Your personal tolerance for investment risk should drive your asset allocation decision - A Tip from The Skilled Investor
Your tolerance for investment risk is a relative thing. Few people like investment risk, but some can handle it better than others do. The more investment risk you can and are willing to tolerate, the higher your potential expected investment returns and investment growth might be. At the same time, the investment road you will take might be rougher.
Also, the scientific finance literature has shown that securities markets tend to pay a return on investment only for shouldering investment risks at the market level — not at the level of individual securities holdings. (For more information see, these asset allocation and diversification articles on The Skilled Investor website: You must stay invested in the securities markets to earn market risk premiums and Investment securities markets do not pay you for the risks of holding individual common stocks and bonds.)
The primary cash, bond-fixed income, and stock-equity financial asset classes have different expected investment risk and return characteristics. Financial asset allocation is the apportionment of your investment portfolio into one or more of these classes of market-traded financial assets. How you allocate major portions of your assets among the primary financial asset classes determines your portfolio’s overall exposure to investment risk and thus your potential for investment growth. (For more information on these subjects, see The Skilled Investor’s articles in these categories: Returns and Risk Premiums (10 articles) and Securities Valuation (4 articles))
You may encounter numerous industry approaches to gauging you investment risk tolerance relative to other investors. Caution may be in order, if someone asks you only a few risk questions or presents you with a similar very short questionnaire. Using your verbal or written responses, you quickly may be labeled a “conservative” or “aggressive investor.” However, investment risk tolerance is a much more personally and emotionally complex subject.
Assessing your personal investment risk tolerance is one of the most important personal investment decisions that you will make, because this decision drives the long-term risk-return composition of your investment portfolio. This decision requires much more personal and family introspection than is provided by trivial risk questionnaires. These short questionnaires often are just a front-end to a securities sales process. After answering a few questions, you may soon be blessed with a canned percentage asset allocation to the cash, bond, and stock asset classes, which supposedly matches the risk tolerance label that has been applied to you.
Once you are given a canned “conservative,” “aggressive” or other asset allocation, the investment sales process can proceed. The risk questionnaire helps to cover the securities vendor’s legal behind regarding investment “suitability.” In the next phase of the sales process, you may wish to watch out for selective investment recommendations that demonstrate superior historical returns. Recommendations may focus on investment funds that beat-the-market in the past, while the fund family’s laggard funds will not be mentioned. Recommendations may tend to have high costs and sales commissions. Simultaneously, there may be a dearth of investment recommendations that target a market return and have very low costs. (See this related article on The Skilled Investor website: “Pay less to get more,” which is one of our articles in this category: Controlling Investment Costs (15 articles). )
There are much more scientific methods to assess personal investment risk tolerance. For example, an Australian company, FinaMetrica, has developed a more extensive, and relatively inexpensive, personal risk tolerance assessment process. FinaMetrica’s approach seems to have some reasonable social science behind it. Furthermore, you can do your own assessment on-line without the involvement of a costly adviser.
FinaMetrica’s website is http://www.myrisktolerance.com/ Even if you do not wish to use their risk evaluations services, it is well worthwhile to explore the links in the left hand column of this website. FinaMetrica provides extensive written materials to help you understand personal financial risk tolerance and asset allocation. (Note that there is no business relationship between The Skilled Investor and FinaMetrica.)
Finally, when you determine your personal asset allocation, you may have other valuable personal assets to consider, such as real estate and private businesses. However, complications arise when these non-financial assets are factored into the mix with the primary cash, bond-fixed income, and stock-equities asset classes. For example, for most people who own any real estate, it is the net equity of their primary residence, after mortgage debt. Some of the net equity in the family home represents a long-term prepaid housing expense. They need somewhere to live the rest of their lives and would otherwise pay rent.
The remaining net equity in their home is a personal portfolio asset. Despite the banking industry’s current push to have people tap their home equity for vacations, pleasure, and other short-term consumption expenditures, those who recognize their possible very long life resist the urge to tap their home equity, except when no other alternative is available.
For people with who own just one piece of real estate, their primary asset allocation consideration might be simply to avoid loading up on more real estate in their portfolio in the same market that could be subject to similar economic forces and risks. Those who have more extensive real estate holdings may wish to select very carefully a reasonably priced adviser and get help in evaluating their asset allocation decision. (See these related adviser selection and payment articles on The Skilled Investor website: Selecting an Advisor (4 articles) and Payment of Advisors (11 articles). )
Comment by Enough Wealth
1 June 4, 2007, 6:47 pm o'clock |
Bear in mind that assessing your risk tolerance is an ongoing process NOT a ‘decision’. You risk tolerance will change over time - affected by factors such as income (you may be more risk tolerant if you get a pay rise and have more ’spare’ income to invest), age (people tend to get more risk averse as they approach retirement and have less time to earn back any losses suffered in their retirement investments - although with retirement years increasing with lifespan people are more interested in investing in growth assets during their retirement phase), family circumstances (second bread-winner, number of children, children leaving home etc)…
It’s therefore not simply a case of evaluating your risk tolerance once and setting your asset allocation for all time. Even apart from the above factors affecting your risk tolerance, you may find that your risk tolerance varies day-to-day with your mood. If I’m in a good mood and the market drops more than a few percent in a day I just find the “market crashes!!” headlines amusing, and might look to buy some stocks that I’ve had my eye on while waiting for a correction. On the other hand, if I’m sick or in a bad mood I’ll tend to find the impact of a 5% plunge in the stock market on my net worth less funny, and won’t be in the mood to shop for stock “bargains”.
Finally, I’ve found that risk tolerance questionnaires (even fairly comprehensive ones like that available from FinaMetrica) are only indicative of how you’ll actually react when you have money invested and there’s a big, bad, bear market. It’s a bit like paper trading - the effect of having real money on the line can affect your thought processes and decision making.
Regards
http://enoughwealth.com
Comment by The Skilled Investor
2 June 5, 2007, 9:40 am o'clock |
Hi Enough Wealth,
Thank you for your very thoughtful comment.
It is true that a person’s (or family’s) risk tolerance may change over time. That is why some asset allocation models have an age declining component in the ratio of stock-equity assets to bond-fixed income and cash assets. For example, that is why our VeriPlan lifetime financial planning application for individuals supports five different and user-adjustable lifetime asset allocation models.
Two of these five VeriPlan asset allocation models have an age declining component. (One holds a fixed percentage as cash and lowers the allocation to equities 1% annually, and the other sets a fixed ratio between bonds and cash and then lowers the allocation to equities 1% annually relative to bonds and cash.)
One person’s risk tolerance may vary with age, while another’s does not. Other potential factors are wealth and income, which you mentioned. One person’s relative risk tolerance may react to changes in wealth or income, while another does not.
Other factors are investment knowledge and psychological stability. The transient mood swings that you discuss would tend to indicate high variability in short-term personal risk tolerance. If an individual exhibits these characteristics, then they might be a more accurate indication of a lower general tolerance for investment risk. A major point of any psychologically oriented assessment of risk tolerance concerns whether an investors reactions are likely to be stable over time
It is easier for most people to handle the euphoria that may come with unanticipated market highs and good times. However, even then, an investor without knowledge and without a high tolerance for investment risk may still make mistakes. This has been documented in the behavioral finance literature. Many individual investors fear that a price run-up may indicate a higher likelihood of a price decline, instead of a potential sustained price increase driven by favorable economic fundamentals. Individuals tend to sell too soon and miss the upside. In the process, they also tend to pay higher transactions fees and investment costs.
However, it is in major market declines and crashes that people who genuinely have a lower tolerance for investment risk tend to make their most personally damaging mistakes. They give in to their inherently lower tolerance for investment risk and panic. They sell because they cannot bear the paper loss, even though they may not have needed the funds to meet their current expenses. They worry that their investments for future needs will all be gone.
Relative risk tolerance tends to be a more stable psychological characteristic, and one’s investment portfolio should be aligned with that risk tolerance psychology. Furthermore, individuals tend to do a great deal of harm to themselves by jumping into and out of markets because of fear — whether the cycle is trending upward or downward. The scientific finance literature shows that individuals (and professionals) are not good at timing securities markets. Furthermore, frequent changes to investment portfolios are very costly due to investment costs and taxes.
Those who are interested in learning more should follow the links in my article above to get more information on these subjects.
The Skilled Investor