How Risk Tolerance affects Asset Allocation
Asset allocation—how you balance the stocks and bonds in your portfolio—is the most important decision an investor makes. This is not overstated! Asset allocation depends on your risk tolerance.
Risk tolerance is a nebulous term, buy maybe we can better understand it given the recent drop in the market.
There are times when people truly believe the stock market is done, on its way to zero, and they do the absolute worst thing—sell low and lock in the paper losses. 2008, dot.com bubble, and even the Covid-crisis folks thought the market was going to zero.
This is why risk tolerance is so important. It allows you to set your asset allocation such that you don’t sell low. You can sleep at night.
Let’s start with this question: what is risk tolerance?
What is Risk Tolerance?
Risk tolerance is not what you do on an average day in the stock market, it is what you do on the worst!
The worst day causes the deadliest 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 and let’s you sleep at night. And not sell low!
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.
How bad can it get?
How Bad Can It Get?
Let’s see how bad it can get. This might help you with your 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, during 5 and 10 year periods, a 100% stock allocation has down sprees. Average stocks returns can be down even over 5- and 10-year periods.
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%?
Let’s get back to risk tolerance. Above, how big of a yearly drop can you can stomach?
Now—importantly—how much risk do you need?
How Much Risk Do You Need to Reach your Goals?
Understand your goals.
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 know what your goal is and how the average returns will help you reach your goals. You need to take some risk only if you need to take some risk to reach your goals based upon the average expected returns.
You can take the amount you currently have, the amount you are adding, 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 average returns?
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.
This is important, so let’s look at another version with real (after tax) returns as well.
After-Tax Returns and Asset Allocation
Just so we are not persuaded too much by big numbers, let’s look at the real (after-tax) returns. This, of course, is what it most important, how much money you have to put in your pocket after taxes.
Note the numbers are not as impressive now. In blue, the nominal (pre-tax) returns, and in pink the real (after-tax) returns. Now 50/50 is 3.7%, 90/10 is 4.8%, and 100% stocks 5.0%.
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 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 have time on your side, go for it. Be 100% stocks.
Or think about compromising a bit.
Compromise in your Asset Allocation
After you determine what you can tolerate, why not step it down a notch? This is not market timing, but think of it as an experiment. We are in the midst of a long run of positive returns.
Until you know how you will respond, compromise a bit and increase the bond portion of you asset allocation.
If, during a crash you are humming along not worried by the bad news, you can always use your bond allocation to buy more stocks.
If you can stomach it. If you can’t stomach it, at least you will have a better chance not to sell low because you compromised and have more bonds than you thought you needed to survive.
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.
And if you are still young, a market crash is wonderful! Keep dollar cost averaging into the down market and buy on sale. This is harder done than said as people panic and the popular press obfuscates the truth, but keep on investing.
For those approaching retirement, there is massive market risk: Sequence of Return Risk. You must de-risk as part of your planning pre-retirement glidepath.
In Summary: How Risk Tolerance affects Asset Allocation
In summary, asset allocation is important. It needs to be based upon true risk tolerance.
Where should you take the risk? Don’t reach for yield in bonds; take the risk in equities.
Risk tolerance may take a while to iron out. Even if you want to go all in, understand your biases and your goals. Use recent past market crashes to hone in on your comfort level with risk as expressed in your asset allocation.