How to Determine Your Investment Risk Tolerance (EP.111)

0:28We all need to make smart decisions with our money. Evaluating your own risk tolerance is difficult for individuals because of the emotions that are intertwined with investing. Even the most self-aware individuals could benefit from having an outside source assess their risk profile. In this episode, I'm going to explain the difference between an investor's ability to take risk and willingness to take risk, as well as how to measure the components of each, starting with an investor's ability to take risk. So measuring an investor's ability to take risk is a pretty objective process. The goal is to determine how much volatility a portfolio can withstand and still meet the investor's goals.

1:08Ability to take risk is driven by time horizon, liquidity needs, size of human capital, and goal and or lifestyle flexibility. So time horizon, the first one. All else equal, as time horizon increases, the investor's ability to take risk increases, Investors with a shorter-term horizon have less ability to take risk because they have less time to recover from poor short-term performance, whereas longer-time horizons allow a portfolio's value to fluctuate more because the investor doesn't need to withdraw the money in a down market. The next one, liquidity needs, are measured relative to the size of the portfolio.

1:47For example, consider two investors that are both beginning retirement at age 65 with a$5 million portfolio. Investor A requires$300 ,000 per year from a portfolio to meet annual living expenses, while investor B requires only$150 ,000. Investor A, who requires an annual withdrawal rate of 2 % in this scenario, is able to take more risk than investor B, whose annual withdrawal rate equates to 5%. Because all else equal, having high liquidity needs relative to the size of the portfolio reduces the amount of losses a portfolio can sustain and still continue to meet expenditures. Now, the next part of ability is human capital, and an investor's human capital can be viewed as their future earnings potential.

2:34An investor that is approaching retirement has relatively low human capital, whereas a younger investor with multiple decades of work remaining is said to have high human capital. The greater an investor's human capital, the greater their ability to take risk because an investor with high human capital can offset the portfolio losses and volatility with their future earnings. In retirement, though, most investors have zero human capital because they don't have any earnings outside of the portfolio. The last item I'm going to touch on on ability to take risk is the goal and lifestyle flexibility.

3:10So lifestyle flexibility can modestly increase the ability to tolerate risk. The difficulty with relying on lifestyle flexibility, though, is that most investors believe it'll be easier to cut back on their lifestyles than it really is. In my mind, there are two ways to define and potentially increase lifestyle flexibility. The first is that a financial advisor can model for higher retirement spending levels than the investor currently uses, which allows for some additional cushion to protect the investor's comforts in a down market. Secondly, investors could rank the importance of their goals or even specific expenses, effectively drawing a line between things deemed to be critical and those that are considered to be a luxury.

3:54Moving on to willingness to take risk. Gauging willingness to take risk is difficult to accurately assess on your own. An unbiased investment professional can be a big help here because measuring the willingness to take risk is a rather subjective process and there are fewer hard and fast rules available. But with that in mind, I like to start with existing holdings. Now, there are two groups of new clients whose holdings I typically have the opportunity to review. The first is a group of investors who are simply changing advisors. And the other is a group of investors who've largely been managing their portfolio on their own.

4:32Now, in this first group, a view of existing holdings is a glance into what another professional felt was the appropriate mix of assets for that individual or household. In these situations, I find it useful to take note of the percent invested in stocks, bonds, cash, and any sort of alternative investments. And I also find it useful to ask the investor for their feelings about the existing portfolio. Now, for the second group, existing holdings are a window into the choices they deem themselves to be a good fit. Now, sometimes investors managing their own portfolio will receive outside feedback from time to time that will influence their holdings.

5:09And so the questions I ask this group may differ a bit from the questions I'll ask of someone that's coming from another advisor. And I think the primary difference in the nature of the questions is to gauge a person's true understanding of their holdings, as well as their underlying investment philosophy and just general worldview of markets. For both sets of investors, the existing holdings and the responses to my questions is generally the most telling component of their willingness to tolerate risk. Now, the second item, which I define as investor statements and definition of risk, is very closely to what I just explained with existing holdings, but it can stand alone in some instances.

5:51Most notably, in my experience, the more someone talks about risk, the more risk adverse they tend to be regardless of their self-assessed risk tolerance. But any statement regarding risk holds little value without context. For one person, might consider the ability to withstand a 10 % loss as a high-risk tolerance, whereas another person considers the ability to withstand a 40 % portfolio loss as high-risk tolerance. Others simply believe that they have a high-risk tolerance because they own some small percentage of stocks. Risk means different things to different people. So I often ask people who are proactively making comments about risk to define what risk means to them.

6:32And if someone's expectations around market volatility is far removed from historical data, I'll sometimes like to gauge the reaction to that historical information regarding market volatility and make some more assessment about willingness to tolerate risk. The next item in this category of assessing willingness is historical behavior. And reviewing past investment statements can provide some clues about an investor's willingness to take risk. Was the investor buying or selling in early 2009? Or how about March 2020? Does the investor trade heavily? And what was the typical stock bond allocation over time?

7:11Now, if I ask a person this question, obviously, the human memory is flawed, but still, any recollections or true evidence from trading statements of past behavior is very informative. I'm also a believer that a person's profession can sometimes offer a glimpse into their experience with risk-taking. For example, a tenured teacher or physician with a steady salary probably has less experience taking risk than someone who started a business that required regular management of risks as part of their daily lives. Now, this isn't a one-size-fits-all approach, but it can provide some useful hints for determining willingness to take risk.

7:50The last item for making this determination of willingness to take risk is risk tolerance questionnaires, and there are lots of versions of risk tolerance questionnaires, but these can provide flawed results as investors can be biased by the wording of a question, order of answers, and even what's happened recently in markets. That said, they aren't completely without merit, but shouldn't be the sole way of measuring willingness to take risk. Frequently, the more important questions are asked when going to the financial planning process anyway. Now, the reason that we assess risk tolerance in the first place is that it helps inform the single most important decision a long-term investor can make, and that is asset allocation.

8:35There's a famous paper that was published in 1986 that I will obviously link to in the show notes at thelongterminvestor.com that determined that asset allocation explains 93.6 % of variation in portfolio returns. Your portfolio is always going to rise and fall with the overall market, But the mix of stocks, bonds, and cash in your portfolio will dictate the range of possible outcomes and your long-term investing experience. The more stocks you own, the wider the range of potential outcomes and the higher the potential long-term returns. Bonds, on the other hand, sacrifice return in exchange for lesser volatility for the overall portfolio.

9:14Now, if the portfolio lacks sufficient exposure to riskier assets like stocks, then you may not generate returns sufficient to meet your goals over the long term. In addition, portfolios that don't take enough risk can require an unrealistic savings rate relative to your cash flow. Building an investment plan to meet your goals boils down to growing your savings faster than inflation without taking undue risks. But as I said at the start of the episode, building the perfect portfolio doesn't matter one bit if it doesn't align with your willingness and ability to take risk. By properly assessing your risk tolerance, you can determine the right asset allocation that allows you to meet your goals while sleeping soundly at night.

9:58As always, you can find resources and a place to sign up for my newsletter at thelongterminvestor.com. Thanks so much for listening and to long-term investing. Thanks for listening to the Long-Term Investor podcast. To access free financial resources and submit questions to be answered on the show, visit thelongterminvestor.com. Peter Lazaroff is an employee of PlanCorp and BrightPlan. All opinions expressed by Peter and any podcast guests are solely their own opinions and do not reflect the opinions of PlanCorp or BrightPlan. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions.

10:40Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.