Risk Tolerance affects Asset Allocation
Risk Tolerance and Asset Allocation are tied at the hip, and depend on age and recency bias.
How you understand risk—and how you balance the stock/bond proportion in your portfolio—is the most important decision an investor makes.
How has the market been doing lately? During a bull run, people can take all the risk in the world.
During market crashes, however, some people truly believe the economy is done, on its way to zero. They do the worst thing—sell low and lock in the paper losses. All because their asset allocation was not appropriate for their age and risk tolerance.
This is why risk tolerance is important. It allows you to set an asset allocation such that you don’t sell low. You can sleep at night even though it feels like the world is falling down around you. And remember, asset allocation is set by how you feel in the bad times, not in the good.
Let’s start with this question: what is risk tolerance?
What is Risk Tolerance?
Risk tolerance is not set for an average day in the stock market, it is set for the worst!
The worst day causes the cardinal sin in investing: selling low and locking in losses.
So, what is risk tolerance? Reverse engineered: it is the asset allocation that meets your goals by age yet lets you sleep at night.
Of course, it is more complex than that, and depends on the environment in which you currently find yourself.
Risk Tolerance Changes Depending on Market Conditions
During a long period of great market returns—folks have high risk tolerance. When the market has crashed, it turns out that their ability to tolerate stock volatility isn’t quite up to snuff.
Recency bias is alive and well.
When stocks have done well, we are comfortable with them. Is it possible that your risk tolerance is too high due to recency bias?
But when stocks crash…
Risk Tolerance Depends on Past History
How did you respond last time there was a crash? Did you sell stocks? Or buy?
If you weren’t investing 10 years ago, consider that you might feel different about your investments when the sky falls and your investments are cut in half!
It is important to remember that the market will crash. Stocks go down by 20% or 40-50% on a regular basis. There are regular business cycles which create corrections or worse. There are also larger credit cycles and irrational exuberance which create bubbles and recessions.
Risk Tolerance depends on Age
Asset allocation depends on risk tolerance and age. As you age, stocks actually become more risky! More on this below.
Read that again! People think that stocks are less risky the longer you hold them- think again!
Moreover, target date funds may be too risky or, more commonly, not risky enough to meet your goals. Consider your ideal pre-retirement glidepath, and de-risk prior to retirement.
So, what is your ideal asset allocation by age and risk tolerance? Well…
How bad can it get?
How Bad Can It Get?
Let’s see how bad it can get. This might help you with your asset allocation by age and risk tolerance.
Above, you have yearly, 5, 10, and 20-year average returns for 100% stocks, 100% bonds, and a 50/50 asset allocation.
Note the one-year returns. A 100% stock allocation can have breath taking lows. Down 43%!
Even a 50/50 asset allocation can lose out big time! Down 24%.
Moreover, even during 5 and 10 year periods, a 100% stock allocation can be down.
Finally, note the average rolling outcomes at 20 years. Are you impressed with how much better 100% stocks did vs. 50/50? 18% vs 15%? Is that smaller than you might have thought?
What does this have to do with tolerance. Above, consider how bad things can get in one year, and how, on average, all asset allocations do over 20 years. How much risk can you tolerate?
Now—importantly—how much risk do you need?
How Much Risk Do You Need to Reach your Goals?
Understand your goals. Understand risk tolerance and asset allocation.
Perhaps a good goal is enough to be financially independent. How much do you need?
What a complicated question! The rule of 25 is a good start. It is based upon the 4% Safe Withdrawal Rate rule of thumb. Of course, in reality, it is much more complicated than that. Social security? Reverse Mortgage? What is your Retirement Income Plan? Will you Bucket or Floor?
The concept is important here. Whatever the number is, try to understand what your goal is, and how the average returns will help you reach your goals. You need to take risk only if you need to take risk to reach your goals!
Take what you currently have, what you plan to add, and multiply by the average return over time to figure out your nest egg in the future. A financial calculator helps.
What are Average Returns?
What are the average returns over time?
Note 100% bonds on the left all the way to 100% stocks on the right. Here we can see in more detail the range of yearly returns based upon the blue bars.
The annualized (average) returns are demonstrated by the green squares in the blue bars. They range from 5.4% for 100% bonds up to 9.7% for 100% stocks.
Look more closely at 50/50 right in the middle. The average there is 8.1%. And 70/30? An 8.9% average return is not too shabby.
Average returns are important. If you don’t need to take as much risk to reach your goals, that is, if a safer asset allocation will allow you to reach your goals with less chance of selling low when the sky falls, why take the risk?
So, What Should My Asset Allocation be Based upon My Age and Risk Tolerance?
Good question. If you have the need to take risk, and you have the willingness to take risk, then go for it! If you are young and most of your capital is still potential (your job), there is no reason not to be 100% stocks. As long as you understand that the market will go down 30% or more at some point. You must view this as something to celebrate! After all, you are buying on sale! If you think you might panic sell, then learn about why bonds are important.
As you age, asset allocation becomes more important. There is no rule of thumb that works for everyone (age minus 100, etc) because you have different needs and abilities to take and tolerate risk. Remember that asset allocation is the second most important decision you make (after deciding to invest in the first place). Understand where to take investment risk and do not chase yield.
When Risk Tolerance doesn’t Equal Asset Allocation
Too often, investment advisors will have you take a risk tolerance questionnaire just to check off a box. If you are interested in a pretty good example of one see Schwab Risk Tolerance Questionnaire.
But to truly understand risk tolerance, you have to do more than fill out a risk questionnaire.
You need to understand that you are allocating for the bad times, not the good. Also, know how much you need: as the saying goes—when you win—quit playing! Or at least dial down the risk.
Risk Tolerance and Asset Allocation
Risk tolerance may take a while to iron out. Think about your asset allocation now. How old are you? How much time do you have left before you need the money? What are your goals? How much risk do you need to take?
Because remember, times are good right now. Chances are, you are being too aggressive with your asset allocation due to recency bias. Times have been too good!
Use the above yearly average market returns to feel how much a bear market would hurt you. Multiply your nest egg by the downturn and project how much actual money you would lose. Is it 100k? 500k? More? How does it feel to lose that much money?
Next, understand that you didn’t actually lose any money. You don’t lose until you sell. Consider your asset allocation by age and risk tolerance, and be ok with how much you will lose (on paper). Be ok with how much you will get hurt by the downturn. Do it now, before you feel it for real.
And don’t chase yield! That is–where should you take your investment risk? In your stocks or in your bonds?
Where to take Investment Risk: Avoid Chasing Yield
When constructing your portfolio, where do you take investment risk? Do you take Risk in your Equities or your Bonds? Are Bonds Low Risk?
Risk means different things to different people, but we all know that without some risk, there is no reward.
So, when investing, how much risk is required for what kind of reward? What is the Risk/Reward Trade-off?
Risk/Reward Trade-off and Chasing Yield
Investment Risk means different things to different people. Any time you have money sitting around, there are many different things you can do with it. Deciding to do one thing rather than another involves trade-offs: you can’t do two different things with the same money.
More specifically, when talking about investing, we are talking about the risk/return trade-off. That is, when you take a risk—like investing—you do so because you expect a reward—a monetary gain.
In investing, risk means the probability of a loss or the probability of an asset providing less than the expected return.
This is not standard deviation—or volatility—which is often considered risk. Volatility is the short term up and down of an asset. While short term losses can feel horrendous and cause poor investing hygiene (such as selling low and locking in losses), the risk/return trade-off infers more of an intermediate or longer time frame.
Where should you take investment risk in your portfolio? What has the best risk/reward trade-off? Or should I avoid risk investing?
Should I Avoid Risk Investing?
Some folks have no investment risk in their portfolio. They just can’t tolerate any market risk and thus don’t have a portfolio! They believe that stocks and bonds are high risk investments and avoid them altogether.
These folks usually invest in what they consider lower risk assets. Sometimes real assets—real estate, metals, tangibles, businesses, etc. They avoid the market and what they consider risk investing.
There is nothing wrong with this approach. For them, stocks are too risky (and bonds aren’t low risk either) and they want more control. Generally, they see volatility as risky. When the market plunges, they believe they have lost money.
We know you don’t lose money unless you sell low and lock in losses. Once you understand that volatility doesn’t mean risk, you are one step ahead of those who avoid risk investing.
For those of us with a more favorable view of stocks and bonds, where should you take your investment risk? In stocks or bonds?
Investment Risk Location—Where to take Investment Risk
The risk/return trade-off implies that you won’t take risk unless you expect higher returns. These are the two sides to the trade-off.
Where should you go looking for risk in your portfolio such that you have adequate return?
Do you look towards your low risk / low return bonds? Or, your high risk / high return stocks? Are bonds actually low risk?
When thinking about Risk Location—where you take your investment risk—asset allocation and asset selection both come into play. Not only do you choose your asset allocation—the percentage of stocks vs bonds in your portfolio—but, you also chose which individual investments to invest in. Both address risk.
Bonds can be “risk-free” or high risk. Respectively, this spectrum is from ultra-safe treasury bills to junk (“High Yield”) bonds. Do you chase yield in bonds or stocks?
Bonds, by their very nature, seem low risk compared to stocks. But is that true? It depends what you mean by risk.
When Low Risk is Actually High Risk
Say you cannot stomach volatility and are invested in 100% bonds. Here, the risk is not volatility, it is actually accomplishing your investing goals! You might never have enough to retire.
The Risk/Return Trade-off implies that a 100% bond portfolio has such “low risk” that you are at high risk of failure. Future expected returns must be considered. Stocks possess equity premiums—higher expected returns due to the volatility.
When High Risk is Actually Low Risk
On the flip side, why not invest in 100% equities? If you can stomach the volatility, this is actually the low-risk play. Young investors have no investment risk if they don’t sell low.
It all depends on your goals! Which, in turn, not infrequently depends on your age.
Chasing Yield for the Young
For instance, the young who dollar cost average into their retirement account have no investment risk as long as they won’t sell their “high risk” investments for decades.
For these folks, they should invest in assets that have the highest long term expected returns regardless of the volatility. Again, the risk is not volatility, it is panicking and selling low.
Risk location for the young can be a high-risk allocation (high stock to bond asset allocation). In addition, within the stock allocation, select asset sub-classes with higher expected future returns.
This includes ‘tilts’ such as small cap, value, emerging markets, real estate, momentum and the like. These have higher expected future returns because they are more volatile. For the young, volatility is not a risk (until it is!).
Let’s take this to the extreme. When young, why not leverage your stock investing? Invest in a 3x leveraged stock index fund??? No thanks, that’s too high risk for me. Here, volatility becomes risky, because enough of a downturn—even a temporary one—can unhinge these products from their indexes.
It is, however, common to take on mortgage debt. Mortgage debt is the same as owning negative bonds. That is, by having a mortgage and choosing to invest in stocks, you are leveraging your investing and taking more risk for the potential of more return. This risk seems more appropriate to take, as hopefully volatility is not correlated with your home price and your human capital.
What if you aren’t young anymore?
Chasing Yield during De-Accumulation
What about someone who is in de-accumulation? One spending down a portfolio has a very different risk profile. Here, instead of volatility, Sequence of Return Risk weighs heavily.
Sequence of Returns Risk implies a prolonged series of negative market returns while you are taking withdrawals. This sequence occurs early in retirement when the portfolio is the largest, and the downturn has the largest absolute affect.
Risk allocation for those in de-accumulation includes a more conservative portfolio. This allows you to take distributions from the bond portion of your assets when stock prices fall.
Having bonds also allows a longer horizon for equity exposure. Therefore, even a retiree very well may consider equity classes with higher future expected returns and more risk. As we see form the Callan table, there are different winners every year. Harvest from your winners and allow the downtrodden time to revert to the mean.
And remember, you do need at least some “safe money” for your RMDs!
Thus, those in de-accumulation can take significant risk in the equity portion of their assets as well, as long as they have their overall asset allocation correct.
Are Bonds Low Risk?
So, fundamentally, here is the point: bonds are not low risk.
Or, more specifically, they are a poor risk/reward trade-off. The reward (Yield) is low, that you have to take too much risk to make the reward acceptable. Don’t chase yield in bonds! This could be either by going for high yield (junk) bonds, or by increasing the duration.
Chasing yield means attempting to get more money out of bonds by taking more risk. Bonds–or your “safe assets”- are not the location in your portfolio for risk.
If you need a higher return, increase your stock allocation rather than taking risk in your bond allocation!
Investment Risk Location and the Risk/Return Trade-off
So, the risk/return trade-off implies that risk location matters. Where to take investment risk? In the equity part of your portfolio, not in the bond part.
Remember: Investment risk for those with an appropriate asset allocation is not volatility.
Volatility is not the same as investment risk when you have your risk levels correct and understand the time considerations of risk/return. This is risk tolerance and asset allocation.
Young folks have time. Older folks have bonds which buy them some time.
Looking at an asset allocation of bonds and stocks, where should you take the risk?
Don’t chase yield in your bonds. Bonds are for safety, and to dampen volatility. In the young, they improve investing hygiene (keep you from selling low). In those less young, they are pretty good to mitigate sequence of return risk. Bonds allow you time to take risk in stocks.
But wait– Are stocks less risky the longer you hold them?
Are Stocks Less Risky the Longer you Hold Them?
People say that stocks are less risky with time. Is that true?
What do you know about time diversification? Sure, we understand if you need the cash soon, don’t invest in stocks. But, if you don’t need to money for a long time, people say that stocks are less risky over the long run. Is that true? Does time diversify your portfolio?
Time diversification states that the volatility of assets decreases over long periods of time.
Some, however, consider time diversification a fallacy. While the probability of losing money might go down over time, the amount of money at risk becomes much larger!
Let’s explore time diversification and think about a way to get around the fallacy.
Time Diversification and Returns Over Time
We are pretty used to looking at the standard deviation around stock market returns. This is the volatility of the stock market. The longer time period, the smaller the standard deviation of an asset over time.
Future returns narrow to the average expected return over time. Makes sense. How does that tie in to Time Diversification?
Time Diversification and Volatility
Let’s get back to the idea of time diversification. If you only have a 5-year timeframe to invest before you need the cash, you know that there is the possibility, regardless of the asset allocation, you might not have a positive return!
Thus, one typically recommends cash or cash equivalents for short investment time periods. You only buy equities if your time frame is long enough.
Time diversification, again, states that the volatility of returns decreases over time. However, think about it this way: year 29 of your 30-year investment timeline has the same actual volatility as year one! That is, there is still the real risk that you could lose 43% of your large cap equity investment in the last year when the stakes (and the absolute amount of money invested) are much larger!
This is the Fallacy of Time Diversification. Sure the chance of a loss may be the same every year of the cycle, but the impact can be huge late in the cycle.
The Fallacy of Time Diversification
As you invest over the years and the amount invested grows, you have more to lose!
For instance, if you are putting in 20k a year, then you might lose 50% the first or the last year of a 30-year investment horizon. If you lose the first year, you are down 10k. If you lose the last year, however, you might be down $1M if your portfolio had grown to be worth $2M. Which loss actually hurts worse?
Thus, while you are just as likely to suffer a loss year one and you are year 29, the loss is much more painful in year 29! The probability is the same, but the magnitude of the loss is much greater as time passes.
While stocks seem less risky the longer you hold them, this is only true ON AVERAGE and not when you look at a string of past returns and only have the unknown future to ponder.
Yet you need that last doubling!
Why You Need the Last Doubling
Interestingly, it is the last doubling that usually makes you “rich.”
That is, think about the rule of 72. If you get, on average, 10% returns each year, it will take your money 7.2 years to double.
The first doubling, if you have 100k invested, you get to 200k. The last doubling in a 30-year cycle, your money goes from 800k to $1.6M.
Thus, the last doubling is the one that really adds to your portfolio. You get 8 times more from the last doubling than the first!
Yet, this is exactly when you cannot take the risk! Again, each year is not an average, each year has actual returns. You are just as likely to lose money the last year as you are the first year of this cycle.
If you need your money to double one last time in order to be able to retire, you might be taking on a lot more risk than you can tolerate. How can you mitigate that risk?
Ways to Mitigate the Fallacy
How can you mitigate the risk of Time Diversification? Consider:
Remember, it is all about your pre-retirement glidepath! You need to have enough risk to get that last doubling, but not so much risk that you get thrown out at the plate.
Fundamentally, the fallacy is a fallacy because you don’t keep the same investment for 30 years. You de-risk with time. Stocks are more risky the longer you hold them, but your portfolio changes over time.
How Long is Long Enough?
Are stocks less risky the longer you hold them? No! They are just as risky every single year, on average, as the year before.
Think about the pre-retirement glidepath and de-risking to mitigate this risk.
In fact, you can mitigate the the fallacy of time diversification AND sequence of returns risk by changing your asset allocation towards the end of a long investment horizons.
So, how long do you need to remain invested in risky stocks? Remember, risk tolerance and asset allocation.
That is, how much time do you need to have before you chose equities over a risk-free return?
Above, you can see the percent of time that the risk-free rate is better than a stock index Source.
In the beginning, most years (70% of the time) stocks beat no-risk treasury bonds. It gets to 80% by year 7, then has an interesting trend upwards (which may reflect the length of a business cycle, 7-11 years).
Finally by year 15, you have a 95% chance of beating treasuries with stocks, and this gets to 100% at year 20.
That is a long haul to ensure that you beat the risk-free rate!
Risk Tolerance and Asset Allocation: Are Stocks Less Risky the Longer you Hold Them?
In summary, it is useful to consider time diversification. Remember, stocks are not less risky the longer you hold them!
The risk year-to-year of a market drop is the same, and as your assets grow, so does the risk of a major loss. The long-term uncertainty from year-to-year volatility doesn’t change over time!
Simply said, you actually have MORE risk the longer you are invested in equities along your expected time horizon of investment.
The goal: understand the risk to your portfolio over time. When you are young, volatility is actually not a risk. Only when close to retirement does volatility matter. Thus, risk in equities actually increases over time, not decreases.
Remember, stocks are always risky investments, even over the long haul. They don’t get safer the longer you hold them. Risk Tolerance and Asset Allocation are tied at the hips.