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Accepting Your Risk Tolerance

Jenna writes in, asking:

“I recently started working with a financial advisor who was recommended by a friend. As part of the initial meeting, the advisor gave me a book by Nick Murray. The gist of the book appears to be that 1) because I’m a long-term investor, the best allocation is 100% stocks and 2) my advisor’s primary purpose is talking me into sticking with that allocation when the market takes a dive. Am I right that this should be setting off all sorts of mental alarms?”

Back when I worked for Edward Jones, Nick Murray was a favorite author among advisors in my region. I agree that one of the most valuable services provided by an advisor is to help people refrain from panic selling after market declines. But I would argue that the first and most important step to achieving that goal is to help the investor find an allocation that’s a good fit for his/her risk tolerance so that there’s no panic in the first place.

Can Risk Tolerance Change?

There are two groups of factors that determine your risk tolerance:

  1. Your life circumstances (e.g., job security, flexibility with regard to goals, a pension that satisfies your basic spending needs), and
  2. The the stuff inside your head (e.g., how comfortable you are with unpredictability, how much you worry about scary world news or economic news, how much stress it causes you if your portfolio drops by X%).

When I first started writing this blog, I thought investors should actively work to increase their risk tolerance by changing the second item above. In essence, learn to care less about volatility so that you can have the higher expected returns that come with higher-risk allocations.

For example, if I met a 20-something investor who expressed fear about investing his retirement savings in stocks, my approach would have been to explain to him that he doesn’t need to worry about market fluctuations because he’s so many years away from spending the money. Then I would have suggested that he use a stock-heavy asset allocation because of his young age.

In the few years since, my view of the matter has changed dramatically. I now believe it’s a much better idea to understand and accept who you are. Forcing yourself into a high-risk portfolio is a dangerous proposition if you’re not truly comfortable with it to begin with.

In other words, if I met a particularly risk-averse 20-something investor today, I would still explain that he doesn’t need to worry about market fluctuations from year to year. But I’d then suggest he use a fairly conservative allocation anyway, because the truth is, this investor probably will worry about market fluctuations, regardless of the fact that other people tell him not to.

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Comments

  1. Advisors often forget the psychological aspect of asset allocation. As you pointed out it is not always necessary to increase risk level. If an investor is conservative by nature a more risky portfolio will only be trouble down the road. Having said that, I think it is important to educate an investor and help them understand risk so that a more “appropriate” asset allocation can be determined. For example a 29 year old with a stable career, a sizable portfolio and long time horizon should not be investing 60% fixed income and 40% equities. The advisors job is to education him and develop a somewhat more appropriate asset allocation, keeping the psychological factors in mind.

  2. Where does valuations come into consideration. Would you recommend the same asset allocation for an individual in April of 2000 as you would in March of 2009. I hope not. Valuations need to be a consideration in asset allocation decisions. We may have different ideas about what valuation methods to use; but how can they not play a role in the decision?

  3. Ken,

    See here for my thoughts on using valuations.

    Alternatively, I think Matthew Amster-Burton did a great job with his recent piece at the Mint blog.

  4. Thanks very much, Mike.

    Ray, whether that’s an appropriate asset allocation for your hypothetical 29-year-old depends on his need to take risk. If it’s low, I’m not sure why 40/60 couldn’t be an appropriate allocation. Plenty of people have made it to retirement using very conservative allocations and saving aggressively. That’ll be harder in the future because today’s bond investors are unlikely to be helped along by the tailwind of falling interest rates–although, who knows?–but it can still be done.

    I’m speaking slightly from experience: I hold higher than my age in bonds, and most planners would probably call my portfolio too conservative. But I’m comfortable with it and believe I have a realistic view of its expected return. I live well, save a lot, and don’t enjoy taking unnecessary risk.

  5. The most important predictor of asset accumulation in the first decade is the contributions that are made. Beginning investors just don’t have enough money at stake for the allocation to matter nearly as much as the behavior. A plan you can stick to is much better than an “optimal” plan that you can’t.

    When you’re 29 it pretty much doesn’t matter what your allocation is. It matters that you’re saving.

  6. Mike,

    I love this post and completely agree. For a lot of years as a self-directed investor, I was trying to learn how to “steel myself” from concern about my portfolio. Now I’ve come to believe that there are two things that make for a great investment. The first is the classic: that the value of the investment rises. The second: that you can sleep well while you own it.

    Our risk tolerance definitely changes over time, there are literally hundreds of variables that can affect it, and we each give a unique weight to those factors…when we want to retire, when we need to send our kids to college, how secure our job is, etc.

    I’m sold that keeping your portfolio aligned with your tolerance for risk and beliefs about the future is the way to go. The “buy and ignore” era is over.

    Aaron

  7. Thanks for another interesting post Mike and to everyone who responds with comments and personal thoughts.

    Mike answered my AA questions in a prior post and really helped me settle my anxiety and fear of investing. i was 40 yrs old and yet not comfortable with investing in the market at my ‘supposed’ AA (60/40).

    By simply adjusting my allocation to 50/50 and understanding I am a long term investor I have been able to sleep peacefully at night and not worry about market volatility or alternatively worry about not being invested.

    As mentioned above our risk tolerances are affected by many things and may change over time as these factors change. I am a consultant with uncertain income hence my slightly conservative approach. Should I secure a long term contract or steady income, I would like to increase my exposure to equities.

  8. I sort of did a double-take when I read this post Mike! 😉

    Isn’t so much of what we do about demystifying the challenges / risks of investment, so that people can position themselves more appropriately?

    But then I thought a bit more — and you’re right, I can’t think of very many people at all whose risk appetite has changed since I’ve known about their finances.

    Those who were happy with a big slug of equities were pretty happy from the get-go, and those who said “I want no risk” still send me links every time a 3% fall in the market makes the front page of the mainstream newspapers to justify their stance, even after I’ve explained multiple times that shares go up and down short term, and you pay that price for hopefully better long term returns.

    So you may be right. Bit depressing!

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