Archives for October 2012

A reader writes in, asking:

“I graduated this spring and found a job this summer. I enrolled in the 401-k to get the match but didn’t originally spend time considering which funds to use. Now I’m rethinking that decision. Do you know of any websites that will help me figure out my risk tolerance? I think my risk tolerance is low, but everyone says it should be high because I’m young.”

As we’ve discussed before, risk tolerance is made up of an economic/financial component and an emotional/psychological component.

I think your economic risk tolerance can be reasonably assessed with a questionnaire (e.g., how secure is your job? How large is your emergency fund? Do you have any debt? Could you significantly cut your monthly expenses if you had to?).

But I’m very skeptical of most quizzes that try to assess your emotional risk tolerance. Most such quizes ask you to consider how you would react to contrived hypothetical investment scenarios. In my opinion, the only way to really know where your emotional risk tolerance stands is to examine your real-world investing experience:

• How did you actually feel last time the market crashed? Were you panicked? Somewhat worried? Entirely calm?
• And what did you actually do with your portfolio? Were you able to rebalance back into stocks exactly according to plan? Were you unable to rebalance, yet not so scared that you sold your stocks? Or did you sell all your stocks and move to cash?

What If You Have No Experience?

If you’re just getting started investing, you don’t know how high your emotional risk tolerance is. And that’s OK. In fact, it’s unavoidable.

My suggestion for people just getting started is to just pick something. You won’t get it exactly right, but that’s OK. When you’re just getting started, the impact of your savings rate absolutely dwarfs the impact of your asset allocation. You have time and can afford to either a) make a mistake due to bailing out of a too-aggressive allocation or b) miss out on some years of good stock returns due to having a too-conservative allocation.

And, one way or the other, you will learn. The important thing is to not forget what you learn. For example, if you find that you get skittish when the market gets scary, remember that feeling and keep it in mind when the market is doing well and you’re tempted to move your stock allocation upward.

(Important note: As a new investor, despite having little with which to assess your emotional risk tolerance, you have all the applicable information for assessing your economic risk tolerance. So be sure not to use an allocation that’s more aggressive than your economic risk tolerance would allow. For example, don’t put any money into stocks that you can’t afford to have fall by 50% in the near-term future.)

In his recent book The Ages of the Investor, after suggesting that young investors start with a 50/50 stock/bond allocation, William Bernstein wrote the following, which I think nicely sums up what I’m talking about here:

“The young investor’s first encounter with a significant market decline serves mainly to ascertain her true risk tolerance. Her responses to the decline define the policy allocation that takes her to age 45 or 50. Does she panic and sell? Then certainly her long-term policy allocation to stocks should be less than 50%. If she holds fast but does not have the stomach to buy more, then 50% is likely about right. And if she piles in, then I say, ‘God bless.’ Perhaps she can increase her policy allocation to stocks to 60% to 80%. The next few decades should allow her to test, adjust, and repeat the process at least a few more times.”

A reader writes in, asking:

“Do you have any suggestions for people who want to invest in environmentally friendly companies? Are there any good mutual funds that do that? Or is it better to research companies/stocks one by one?”

If you really want to be careful about which companies you invest in, researching companies one-by-one certainly gives you the most control. The downside, of course, is that doing so takes a lot of time and leads to a far less diversified portfolio than you could have by using something like a “total stock market” index fund.

If you’re willing to give up some control, you could consider Vanguard’s FTSE Social Index Fund. The fund tracks the FTSE4Good US Select Index, which screens companies based on an assortment of social issues, including environmental ones. The fund owns 340 stocks, which is a heck of a lot more than a person could handle via individual stock picks.

That said, using such a fund for the stock portion of your portfolio certainly has its drawbacks:

1. With 340 stocks, it’s meaningfully less diversified than a portfolio including both a “total U.S.” index fund and a “total international” index fund, which means you’d be taking on more risk for a given level of expected return, and
2. Its 0.29% expense ratio is slightly more expensive than non-socially-responsible index funds. (It is, however, far less expensive than most socially responsible mutual funds.)

Lower Returns is the Goal

In addition, it’s worth noting that, if the goal of socially responsible investing is to drive cost of capital down for socially responsible companies, that’s the same thing as driving investment returns down for investors in socially responsible companies.

This is easier to understand if we think for a minute about bonds rather than stocks. Consider a socially responsible company (whatever that means to you) that is planning to expand, but which needs to raise capital to do so. The company decides to raise capital by issuing bonds. As a socially responsible investor, you like the idea of lending money to this company by buying its bonds. And your hope is that other socially responsible investors would make the same decision, thereby significantly increasing demand for the company’s bonds and allowing the company to get access to capital at a lower interest rate.

Well, that lower interest rate is not only a lower cost of capital for the company, it’s also a lower rate of return for people who buy the bonds.

And an analogous thing happens with stocks. If socially responsible investors are numerous/wealthy enough to succeed in materially increasing the demand for socially responsible stocks, investors will have to pay more for each dollar of socially responsible corporate earnings than for each dollar of socially irresponsible corporate earnings.

In other words, by attempting to help out socially responsible companies by giving them lower cost access to capital, you are intentionally seeking lower returns. Of course, depending on your goals, that might be a tradeoff you’re happy with.