately, we do not need to be perfectly precise. However, we will use multiple tools and exercises to do the best that we can. Write down the asset allocation that you come up with after each step so that you can use that to make a final decision.
Overview of Multi-Modality Risk Tolerance Assessment
Step 1: The Vanguard Risk Tolerance Questionnaire
The Vanguard investor questionnaire will give you a good start-point to consider and adjust as you move through the different aspects of risk tolerance assessment. It asks 1-2 questions that elude to major risk tolerance considerations and then spits out a stock:bond allocation based on your answers. That usually takes less than 10 minutes. We will then expand on that by spending some time learning about and considering the data or rationale behind the questions further.
Step 2: Consider the balance between expected return & volatility
In choosing an asset allocation, we want to take enough equity risk (stocks) to maximize our potential return, but balance that with enough bonds to sooth our inner investor beast. Many people think that the role of bonds in a portfolio is to pay income. However, the most important role is really to dampen volatility. Bonds dampen volatility by swinging up and down in price less than equities. Government bonds are the best for dampening volatility because their price also often moves in the opposite direction of equities.
Volatility & The Investor Behaviour Gap
Volatility is like poking our inner emotional investor beast in the eye. Rousing them can quickly destroy a portfolio through bad behaviour. The average investor has gap in performance due to bad behaviour of 0.2-2%/yr. That means their return is 0.2-2%/yr less than it would be if the bought and held their investments systematically. It results because they try to time the market. Emotions may drive them to buy when prices are up (greed or fear of missing out) and sell or delay buying when markets are down (fear). People may even avoid buying when the market is rising because they fear that this is the top. All-time highs are followed by more all-time highs more than 70% of the time. However, the feelings don’t match the math. Emotions and behaviours are complex, but the data shows that bad behaviour worsens with increasing portfolio volatility.
Historical Returns & Volatilty For Different Asset Allocations.
In the chart below, you can see that you increase the proportion of stock:bonds in a portfolio, the historical return was greater. That is to be expected because risk and return are closely related with investing. However, also note that it is not linear. The slope of the curve flattens as you move past 60-70% stocks. The risk (volatility as measured by standard deviation) also increases with increased stocks. Again, it is not linear and the volatility really shoots up with higher than 80% stocks.
The usual balance.
Consider whether a much greater risk for using more than 60-80% stocks is worth a relatively small increase in expected return for you. The answer is different for everyone, but most people end up in the 60-80% equity range.
The aggressive investor.
Despite the decreasing reward:risk ratio, some investors opt for 80-100% equity. They may be experienced investors with guts of iron (high risk tolerance) having weathered multiple bear markets and developed good investor habits to minimize their behavioural risk. Unfortunately, less experienced investors with over-confidence may also think that is them. Be careful and be honest with yourself.
Those with really long time-frames and/or large portfolios (high risk capacity) sometimes use 80-100% equity. Ironically, those are also the same people who usually do not need to take major risks to meet their financial goals. So, the sleep-at-night-factor should also be considered.
Step 3: What does a market drawdown look like for your hard-earned money?
Thinking in terms of percentages doesn’t and conceptual drawdowns in the fuzzy future does not always have the same punch in the gut as a concrete number. So, let’s try a visualization exercise.
How much money do you plan to have invested five to ten years from now? That would be the money you aleady have invested plus what you put in plus the profits. For example, if you already have a large portfolio and are adding to it, the annual investment may be small but the balance large. Just take a guess. Doesn’t need to be perfect.
Enter these numbers in The Stick Shock Tool below. I was going to call it “The Gut Puncher”, but did not want to confuse it with the “Investin’ Intestinal Fortitude Tester” that we will use later. The cream coloured fields are editable.
We all hope to see our portfolio achieve our goals. Over the long run, they should. However, it is normal to have significant drawdowns along the way. Seeing how much money you are down in actual dollars bothers grabs your attention. Thinking about how many years of toil and investing that has temporarily set you back can make you feel ill. We naturally do that even though it is not a real loss unless we sell. That feeling could easily cause you to sell to make that pain go away. Our brains are wired that way.
So, pick a stock:bond allocation that isn’t going to make you feel that way during a major market drawdown. They happen every few years and that is when your risk tolerance really matters.
Step 4: Consider what a 3 to 5-year bear market feels like with your asset allocation.
Secular bear markets can last decades before breaking out to new highs. A major bear market occurs every 5-20 years. It is not just how much money your portfolio drops that tests your resolve. The events that surround these rough periods usually beat at you from every angle – work, your friends or families struggles, and the mainstream media loves it. It is also one thing to see a few bad investment statements and brush it off knowing that the markets always recover. It is more difficult when you see that month after month, year after year. You question whether it is different this time and the media and your brother-in-law loves to tell you why it is.
This is why I created the Investin’ Intestinal Foritude Tester. It is a visualization exercise to simulate a bear market. It has a lot of interactive coding. So, there is a mobile and desktop version – you click the picture below to open it. Enter in the asset allocation you are considering and give it a try. See how it makes you feel. It you feel really bad, consider a less aggressive asset allocation.
Step 5: Consider Your Actual Investing Experience.
So far we have done multiple exercises to consider how we feel and may act in a market downturn. However, nothing is as good of an educator on risk tolerance as the real thing. By the real thing, I mean secular bear market that sees a >30% drop and years to recover. Anyone who started investing after 2008/9 has not experienced that. This does not mean you should live in fear until you do. Just invest, be humble, and learn as you go. Every bear market is a bit different anyway.
If you are sitting on the edge of two different asset allocations, consider going with the more conservative one to start. As you gain some more experience, you can always ramp up the aggression.
There are actually conflicting opinions on this advice. One the one hand, if you over-estimate your risk tolerance, as many people do, then you may exceed it. That could result in a big loss if you panic sell at a market bottom. The big mistake. Whether my advice is good or not depends on how you’d react to that. If that scares you off of DIY investing or investing at all, then my advice is good. If it teaches you a lesson while your portfolio was small, then maybe the school of hard knocks was a better option for you. Consider how this gels with your psyche.
Step 6: Reflect As You Gain Experience & Make Gentle Adjustments
As you experience some market corrections or bear markets, reflect on what happened.
Consider how it makes your feel, and more importantly act. Did you sell or come close to it? Did you sit and watch instead of sticking to your schedule of planned buying? Did you check your bank accounts and the crack of the couch for any loose change that you could invest?
Reflect and adjust you asset allocation if needed. However, do not adjust it to frequently.
You don’t want to let your emotions drive you to quasi-market time or performance chase. For example, you feel bad after there is a market drawdown and adjust to a more conservative asset allocation. The market then explodes back up like it usually does and you figure you are missing out and feel good and experienced and move back to a more aggressive allocation. Often just in time for another drawdown.
Look back at this chart again. Gentle moves in asset allocation make small differences in expected return, but large differences in volatility. Make gentle adjustments if you need to. Don’t over-steer.